Offense or Defense? A Playbook For Lender-Owned Businesses

by Jay Jacquin
JAY
JACQUIN
Managing Partner
Configure Partners

Most lenders never want to be handed the keys to a borrower company, but in an instance in which a sponsor exits and leaves no other choice, the lender must make important decisions to minimize risk and maximize value.

Private credit lenders with a deep portfolio will inevitably have proverbial problem children — businesses with financial difficulties that cause a lender to have no other option but to assume ownership of the company. In such an instance, how should a lender think about next steps? Much like with a parent’s impact on a child, a lender’s actions will define the future of the business that a tapped-out sponsor foisted upon it. There are a series of questions, analyses and tasks that must accompany the likely unwanted ownership of the borrower by a lender, as well as a variety of pitfalls that can beset a lender once it has been forced to take ownership. The following piece will cover the lifespan of a lender-owned business with strategies for minimizing ongoing risk and maximizing value going forward.

IMMEDIATE STEPS TO CONSIDER AS LENDER-OWNER

When a sponsor tosses a lender the keys to a company, there are endless decisions to be made, but the first should be: What is the lender playing for? What is the lender’s objective? Of course, there’s always the option of selling the business — the traditional, go-to strategy of most banks. However, sometimes there is something redeeming or engaging in a business, creating a possible light at the end of the tunnel. If that is the case, there are two general approaches: defense or offense.

Playing defense means stabilizing and then pivoting to a sale of the business, usually within 12 to 24 months. The goal with this approach is to stop the company from bleeding cash and fortify it to the point it no longer needs additional capital. To reach said goal, a lender-owner needs to achieve stability of governance, strengthen the management team as needed, and oversee the tactical improvements needed to sustain and perhaps even improve cash flow. This improvement process does not need to be Herculean, but it needs to be able to be underwritten for the next owner.

The other option is to play offense, which entails investing, pivoting, growing and eventually exiting the company, typically over a longer hold period. In this instance, a lender-owner needs to perform the role of a private equity professional to reinvigorate the business while creating the opportunity to achieve a full recovery or even upside profit from a situation that may have not been ideal in the first place.

So, how do you decide whether to play offense or defense? While a lender may not always expect (or want) to take the helm of a company, it is important for those new owners to stay informed about their options and the assessments needed to shape the future of the business (and the outcome of the lender’s investment). Deciding on playing offense or defense can be influenced by multiple factors, including the depth of the team, the time remaining in the fund life, the capital available and the amount of lenders at play. Once a decision is made, there are many components to the beginning of a successful turnaround.

ASSESSING THE TEAM

The first step to determine an approach is to evaluate whether the right people are in the right seats. How deep is the bench around the lender, and is the lender’s organization set up to succeed in owning a business should it decide to play offense and strive to rebuild the company? Ideally, a lender’s team is made up of a robust network of people capable of identifying board members and bringing on operating partners and/or new C-suite executives, as well as subject matter experts in tax, legal, human resources and technology.

Once a lender has identified the capabilities of the lender bench, it is essential to analyze if the former borrower has proper leadership and governance. Evaluating the borrower’s management team is a vital starting point — after all, this is the team that likely oversaw the descent of the company’s health that resulted in it becoming lender-owned. Does the leadership have what it takes to address the company’s challenges, and if not, where are the gaps? Based on the assessment of management, the lender can evaluate what is needed from a governance standpoint, as managerial shortcomings can at least partially be ameliorated through board leadership. Speaking of, board members can and should be selected based on their strategic industry knowledge, operational execution experience and/or turnaround and cash conservation expertise. While that may sound like a tall order, these factors are crucial to deciding if the team helping to craft the future of the business has what it takes to fully play out the selected route.

CONSIDERING TIME & CAPITAL

After considering and addressing corporate and managerial leadership, lenders must next assess time horizon. Non-bank lenders often have fund structures that contain provisions sunsetting lending vehicles, which can put a natural time constraint on how long they can hold an investment. This can have a massive effect on a lender’s choice to play offense or defense.

Additionally, assessing the adopted company’s ongoing capital needs is crucial. Is there an amount of capital needed in order to stabilize operations so that cash flow is consistently generated into the future? On top of that, if the team decides to play offense, what is its willingness to invest, and how much capital is available to grow the business to an eventual exit?

TOO MANY COOKS IN THE KITCHEN

As complicated and thought-provoking as the questions and decisions earlier in this article may be, the process is easiest when the answers are controlled by one institution. However, there are often multiple lenders involved in a deal. This too-many-cooks-in-the-kitchen issue can quickly complicate the decision-making process and variables at play. In such an instance, multiple lenders have to align on an array of factors, including timing, willingness to invest capital, board and management composition, overall strategy and so forth.

HOW TO PLAY OFFENSE

If you decide to embark on the journey of a successful rebound or turnaround, what are the components, and how do you move forward?

Because lenders are focused on receiving interest and principal payments, they often elect to leave a company’s old capital structure in place. However, this can drain the company’s cash flow and lead to a tired, under-invested business losing market share and suffering lower margins in the future. By realistically resetting the capital structure based on current debt capacity, a business can pay its lenders a sustainable and appropriate amount of interest while maintaining adequate cash flow to refresh the business and inspire the management team/workforce to achieve some wins.

Next, the lender must make decisions about the team. While the lender should already have assessed this part of the business, finding the “right people” is essential. Often, the most important players in these situations will be agents of change who are unafraid to break up the current system, challenge strategic direction and shake the dust off the business. With such a team, a value creation plan must come into shape. By choosing to play offense, that plan must include considerations such as capital expenditures with a focus on return on investment, the addition of new production lines, sales improvements, system enhancements and even new markets. And, of course, the lender should always keep one eye on the exit plan. •

Jay Jacquin has more than 25 years of investment banking and advisory experience. Prior to co-founding Configure Partners, he established the middle-market special situations practice at Guggenheim Securities. Before joining Guggenheim, he was a senior member of the recapitalization and restructuring group at Morgan Joseph TriArtisan for approximately five years. He also has previous experience at Alvarez & Marsal and Houlihan Lokey.