Operational Restructuring — Why a Successful Turnaround Relies on More than Cash-Flow
The founders of Alderney Advisors discuss the underlying causes of financial distress, barriers to successful turnarounds and why advisors seeking viable restructurings cannot stop at the balance sheet.
Most practitioners, whether financial or legal, would agree the purpose of any bankruptcy or other restructuring process is to get a viable business back on its feet, not to recapitalize a business with little or no hope of forward viability. But with the prevalence of recidivism (namely, Chapter 22 and Chapter 33 filings), is this purpose being met?
A review of the literature suggests about a third of public filings are followed by another filing; not a comfortable statistic. On the other hand, who is in place to ensure a plan is actually viable; is it reasonable to conclude a court is an effective arbiter of plan viability? Or, as a practical matter, does one have to look to the constituents and their professionals?
What causes the recidivism that is too prevalent in the bankruptcy and restructuring process? Are entities not shedding enough debt to succeed, or are the operational issues that got the entity in trouble in the first place not sufficiently addressed in the plans? Or both?
Another hard question is whether management and the constituents of troubled entities are able to get past the natural tendency to believe their entity is viable, whether it is or is not. Do too many in positions of responsibility view a company as a biological entity whose life should be preserved at almost any cost?
In answering these questions, one first has to examine why entities get into trouble in the first place. In our practice, we have observed any number of underlying causes of financial distress.
Heavy Debt Load
One issue that comes and goes as a primary cause of stress is the ability of entities to incur more debt than can be serviced. In today’s environment of quick returns and quarterly measurements, how surprising is it that managers and owners would maximize, instead of optimize, their debt? Before the financial crisis, we spent many hours with clients explaining that refinancings should not get done, but likely would, and the entities would most likely require further attention in the future. Unfortunately, most of these entities did in fact get into trouble again due to their debt loads. The answer is, when shedding debt, go big.
Even if credit market conditions are not frothy, any entity has a limited amount of liquidity, and nearly any organization will trade some (or all) of its liquidity for time to develop what it considers its own restructuring plan. So organizations often arrive at the end of the liquidity road with a single plan to go forward, without the necessary constituents lined-up to support and execute the plan. The answer is, when developing a plan, go fast and get broad support.
Shifting microeconomics at the firm level (often seen as reduced demand conditions, but generally accompanied by reduced pricing) often destabilizes entities. Those of us that witnessed the burn-down in the environmental industry years ago, or, more recently, in many segments of the “new energy” industries, know that just because something is desirable does not mean it is viable. In much of the United States, it makes no sense to generate electricity with solar when natural gas trades at less than $5 MBTUs. But the picture was different when natural gas traded at $8 MBTU and was thought to be headed for $15 MBTU. The answer is, when evaluating a plan, ask if this can even work in a just slightly different world, or the world we likely will have to live in.
High Cost Structures
Finally, chronically high cost structures, whether relative to foreign or other domestic competition or disruptive technologies, can be fatal to any plan. For years we observed automotive suppliers with some element of their cost structure out of kilter versus the best in class; the customer will not pay for inefficiencies. Any of a number of other prominent restructurings in recent years have met similar fates; if one could not get labor costs down through negotiation, the industry will get them down via liquidation. Good for the industry, not so good for the employees. The answer is, when evaluating a plan, look outward and not just inward; it does not help to be as efficient as one can if in so doing you still are not as low-cost as the next best alternative.
We know from the literature there is too much recidivism — why companies get into trouble in the first place — and what corrective action is required to avoid recidivism. Why can’t we get from here to there?
Certainly, the need to reduce debt and forward legacy costs is front and center in any restructuring. But if business and operational problems led to the unsustainable debt in the first place, is it even possible that a balance sheet restructuring alone can address the problem? And since the changes to the bankruptcy code in 2005, is it reasonable to believe in most cases there are time, resources and energy to deal with the operational issues in bankruptcy? Or, as a practical matter, are there more or fewer institutional barriers to an operational restructuring, and what are those barriers in the real world?
One practical institutional barrier is the oft-cited statement by many advisors that they are industry agnostic; cash-flow is cash-flow. But if the only thing the advisors understand is the cash-flow, who is ensuring the emergent entity is viable, and can you really judge a restructuring by its “expected” cash-flow?
A second barrier to a true restructuring is operational restructuring, which often takes longer than a financial restructuring, and involves still more and different constituents. It is one thing to work on an engagement with the counsel, advisors and even executive leaders, who are used to the process, but it is another level of complexity to involve various sales and operational executives, who are more comfortable with the customer or on the plant floor than in the board room.
The need for operational restructuring is also less measurable. While debt ratios exist for many industries and can be associated with all the various credit ratings, judging operations and the efficacy of an operating plan, and getting real comparisons in place against other industry participants, are a real chore. It is rare that any two entities are actually alike. Therefore, judgments have to be made that simply cannot be reduced to mathematical proofs.
Finally, management generally likes things the way they are. An operational restructuring that is difficult to measure makes it difficult to criticize, second guess and judge not viable. Operational restructurings open up a Pandora’s Box — one that those involved in continuing the operation would prefer to keep under their lock and key.
Preserving an Entity’s Viability
Operational Restructurings are often a necessary condition to an entity’s viability. Another Alderney Advisors founder, who worked with the City of Detroit in its restructuring efforts, concluded that just fixing the city’s balance sheet will not solve the problem. The machinery of government is broken, most of the neighborhoods are in a horrendous state and the cash-flow is challenged. Money alone will not solve Detroit’s problems.
Our firm also recently completed a receivership in a new-era company. We were able to assist in the sale of the entity to a new owner, but the business plan of the new owner is nothing like that of the prior ownership. The footprint is smaller, the business is more focused, the investment is smaller from most dimensions and the use of technology is greatly accentuated. It is just a different go-forward business.
All of the Alderney Advisors founders spent years in the restructuring of the automotive supply industry. We have all dealt with many suppliers that simply could not obtain the consistent volume and cost structure necessary to maintain viability. Many of those suppliers were sold in §363 sales processes and successor suppliers often found that a true operational turnaround took twice as long and cost twice as much than originally thought.
Solutions That Work
We earlier discussed the environmental and solar industries. The firms in those industries were subjected to microeconomic changes that forced wholesale changes to business plans, but many companies in those industries simply no longer fit. If the wrong bets were placed when the solar industry was developing, recovery years later no longer was a choice. Some chemistries in the solar industry were viable; others simply were not. And even the federal government could not give enough money away to change the tide.
Similar conditions existed in much of the media industry. There were a few newspapers spared the drama that swept the industry. Though some readers still get their physical newspaper every day, many others do not. Few opportunities for cost reduction remain. Even greater change hit the digital recording industry, the imaging industry and bookstores. Just addressing debt problems in those industries would do little to make anything that was left viable.
If one wants a truly viable plan, one cannot stop at the balance sheet and reject a few obviously poor contracts. Courts and advisors must search for solutions that might actually work. Just erasing debt and bad contracts simply will not cut it most of the time.
Kriss Andrews, Alicia Masse and Greg Coppola are the founders and managing directors of Alderney Advisors, LLC, based in Southfield, MI. Alderney is a business advisory firm providing uniquely valuable expertise in the areas of management consulting, supply risk management, interim management, and related areas. For 15 years prior, Andrews, Masse and Coppola worked together in other capacities, driving financial and organizational restructuring, divestitures, M&A and risk mitigation.