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Turnaround and Recovery in 2008

SOURCE: Corporate UK magazine May 2008 Issue.

Edited for the purpose of this page by Nicholas Broughton (Director Fortuna Search & Selection) 'As a firm we are increasingly seeing more activity in this area and i believe the article below gives some insights into why'

 

With leaner times on the horizon for the UK economy, many professionals in the turnaround and restructuring marketplace are preparing for a busy 12 months. Daniel Wilkins spoke to a number of professionals from the industry about the prospects for turning around businesses in the aftermath of the credit crunch.

It has been 15 years since the end of the last major economic depression in the UK, and the domestic turnaround market has changed a great deal. The availability of finance for restructurings has been good for many years. While fundamentally a positive force, this has had some negative impacts on the way in which the management teams of distressed businesses view their prospects.

Now that all the major banks have reported their write-downs from the collapse of the US sub-prime market, there is a sense that a line has been drawn from which lenders can move forward.

Added to this is the fact that UK lenders have become more receptive to the idea of assisting in corporate recovery, rather than adopting a more uncompromising stance. With this has come a general evolution in the mindsets of management teams, who are far more likely in today’s environment to ask for help when a business goes into a decline curve, rather than crossing their fingers and burying their heads in the sand.

However, the ostrich mentality has not evaporated altogether. There is still a real need to raise awareness of the crucial time pressures that come into play when dealing with an ailing business. The insolvency practitioner’s mantra continues to ring true: the sooner you seek advice, the better your chances of survival.

Increasing workflow

Matthew Quade of PKF explained that, while many are predicting an upturn in figures in the coming year, his workflow has already increased. “The pick up in work really started in November of last year,” he said. “We were certainly very busy before Christmas. At that stage, we were dealing with a number of things that required a substantial element of refinancing. Obviously that has been slightly more difficult to come by so far in 2008.

“It has continued to get busier since New Year and I think that will last for quite a while yet. The difficulty now is that many businesses are simply coming to us too late. The reality is that a lot of them are not in a position to consider a turnaround because they simply do not have enough time.”

As is often the case, the retail sector currently appears to be playing the role of the canary. The budget segment has been the first to see an increased level of distress, and recent months have seen a number of budget retailers falling down, bookseller The Works among them.

 

This view correlates with statistics released by The Insolvency Service at the end of last month, which appear to be cause for concern. Receiverships rose to 273 in Q1 of 2008 – the highest level since 2003 – 85.7% higher than the previous period and 145.9% higher than a year ago.

Too easy

The availability of debt for restructurings in recent years, while assisting several companies to recover, has not been entirely positive. As Matthew Quade explained, the bounty of financing products available led to a certain short-termism among some company directors and management teams.

“The effects of the availability have been twofold,” Mr Quade said. “The first impact is that directors have just assumed that they will be able to get money from somewhere if they run into trouble. Many of the businesses we are advising are already talking to a number of potential investors, thinking that something would fall into place. What they often don’t realise is that those investors are now themselves struggling to raise the funds required to make any investment.”

The other issue is that where refinancings have been carried out in recent years, often they have not involved a focus on changing the operational failings of the business, effectively providing just a short term solution for more deeply rooted problems. “People did not try to address the underlying causes of the refinancing requirement,” Mr Quade said. “There are always operational issues in the business that need to be addressed as well, but they weren’t being addressed because it was just too easy to get hold of the money.”

The challenge for turnaround professionals in recent years has been impressing upon those business that do ask for help that a new slug of debt will not be enough to significantly change the fortunes of a business in the long term. While an essential element of any successful turnaround, a refinancing is intended to buy the company time in order for them to make the sometimes drastic operational and directorial changes that may be required.

New tactics

However, as the money dries up slightly there may be a positive move back towards the holistic approach favoured by professionals. This is being driven in large part by the shift in approach on the part of the major lenders, not just in the last 12 months but more steadily, over the past decade.

The slash and burn policies that many lenders practiced in the early 1990s are long gone, as the major banks have seen opportunities in distressed debt. This development has driven the banks to create specific departments for dealing with customers in distress, which pay close attention to the warning signs.

John Drinkwater said: “The banks are not so inclined to follow a scorched earth policy now. They have been far more accommodating. For those entities that have breached covenants, they have been prepared to look at the innate value of the business. If it is likely to heal itself they are far more likely to be supportive.”

The other aspect of the more long term view taken by banks is a reluctance to apply quick fix financing solutions, as Graham Barber of KBC Business Capital explained. “Lenders increasingly refuse to put a sticking plaster on a wound anymore. Instead they want to address the cause of the wound and try to prevent it happening again. We look at the validity of the management, the strengths and weaknesses of individuals and whether they have a real vision of why the business is failing.”

