A Graphical Explanation Of The Financial Restructuring Process
April 19th, 2009
Troubled company restructurings are complex endeavors. To be successful, a company must fix both the challenges that caused the problem in the first place, and create revisions to the debt that accumulated from past transactions. Most companies are ill-equipped to address even one of these two problems without assistance from financial advisors experienced in such matters. While this article may be a useful starting point for understanding a financial restructuring process, no short article can expect to provide comprehensive advice … or perhaps any advice, other than to get more assistance.
The graphic that appears below describes the stages of performing a troubled company workout. This article discusses some of the key factors that should be addressed at each of these steps.
The graphic is perhaps misleading in one important way. Although the graphic describes a sequential process, success is more likely if the various adjacent steps are addressed simultaneously instead of sequentially. The troubled company usually needs options, and more options are better than few. Time is rarely the troubled company’s friend, so the ability to create additional options more quickly improves the chances for success.
As already noted, each of these steps needs to be done quickly, almost always more quickly than the existing management finds comfortable. In the typical situation where accurate information is in short supply, decisions are often made with incomplete information. This is where experience is invaluable, and how an expensive consultant is able to add value.
For every one of these steps, cash is king. No company with a relatively large hoard of cash ever filed bankruptcy. For a company in a liquidity crisis, all ideas should be evaluated based upon the idea’s impact on the cash account when compared to the cash impact of other options. A transaction that does not generate cash in the near term should not occur in a workout situation, regardless of either (i) the long-term benefit that is expected, or (ii) the impact on accrual-based earnings.
Management often believes that they can grow their way out of the problems that are already upon them. Hope runs eternal, and the next great idea is often thought to be the company’s savior. The problem is that most new products and ideas require up-front investment for development, plus additional working capital for inventory and receivables. The new product may indeed be great, but growth from the new product will almost never generate sufficient cash by itself, particularly in the short-term. For this reason, cash will almost always need to be generated from other painful steps in the following chart.
Here are some of the key factors that will assist in achieving success in each of the steps illustrated above:
Assessment of the company’s situation is a necessary first step before any long-term action is taken. The goal is to have an accurate picture of the most important factors that drive the business’s success or failure, regardless of how dismal the assessment is.
If the troubled company has good accounting records, this step can be done in just days. More realistically, most troubled companies have lousy records. Nevertheless, the assessment period should not take more than three weeks, simply because most troubled companies have little time before dire consequences occur.
During the assessment period, most efforts that are not generating additional cash will be delayed until after the initial assessment is complete. Most checks will be delayed. Exceptions include:
- A secured lender that clearly is in an over collateralized position
- COD requirements for orders that are clearly profitable to customers that are clearly credit-worthy
- Critical support functions that are on the verge of being cutoff for non-payment. Examples of critical support functions are utilities, phone, internet connection, key licensing agreements, and leases without which operations cannot continue. Most companies are surprised at how few items are really “must haves”.
At this initial step, and through each step, a detailed cash flow forecast is needed. Most companies are not used to this rigor, but the forecast is required to understand what further action is needed.
The company must have a clear understanding of what caused the existing problem(s). Beware of any explanation that asserts the problem(s) will disappear if there were just a little more money available to borrow. Additional financing (discussed below) may be part of the solution, but one must also have a clear understanding of the current operational and cash flow deterioration, and how these underlying challenges will change.
Reduction of headcount (payroll) is usually part of every restructuring. This is normally left to the outside consultant because existing management is unable or unwilling to make the necessary decisions. The starting point for these difficult decisions is an organization chart that shows (i) responsibilities of each person/group, and (ii) compensation. Sales personnel should usually be moved to a fully contingent (commission) compensation program, at least in the short-term.
An area where additional personnel cuts are not likely is the accounting staff, usually because this group has often already been decimated. We see many troubled companies, in the name of earlier cost-cutting, that have already eliminated the majority of the accounting function. The accountants are perceived as being “overhead”, and are sometimes viewed as naysayers about the CEO’s growth plans. Perhaps the existing accounting personnel are not well qualified and should be replaced, but sufficient resources need to be given to the accounting area. The accountants are required to provide information that will (i) allow the troubled company to monitor its affairs, (ii) provide credible answers to secured lenders, vendors, investors and others whose cooperation the company must have, and (iii) assist in developing and implementing plans that will preserve cash, sell assets, and perform other tasks required by the restricting plan.
It is preferable to make personnel reductions all at once. Meet with those who remain to explain what has just happened, the plan for solving the problem, and the role of the remaining people in the company’s future success.
Cost cutting gets prominent attention in most restructurings, but this need not be the emphasis. Instead, the emphasis should be improving operational effectiveness by solving the challenges that prevent profitability and liquidity. If solving these challenges involves cost-cutting, so be it, but this is not always the case.
Increase Net Asset Turnover; Sell Non-Operating Assets
Vendors who are owed money need to be explicitly classified based on their importance to future operations. This needs to be done to ensure that the limited cash resources are used to pay those creditors who enable the business to continue, and not simply those creditors with the most aggressive collections department.
