Former New York Yankees star Yogi Berra famously said, “When you come to a fork in the road, take it!” This seemingly unhelpful advice appears to signify uncertainty about the future, which could be applied to the current climate for turnaround management.
While turnaround activity abounds in the energy and retail industries, (RadioShack has just filed Chapter 22 after filing Chapter 11 twice in recent years), in nearly all other industries, the future is far from clear for turnaround professionals. Several factors contribute to this uncertainty, with the new administration unpredictably delivering announcements regarding intended policies and legislation on a daily basis, each of which creates risk for the future. There’s a great deal of uncertainty regarding how turnaround activity will develop in the coming year, if at all.
Ironically, uncertainty has historically been a good thing for turnaround professionals. Anything that appears to increase risk — especially in the hearts and minds of bank lenders — has traditionally led to phones ringing for turnaround firms. In the current situation, however, it is far from clear whether the type of uncertainty we’re experiencing will result in greater or fewer opportunities. Let’s start with the factors which may favor an increase in turnaround activity.
Impact of Interest Rates Hikes
Interest rates are the most often cited. After many months (years, in fact) of Delphic murmurings about the end of quantitative easing and the tightening of slackness in employment, in March the venerable Federal Reserve finally budged off its indiscernible post-downturn interest rates by a whopping 25 basis points, with glum susurrations about further increases in the year to come. While increases in interest rates have been the textbook cause of companies being pushed into loan default and distress, it’s hard to imagine that interest rate increases this small will cause too great an effect.
Disruption in international trade seems likely, given the administration’s almost daily (digitally-communicated and otherwise) attacks against our erstwhile foreign friends and trading partners: China, Mexico, the EU, our NATO allies, even our inoffensive neighbor Canada. The process of globalization has been strong, steady and pervasive over the past decades, with almost every industry now inexorably connected to foreign suppliers and/or customers. The threat of interrupting that progression, even if it turns out to be political bluster and is never realized, already has companies scrambling for alternative sources of supply and outlets for their products. I can almost hear the questions posed in lender credit meetings,
“What happens if Company X can no longer import its supplies from Country A or export to Country B or receive shipments from their own plants in Country C?”
Another administration-driven effect might be its planned changes in immigration policy. Whether you favor or oppose these actions, it’s undisputed that some industries like agriculture and food services depend heavily upon undocumented immigrants for labor. If those populations become unavailable, these industries will doubtlessly suffer cost increases, which they may or may not be able to pass along in pricing. Such disruption could create turnaround opportunities, although agriculture has not typically been an active area for turnaround professionals.
Finally, the general feel of riskiness brought on by the new administration and its seemingly intentional unpredictability could conceivably leach into companies’ willingness to invest and expand, as well as lenders’ willingness to be expansive, notwithstanding low interest rates and a surplus of lendable funds, resulting in a general economic malaise. The stock market clearly disagrees with this possibility.
There are several additional factors, which tend to oppose an increase in turnaround activity:
Good Economy, Poor Turnaround Outlook
If the status quo remains, the low level of turnarounds will continue, with exceptions in industries that experience adverse conditions specific to them. Interest rates have been so low for so long, and there has been so much money chasing so few deals, that companies suffering a hiccup can typically finance their way out of it or easily find a buyer that can find financing.
If the economy grows stronger, it would likely improve company performance and further reduce the likelihood or need for turnarounds. The current administration has pledged to reduce taxes and regulation, along with other business-friendly changes, with draft bills and budgets already drawing comments from both sides of the political aisle. It seems likely that at least some of these changes will take effect, and the stock market clearly appears to agree, given the run-up in the indexes since the election.Since the economic downturn, lenders have a much-diminished appetite for seeing a company through a long turnaround process. The growth in credit funds, which purchase loan portfolios and even one-off loans, has mushroomed, giving lenders a ready alternative to monetize their position, often at a price that exceeds the written-down book value of an underperforming loan.
Bankruptcy reorganization previously regarded as well-understood, fair, and reasonably reliable and predictable, is no longer the alternative preferred by lenders. Often, bankruptcy is regarded as too expensive and time-consuming, especially when unregulated funds are lined up at the lender’s door bidding to buy these loans for cash. Given the regulatory requirement to write down loans steeply early in the process, the alternative to sell loans at the first sign of trouble seems irresistible compared to going through a long and painful turnaround.
Credit Funds Buy Loans
I refer to this process as regulatory arbitrage — the way regulators (or excessive anticipation of regulators) cause lenders to mark down loans more steeply than might be necessary, taking into account liquidation value and especially potential sale value to a credit fund. The result is credit funds can often buy loans that still have “meat on the bone” in the sense that the fund could liquidate the borrower immediately and possibly make money. Of course, most credit funds buy loans at a steep discount, look to recover as much of the par loan amount as possible and can wait to do so.
Might those buyers of loans still need turnaround assistance, inasmuch as the sale of the loan did not improve the borrower’s performance? Unlike the regulated banks of yesteryear, privately owned funds have typically not engaged turnaround professionals as a common practice. Being unregulated, they are under no pressure to do anything and can even lend more money if desired. Unlike regulated banks, which are loathe to exert anything that looks like “control” over a borrower since it could lead to lender liability lawsuits and equitable subordination, the unregulated funds have little concept of reputational risk. They likely view potential litigation by a borrower or other creditors as laughable and possibly even a good thing — it might build the tough “street cred” of the fund.
In contrast to banks, credit funds can participate directly by helping the borrower improve its performance. They also can look at possibilities for acquiring or divesting operations, which is not part of the bank’s toolkit. If necessary, the fund can “take the keys” and treat the borrower the way a private equity fund looks at a portfolio company, rather than deal with regulators regarding a noncash asset as banks are forced to do.
It’s always possible that, even with the air brakes created by Dodd-Frank and other regulatory schemes, there could be another serious downturn. With the Great Recession having officially ended in mid-2009 with a cessation in GNP decline, we are already in a historically long, painfully slow recovery.
However, the economy is cyclical and another downturn is coming; no one knows when it will occur and how deep it will be. When — not if — that happens, there will be many turnarounds, but the question will remain. Will banks call in turnaround professionals as they used to do or just sell the underperforming loans and let the borrower be someone else’s problem? Recent trends suggest the latter, but, like everything else, time will tell.
As Yogi Berra said, “You can observe a lot by just watching.”