The other concern for banks now is the end of the relationship at some point in the future. “Because of the lending squeeze, our exit is far less likely to be just a refinancing by another lender,” Mr Barber said. “We have to plan our exit strategy even more carefully now, because there are far fewer chances of selling the deal off to another lender.”

The lending squeeze has certainly affected the availability of finance for healthy M&A. However, John Drinkwater did not express any major concerns about the ongoing ability to find funding for restructurings. “We will still get an appropriate amount of debt for transactions,” he said. “Small to medium sized private equity deals so far has not really reflected what we have seen in the mid-cap and listed companies.”

Developments in the ABL market

Perhaps the most marked change in the last 15 years has been the dramatic increase in the application and acceptance of asset based lending, not just within the turnaround market but in M&A in general. The ABL community has proved itself to be almost relentlessly innovative in its provision of products to the marketplace. There are now more options for distressed debt than ever before and improvements to existing products are being made all the time.

Paul Hooper of KBC Business Capital pointed to finance secured against intellectual property as the newest development in the marketplace. “The next logical step for us is financing against brands,” he said. “Of course it has to be the right kind of brand, but we are certainly expecting that area to develop in the next few years. That will take time, and it won’t involve large sums of money to start off with, but it is certainly a direction in which a lot of lenders are moving in now.”

The challenge faced by the development of this trend appears to be access to good valuing services for intangible assets. While it is easy to find a firm that can value plant, property and other typical subjects of ABL, placing a quantitative cash value on a piece of goodwill is far more difficult.

However, Paul Hooper expects this to be overcome soon. “There are players in the marketplace here who can value assets of that nature,” he said. “It is certainly not as easy as finding someone who can value a property, but I suspect that the expertise will grow up alongside the lending products, as we have seen in the past.”

Cultural shift

UK business culture in general has always been counter intuitive to the turnaround ethic to a certain extent. Admitting a failure and asking for help is not something that comes naturally to businesses in the UK, and the ostrich mentality that has contributed to the downfall of many a business remains a problem.

There is also a stigma attached to failure in a way that is not seen to the same extent in the USA, where the concept of corporate rescue was first developed. While this may be changing, bankruptcy and insolvency are still not looked upon as favourably as they are in the USA, where a previous business failure is almost seen as a badge of honour.

“The culture has changed a little bit,” Graham Barber said. “We are not in the position that the Americans are in just yet. We would not look at someone that had gone bust before and walk away from the transaction on those grounds. We tend to look more closely at why they went bust last time and work out how to avoid it happening again.

“We would certainly not reject someone on the grounds that they had failed before. But we would still want to have a very frank discussion with them about what happened in the past. The culture is definitely improving and I think that the ABL community has been a big part of encouraging that change.”

So have we overcome the ostrich mentality? Bryan Green of Salans thinks not. “There is definitely still an ostrich mentality on the part of management teams,” he said. “But because the financial institutions have become more sophisticated in the monitoring of their loans, they see a lot earlier the financial problems of a business.

“I don’t think that the enterprise culture that the government envisaged with the new Enterprise Act actually achieved its objectives,” he continued. “The Act effectively just provides for receivership under a different guise. There is a much greater complexity of funding of companies. As such there is an increased willingness now for many stakeholders to participate in a restructuring, where previously it was just the clearing banks relying on security, who also lead the restructuring.”

Philip Long of PKF agreed that more needs to be done to raise awareness of the potential for turnaround among company directors and management teams. “There is still a need to publicise services,” he said. “In the owner-managed business sector there are certainly things that can be done, provided you can convince the stakeholders to face up to the operational issues that need attention.”

Legal challenges

The increasing instance of more sophisticated structures in acquisitions has created a layer of legal complexity that may be detrimental to the ongoing fortunes of businesses going through a recovery. Bryan Green explained: “On the more complex leveraged deals, there are already conflicts arising between the different levels of lending.

“We expect to see a growing occurrence of conflict between the bond holders, the mezzanine lenders, the secured lenders etc, when there are defaults on loans. The big problem is that a lot of these structures were put in place in a period of optimism. This can cause real problems at the intercreditor level and agreements are being looked at very closely.”

This is likely to cause problems in situations in which a member of the lending syndicate does not agree with the methodology of a restructuring. The blocks that a lender can put up in such a scenario can be damaging, and there is currently a lack of a clear legal provision to overcome these obastacles