Since your negotiating position with important sole-source vendors is poor, attempt to identify a secondary source of supply that will extend credit on terms more favorable than what the existing vendor is offering. Absent having a replacement vendor, suppliers who are (i) critical to future operations and (ii) owed amounts that are already seriously past due should be contacted. Explain that changes are underway with the assistance of restructuring experts. Provide payment commitments that are realistic. Do not make promises that you cannot keep. One of the big problems in many restructurings is the lack of cooperation from important vendors because management lacks credibility with payment promises. Once a payment commitment is made to a key vendor, the commitment must be met as a means of rebuilding trust and obtaining ongoing cooperation.
At the risk of being obvious, past due amounts from the company’s customers must be more aggressively collected. An otherwise great customer that is not paying its bills is not really a great customer.
Most businesses have assets that are not being used in, or are not critical to, current operations. Examples of such assets are (i) equipment that might be useful in the future but is not being actively used now, (ii) valuable assets that are infrequently used, and whose underlying purpose can be outsourced, and (iii) inventory with low turnover. Any such assets that can be converted to meaningful cash should be sold.
Sell Operating Assets or Divisions
Sometimes, prior growth or acquisition efforts generated too much debt. This requires an assessment of the cash returns that are earned by each business segment, compared to the value of that segment. Those businesses, product lines, or divisions that have no near-term realistic means of earning more than their cost of capital must be sold.
This requires valuation expertise. Preferably, the restructuring consultant you have employed has this capability as part of its available resources.
Debt and Capital Restructuring
In recent years, companies facing liquidity problems were sometimes able to borrow or refinance in a capital market that was flush with liquidity, and looking to earn additional yield. As has been widely reported, this is no longer the case.
Be careful with any lending consultant or lender who promises new money sources, but who also requires a substantial up-front, non-recoverable fee for their pre-funding efforts. Learn up-front the terms of these proposed new lenders. There is no magic (despite claims of “contacts”), and no lender generosity in the current market. The promised new loan (if it exists at all) will likely come with substantial new requirements and risks that you should understand before investing your hope and time.
No existing lender is going to engage in any restructuring transaction unless the borrower is improving on the lender’s current situation. Believing otherwise is simply naïve. Be realistic in terms of what you will be willing and able to offer a new or existing lender in a refinancing. For example:
- If the lender does not already have a collateralized position, a security interest will have to be given.
- Can existing or new investors contribute additional equity as part of a lender workout?
- If the owner’s personal guarantee has not already been given, such a guarantee will now likely be a requirement.
- If the loan agreement does not already have significant operating restrictions and events of default, these will be added as part of any new deal.
- If dealing with a nontraditional lender, expect to offer convertible equity positions that will usually give operational control to the new financing source unless strict benchmarks are met.
If you have nothing new to give in terms of the above, you will be left to offer your new business plan and related forecast. The plan will need to identify (i) what is being asked of the secured lender, and (ii) how whatever is being asked of the secured lender will improve the secured lender’s current situation. If existing management lacks sufficient credibility with the lender, a workout consultant may assist the borrower in asking for more time, a release of cash collateral, or other provisions that will provide necessary operating cash and/or freedom.
A debt-for-equity exchange is a difficult transaction that is most often accomplished only when the threat of bankruptcy is relatively close. Debt-for-equity swaps are done in a context where each claimant group is aware of their priority and recovery in a bankruptcy. Lenders will accept the swap only if it improves what they perceive will occur in a bankruptcy. In any substantial troubled debt swap, existing stockholders will be severely diluted or wiped out entirely. Similarly, the former debt holders (now stock holders) will generally gain corporate governance control.
Chapter 11 Bankruptcy
Only approximately a third of companies entering Chapter 11 are able to successfully reorganize. This approximate one-third of successful reorganizers includes companies that (i) have only isolated problems to address, and (ii) have already performed all of the above steps well. Despite the significant protections offered by Chapter 11, this dismal result is not terribly surprising. Most companies filing for Chapter 11 reorganization (i) have not performed the necessary steps already described, (ii) wait too long before seeking protection, and/or (iii) enter the bankruptcy with insufficient post-petition financing and cash reserves to perform a successful reorganization.
The complexity of a bankruptcy process is well beyond the scope of this article. There are times when a company benefits from having additional time that a bankruptcy proceeding provides, and/or bankruptcy protection is required to get an uncooperative creditor or contract holder (e.g., a union) to restructure obligations otherwise owed to them. A bankruptcy may also be required because the bankruptcy court can provide protections to lenders and acquirers that are not available in an out-of-court restructuring. Specifically, (i) a lender in a bankruptcy can receive a senior collateral position, and (ii) buyers purchasing assets can be protected from fraudulent conveyance allegations by obtaining bankruptcy court approval of the acquisition.
– – – –
It is quite difficult to perform these numerous steps on your own. An experienced workout consultant with good forensic accounting and business valuation skills is often a necessary ingredient for success.
Fulcrum performs bankruptcy and troubled company restructuring.