September/October 2018

Factors Driving Success in Middle-Market Restructuring

What goes up must come down, and David Johnson points out that the current strong economy will eventually turn downward. Urging lenders to be prepared for the next downturn, he offers practical ways to assess a restructuring plan.



David Johnson, Founder/Managing Partner, Abraxas Group

David Johnson, Founder/Managing Partner,
Abraxas Group

Middle-market lenders are never entirely without worry, but the benign economic conditions of the past nine years have certainly rewarded optimism. Outstanding commercial and industrial loans have experienced a peak to trough increase of nearly 104% while the rate of nonperforming loans has declined by 279 basis points.

In this environment, cultivating new business opportunities has crowded out thoughts of troubled loans for all but those in the trenches. Nevertheless, all credit cycles turn, and savvy lenders must consider how they will adjust in a scenario in which nonperforming loan rates return to the levels seen in prior recessions. Fortunately, an examination of the best practices for restructuring in the current market offer valuable lessons as concerns grow that a recession, regardless of the triggering event, may loom in the near- to mid-term. A restructuring, here defined as the reorganization of the capital structure of a company, is best thought of as a realignment of interests among a company’s capital providers and other stakeholders to allow for a turnaround to take place. The ultimate success or failure of a restructuring and subsequent turnaround can often be traced to the structure of the transaction. Factors such as the number and type of capital providers involved, outstanding debt and leadership team all have considerable impact on the ability of a company to successfully execute a turnaround. When the rush to finalize a restructuring transaction overwhelms the need to consider these factors, lenders find themselves backing companies that remain saddled with suboptimal capital structures, disgruntled stakeholders, inadequate liquidity and few good options.

The proper goal of any restructuring must be the close of the optimal transaction to best position the company and stakeholders for success or, failing that, for the least bad outcome. Whether evaluating a prepared restructuring plan or working in tandem with various parties to create one, lenders would be well served to keep in mind the key factors successful middle-market restructurings share and which many of the more ignominious failures lacked.

Extrapolating from the percentage of nonperforming loans in the prior three recessions, U.S. banks will likely see nonperforming C&I loans peak between $70 billion and $110 billion during the next recession.

Capital Provider Alignment

When addressing a distressed portfolio company, capital providers usually agree the status quo is untenable, but bridging from this point to a more substantive agreement on what a new status quo might look like often requires a herculean effort. The challenge most frequently comes down to a fundamental misreading of the risk tolerance of various parties. To craft a workable solution, all involved must appreciate the position and motivations of their counterparts, but, most importantly, the under-performing company must have a leadership team that understands the crosscurrents at work and keeps those factors foremost in their minds as they work with advisors to right-size the capital structure.

Rationalized Capital Structure

A restructuring transaction highlights the brutality of Occam’s Razor — all else being equal the simplest solution is usually correct. For a company unable to support its current debt load, Occam’s Razor would indicate the simplest solution is to maximize debt reduction. Unfortunately, this is often unworkable due to the conflicting risk tolerances of different lenders, efforts of equity owners to maintain a stake in the company and a preference by all involved to execute a transaction outside of bankruptcy. As a result, the tendency in middle-market restructuring situations is to modestly reduce debt while also backing a plan that will permit the troubled company to grow into its new capital structure.

Viable Turnaround Plan

The underlying assumption of most restructurings is that the under-performing company can be fixed. The plan to achieve this outcome deserves intense scrutiny, and lenders should be on the lookout for certain key components common in successful turnaround plans.

  • Bias for Action. A company that has undergone a restructuring has, in a very fundamental way, failed. A plan that assumes everything will go “back to normal” post-restructuring is almost certain to fail. At a minimum, the prior leadership team adopted a capital structure at odds with the endogenous and exogenous risk factors of the company. Recognizing this and seeking to do the hard work of reexamining old assumptions, making drastic changes in cost structure, reevaluating struggling divisions and unprofitable customers, and acting swiftly and decisively on those findings is necessary to ensure long-term success.
  • New Leadership. Value-maximizing turnaround plans combine aggressive goals with rigorous attention to detail, obsessive focus on the key drivers of success, a nuanced understanding of human nature and humility in the face of the unknown. Unfortunately, the specialized skillsets required to design and execute such a plan are in short supply in the leadership ranks of most middle-market companies. Successful turnaround teams do not rely exclusively on outsiders. Instead, they insert outsiders as catalysts — often in interim management positions — to help rebuild a leadership team and execute on a new plan.
  • Buy-in. Critical vendors, top employees and other key stakeholders do not have a voice in an out-of-court restructuring. Nevertheless, the support of these constituencies is crucial. A plan convincingly sold to capital providers must be distilled to its essence and appropriately communicated to key stakeholders. The communication cannot be a one-off. Each stakeholder constituency will require status updates as the turnaround takes shape.

When a turnaround plan possesses these key factors, the potential exists for rapid and sizeable increases in profitability, cash flow and enterprise value.

Benign markets lead to ugly downturns, and for middle-market lenders, the market has been benign for quite a while. Regardless of the timing of the next downturn, forward-thinking lenders of all risk tolerances must begin considering how they will approach the inevitable increase in restructuring situations across the middle market. Understanding the drivers of a successful restructuring will help lenders assess the strength or weakness of the restructuring proposals they and their staffs are likely to see in the coming years.