Basis for Selection: Choosing the Right Turnaround Advisor
Experienced lenders know that sooner or later, some portion of their portfolio will become financially distressed. The causes of distress range from the macro: (e.g. increased unemployment, declining demand, etc.) to the micro (e.g. poorly executed growth initiatives, loss of core customers, etc.). Regardless of the cause, when lenders see that they have a troubled company in their portfolio, they often agree that a turnaround advisor is needed. The key question lenders should ask themselves in these situations is: What turnaround advisor is right for the situation at hand?
The turnaround industry offers a diverse set of firms serving all areas of the market, and savvy lenders should seek to make use of this diversity by developing a network of trusted advisors to contact for their troubled companies. By seeking to better match turnaround firms with the turnaround situations they are best suited to, lenders will give their troubled portfolio companies the best chance of recovery while minimizing the costs (financial and otherwise) of a poor match between firm and opportunity.
The recession of 2008-2009 had many negative effects, but for the turnaround industry perhaps the worst was the spread of the “leveraged model” throughout many middle-market advisory firms. The leveraged model, which employs a large number of junior professionals managed by a smaller group of highly experienced professionals, is certainly appropriate for large turnaround and restructuring situations, but is of questionable utility in the middle market. Smaller troubled companies have less need for talented but inexperienced professionals being overseen (sometimes remotely) by a seasoned professional.
With a dual mandate to steer troubled companies to an optimal outcome while minimizing costs, lenders must be cognizant of the way those turnaround firms in their network approach the market. The market is broad enough to allow for multiple points of view, but lenders should seek to limit involvement with firms whose view of the market does not align with their own or their institutions.’ Lenders might consider the following when vetting turnaround firms:
- Approach to Staffing: Does the turnaround firm employ a leveraged model, and if so, why? The leveraged model has a tendency to lead to over-staffing, and over-staffed teams have a tendency to diffuse accountability and increase costs, which in a turnaround situation is a recipe for enterprise value destruction.
- Deliverables: Does the turnaround firm approach troubled situations with a view toward presenting stakeholders with interim findings and thereby allowing it to choose a less intensive course of action? Many lenders have retained turnaround firms seeking only an objective analysis of a situation, but have found themselves stuck with an over-staffed turnaround team unwilling to provide sufficient information to allow lenders and other stakeholders to make informed decisions absent the turnaround advisor.
- Fee Structure: How does the turnaround firm approach billing? Does it offer a flat fee for an initial assessment? If the assignment is long term or has a definable goal (e.g. stabilize company for a sale, etc.), is it willing to accept a flat monthly fee or take some portion of its overall billings as a success fee?
- Market Segmentation: Does the turnaround firm approach the market with a rational view of the segment(s) it targets? Too many firms, especially in the middle market, take an overly broad view of the areas they serve. Any firm claiming that it serves troubled companies from $25 million to $500 million in sales (or some other similarly broad swath of the market) should be challenged on the enormous differences in core competencies, management and staffing that this range implies.
Lenders in search of skilled advisors for their troubled companies will find a large number of turnaround advisory firms in the market. This large number of advisors should not be a source of comfort, however, but instead should be viewed as an opportunity to push for optimal alignment of advisors and situations. Turnaround situations come in all shapes and sizes, and lenders should seek to take advantage of this diversity to do away with a one-size-fits-all approach when it comes to selecting the right advisor.
Current Market Dynamics
The lending market has undeniably improved since the dark days of 2008-2009, but trouble remains for those active in the U.S. market. Credit risk transfer (CRT) options are primarily available for larger credits, with middle-market credits continuing to require more intensive workout solutions. The high level of debt refinancing that will be required in the coming years has the potential to strain the capacity of the capital markets to absorb the deluge. Commodity price increases are likely to compress margins across numerous industries. In short, the current market is fraught with challenges that will require lenders and turnaround advisors to work closely together.
Regardless of our place in the credit cycle, experienced lenders know that a certain level of distress in a portfolio is inevitable. For larger credits, the risk that lenders accept can be mitigated through due diligence prior to the decision to extend a loan, and through CRT strategies such as active use of the secondary loan market and/or the employment of credit default swap (CDS) contracts once the loan is made. Smaller credits offer fewer CRT opportunities, however, and as such higher levels of distress in the middle market should tend to involve an increased need for turnaround advisors (as the most cost-effective value preserving option).
The U.S. market will see considerable refinancing activity in the coming years (See Exhibit 1). The high volume of refinancing needed in each year through 2015 (a total of over $500 billion each year, with speculative debt over $120 billion each year) presents a considerable capital markets challenges in finding buyers for the debt. Regarding speculative debt in particular, the refinancing need through 2015 exceeds $1 trillion. For the markets to accept this level of refinancing volume, appetite for both investment grade and speculative credits will need to remain at a constantly elevated level for a number of years.
Commodities present another area of concern. Demand-driven price increases in a number of commodities are threatening to reshape the profitability picture for whole industries. Companies, especially those in the middle market, face considerable pressures if they are unable to pass along the impact of rise raw materials costs through price increases. As larger companies pursue vertical integration strategies or aggressive hedging techniques to blunt the impact of medium- to long-term demand-driven price shocks, there is a growing possibility that we could see a reordering of the fundamentals of some industries, with the minimum efficient scale, in particular, increasing significantly.
While the level of distress in the U.S. market has declined considerably, there remain a number of challenges that argue strongly for lenders to continue to devote time and effort to the development and maintenance of a robust network of turnaround advisors. Such advisors have the skills necessary to act quickly and efficiently to help companies manage through the challenges posed by broader macro forces or micro challenges.
The markets have given lenders some rest from the wrenching distress seen recently, but the respite may prove to be a short one. Overall level of distress in the U.S. has decreased substantially from the levels seen in 2008-2009, but this could prove to be the calm before a renewed storm (See Exhibit 2).
Commodity price increases are battering numerous industries, setting the stage for severe margin pressures in coming months. Substantial amounts of U.S. speculative debt will need to be refinanced each year through 2015, raising the prospect of a capital markets slowdown leading to a liquidity squeeze. Forward-thinking lenders should take advantage of current benign credit market conditions to rigorously assess the turnaround advisory firms they utilize and make whatever changes are necessary to ensure optimal service for their portfolio companies.
David Johnson is a partner with ACM Partners, a boutique advisory firm focused on distressed lower middle-market companies in the U.S. He can be reached at 312-505-7238 or david [at] acm-partners [dot] com.