September/October 2016

An M&A Advisor’s Perspective: Eight Common Mistakes Companies Make During a Turnaround

Turning around and/or selling the assets of a distressed company is filled with pitfalls. Ken Mann points out eight common mistakes that occur during the turnaround process. Avoiding these mistakes is tantamount to realizing a satisfactory recovery.



Ken Mann, Senior Managing Director, Heritage Equity Partners

Ken Mann, Senior Managing Director, Heritage Equity Partners

My partners and I have completed transactions for more than 500 financially distressed companies. Our repeated dealings with these creditors provide us a unique window into the decision making process, which, in turn, helps us avoid many of the common mistakes made by lenders in a turnaround situation. The absence of experience-based insight may preclude a lender from realizing a smooth process and quick recovery.

These eight common workout mistakes frequently occur in a turnaround situation.

Believing Every Offer Is a “Real” Offer

In many cases, by the time an M&A advisor arrives on the scene, a prospective buyer has already expressed verbal interest in a business or an asset at a certain price. Maybe a written letter of intent has been submitted at that price, but the deal hasn’t closed. Taking a bidder’s price as an indication of true value or believing that an offer will close are huge mistakes. Every deal that closes usually has about 50 interested prospects, and an indication of interest is light years away from closing.

The deal might not close because the buyer or its lender realized the price made no sense. If one lender isn’t willing to advance funds at a valuation because the deal did not have the necessary collateral value or cash flow, then it’s a safe bet that other lenders will not either.

While an offer that doesn’t close may not provide a real indication of true value, it might indicate that the collateral’s worth does not match that valuation. In any case, serious buyers with real offers usually:

  • Provide a logical and compelling reason for their
    interest
  • Perform due diligence, including on-site visits
  • Hire an attorney and/or other professionals
  • Establish genuine interest with a deposit

Until then, a proposed value should not influence decisions. Similarly, just because a borrower says assets are worth a certain price or “had an offer” for that amount does not make it so.

Foregoing a Process

Often a continuation of the first mistake, forgoing the process to save money because a bid is in hand, usually leads to asking an advisor for help a few months later when it may already be too late. All too often, skipping the formal process causes the sale to take more time, nets less money or results in no sale at all and leads to an eventual liquidation.

Prospective buyers often walk away 60 to 90 days after saying they are going to buy. They will often throw out big numbers to get attention, only to back off the initial purchase price simply because they can. To avoid starting all over again from ground zero, a way to keep bidders honest is necessary. Competition and deadlines are the best tools to achieve this. Nothing drives price up better than competition; experience shows that the price can often go up 50% or more by subjecting a stalking horse bid to a brief overbid process. Completing a process usually costs less because even if the price doesn’t go up, it prevents having to start over if one buyer falls through.

Lacking Influence on Bid Procedures

In an ideal situation, the borrower will have professional help and embark on a formal process to maximize value. A lender’s attorney will correctly warn against trying to affect the process. However, influencing the process is okay, particularly if the borrower asks the lender to do something it’s not obligated to do, such as fund an over-advance position or continue to lend post default. A lender should be comfortable that bid procedures, in or out of bankruptcy, are written to create certainty and finality. Welcome prospective bidders by removing terms that could chill the bidding.

In an auction among going concern bidders, for example, it is not a good idea to force bidders to place offers on assets they don’t want or demand over-the-top deposits. But be sure that bidders are required to make non-contingent offers, have put up reasonable good faith deposits, bid on a marked-up agreement (provided by the seller in advance) and shown they have the money to close. Also make sure the seller’s procedures call for approval of not only a successful bidder but also a backup that can quickly close if the first falls out of bed. Finally, make sure it is stipulated that the lender either is paid in full or has the right to veto any sale and/or credit bid at the final bid off.

Failing to Monitor the M&A Process

When the process starts moving, pay close attention. Is management really trying to close a deal or is it just appeasing the lender and buying time? Is it unnecessarily limiting access to information and visits? Is it really only interested in the particular solution or suitor that is best for its needs? Assuming the business is in the insolvency zone, the lender should expect transparency in the process, including regular updates, particularly if a lender is granting forbearance so that the borrower can have time to conduct an M&A process.

The borrowers’ advisor should provide the lender an unedited weekly status report of the M&A process, as well as brief, bi-weekly conference call updates to make sure everyone is on the same page. To avoid liability issues, the lender should not attempt to control the process, but watch it closely to be sure that it is leading to a maximum recovery. Lenders should chime in with suggestions if they see any gaps in the process because their experience, business savvy and relationships can be helpful. Furthermore, understanding the amount of interest the offering is generating, staying informed of any valuation discussions and assessing the cooperation level of the borrower should help supplement the lender’s ability to make informed decisions about funding.

Selling Paper Prematurely

Experienced distressed-company buyers sometimes try to avoid the competition of a genuine sale process by going directly to the secured creditor in an attempt to buy the lender’s note and thereby control the out-come. They can then foreclose and gain possession without being subjected to competition. While it often makes sense for a secured creditor to eliminate its risk and go with the “first loss is best loss” theory, there are times when it makes more sense to sit tight and see how your hand plays out. If you have a robust process going and can push the potential note buyer to bid in the process, you will likely have competitive bidding and receive a substantially higher price. If the process is underway and going well, you might as well play out your hand rather than fold for a smaller payout. Ask the M&A advisor if it is likely that there will be multiple bidders.

Decisions Driven By Self-Preservation

Lenders sometimes make bad decisions in an attempt to protect themselves personally. These actions are understandable and part of human nature, but they can be costly. Bad decisions can manifest in one of two ways. One way is by turning down potential deals out of fear.

According to the old saying, “nobody gets fired for saying ‘no.’” In other words, in some organizations, agreeing to a deal that offers less than full repayment can be more dangerous than just saying no, even when it is in the organization’s best interest to accept the offer. A special asset division should not foster a culture of fear and individual self-preservation. Instead, a workout officer and his or her supervisors should focus on questions such as, “What is the best recovery available? Can I reasonably expect to do better in a different way or at another time?” It doesn’t matter if the best recovery is less than expected. One thing matters: is it the best recovery available?

Sometimes, lenders simply say “no,” so the can is kicked down the road for a while. But saying “no” just to avoid having difficult conversations almost always leads to an even worse result later. Troubled deals are not like fine wine — they don’t get better with time. It is incumbent upon departmental leadership to create a safe environment for workout officers to speak the truth and seek what is best for the organization, without fear of losing their jobs.

Bad decisions can also be a result of relying too heavily on appraisals. Although a useful tool, appraisals are not a factual determinant of value; they are somebody’s opinion of value made with certain assumptions at a very specific moment in time. They are prone to error in several ways. First, comparable sales for commercial and industrial assets are often not easy to find. Income approaches rely on the survival of the underlying business. The industry or general economy changes, and collateral ages. For these reasons, smart lenders will reference an appraisal but recognize that a true market test, defined by somebody willing to write a check, is the most accurate illustration of true value. They weigh the quality of the sale process in their decision. Yet, even when they believe an offer is the best the market will bear, some lenders will reject it rather than tell their supervisors they accepted less than appraised value.

Making Bad Assumptions

A list of bad assumptions could be the subject of an entire article, but here are a few of the most common. Surprisingly, lenders often assume that personal property and real estate taxes are paid and current. Moreover, some aren’t sure if there are liens in front of their position or even what specific collateral is subject to their liens.

Another common misconception is that buyers must assume or pay trade payables to continue operating the business, which is almost never true. If secured creditors evaluate a purchase price using that perspective, then they will almost certainly miscalculate the benefit to them. Experienced workout officers view the purchase price with a firm understanding of their lien position and ask for clarification about whether other debts are being assumed, paid at closing or eliminated via settlement, foreclosure or some other mechanism. Of course, there are some circumstances when it makes sense to allow payment of certain subordinated debts because it is either critical to capturing the going concern value or gaining needed cooperation from a creditor body.

Evaluating Outcome Without Factoring Costs

Lenders, like sellers, can sometimes lock into a number they hear and then proceed to seek approval for that number, only to later find out the deal nets less. This can occur for many reasons, but these are the more obvious ones:

  • Delinquent ad valorem taxes, like property and personal property tax, that must be paid to transfer title
  • Mechanics’ and other special priority liens, such as PACA liens on produce inventory that can jump in front of a secured creditor
  • Certain pieces of equipment may have been financed by the manufacturer or a leasing company and are included in the purchase price but don’t generate proceeds to the lender
  • Employee obligations, WARN Act claims and other similar items
  • Escrowed dollars for potential environmental cleanup and/or delinquent taxes related to business asset sales with real property, which some states require
  • Necessary payouts to trade creditors, or in the case of bankruptcy, creditor committees that must be paid first for the court to approve the sale
  • Professional fees to brokers, investment bankers, auctioneers, attorneys and other related professionals

Bottom line, make sure you know the costs and net proceeds before presenting an offer for approval because it is hard to get people to backup once they lock into an expected payout.

No one pursues an exit intending to leave money on the table or have it drag out for months, but all too often, that is precisely what happens. This article addresses the most common mistakes that lenders make in workout situations. Becoming aware of the pitfalls and paying attention to the details will lead to a better process and maximized recovery — not to mention happier creditors.