The turnaround comeback

By common consent, the European and global economy is on the verge of recession, if not already tipped into it. According to which report you read, it is as bad as it was in 2000 to 2002 – in the wake of the bust – or as bad as in the early 1990s – following the stock market crisis of 1987 and the subsequent property crash. Or even, to take the most pessimistic approach, verging on the horror years of the 1939 Wall Street crash and the Great Depression.

For venture capital and private equity firms, the environment could provide just as many opportunities as threats, as company valuations fall and assets become both cheaper and, in some cases, distressed, with more demand for turnaround and restructuring skills.

Many experts and commentators agree that conditions are distinctly different this time around, bringing a sense of excitement, unpredictability, danger and promise to the corporate investment sector. While conditions have been remarkably benign for the past few years for private equity investors in particular, the credit crunch, sub-prime mortgage losses and downturn have thrown everything into the air once more.

One fundamental difference in today’s environment is the global nature of business, meaning that companies are no longer reliant on business conditions in one or two markets, but commonly trade in Europe, the US and the Far East, if not further afield. For the moment, conditions in the Far East have held up, with GDP growth predictions for India and China still in the high single digits or low teens. Profits from these emerging economies can help a company ride out difficulties elsewhere.

A wider geographical spread of investors brings its own sense of optimism. “It is a question of markets that are now active that were not there before,” says Ken Baird, head of restructuring at international law firm Freshfields. “In the 1990s, the Indian and Chinese were not competitors as investors, along with the Sovereign Wealth Funds. For example, Tata buying Jaguar is a deal that until recently would have been done by private equity. These buyers disappeared once the credit crunch happened, whereas it is a strategic investment for Tata.”

Baird sees the same pattern with Mittal Steel buying large assets around the world, providing liquidity for distressed companies that did not previously exist. “I can remember when there wasn’t a buyer for good assets,” he says. Today, even though prices for assets are falling, some private equity buyers are unable to raise debt at manageable levels.

And despite the newly enlarged spread of investors, the surprise spike in oil, food and commodity prices has changed the outlook of many market observers. “Until a few weeks ago I was more of an optimist,” says Baird, “but the fundamental issues with oil and commodity prices will lengthen and deepen the economic downturn. The aviation sector for example is unsustainable at current levels.”

Like several other experts, Baird stresses the difference between bad companies and over-leveraged companies that simply need a dose of financial restructuring to return them to health. As fellow lawyer Keith Bordell, head of corporate recovery at Travers Smith, points out, there has been some “fairly racy leverage” going on, along with a sustained period of expansion, meaning that few people have much experience of what happens in a recession.

Bordell distinguishes between the financial restructuring that needs to address the problems of gearing, and the operational restructuring to look at the underlying business. “I think we will see more opportunities for private equity to buy, for those who can spot the opportunities and think they can fix the problems: companies like Alchemy, Rutland and Kelso Place. And other houses may have opportunities to create synergies and bolt things on at attractive prices.” Large private equity firms such as Carlyle have already moved into the sector, creating a US$1.35bn fund to invest in distressed debt and corporate restructuring opportunities earlier this year.

The decline of insolvency

Today’s banking sector is more willing to work at turning companies around than in the past, according to Bordell. There is also more competition for distressed assets, as more people see opportunities rather than disaster, he says. “The trend is more towards turnaround than insolvency,” he says. “People are more familiar with Chapter 11, so rather than using insolvency to limit the downside, they are looking at the potential upside. Insolvency may be needed, if you have a complex structure and you can’t find a consensual solution, or as a means of amputation, but it’s just one of a series of tools.”

“In the 1990s, the default action of banks was to appoint receivers,” says Garry Wilson, who founded Endless, a specialist turnaround investment house, in 2005. “Now they are trying to find a way through, by looking to new investors or by putting in other managers. One of the key performance indicators for bankers is how many administrators or receivers they appoint, so it influences their job prospects.” The number of alternatives to receivership has increased, with the emergence of widespread asset-based lending and turnaround funds. “These didn’t exist at anywhere near the same scale before,” says Wilson. “They can see the opportunity to make money in these situations and they’re more prepared to be flexible.” In addition, the 2004 Enterprise Act made it significantly easier to rescue distressed companies, since it abolished a layer of preferential creditors (including Inland Revenue and Customs), recognising that this was a barrier to turning companies around.

This issue of the complexity of debt structures has emerged as another major shift in the turnaround environment, in contrast to previous cycles. Whereas in the 1980s and 1990s companies would borrow from banks and perhaps one other lender, today even smaller companies may have four or five layers of debt and large deals may be funded through a labyrinthine system of syndicated debt and subordinated lenders. “It’s harder to corral everyone into a more constructive solution,” says Bordell. “In previous cycles, banks were sitting on most of the credit,” says Håkan Johansson at EQT in Stockholm. “Today there is more syndicated debt and spread out financing, there are many more counterparties than before, who might sell their debt tomorrow. It takes more analysis to understand.”

“With equity-sponsored deals there are so many different creditors,” points out Sarah Coucher at DLA Piper. “It’s been so easy to lend money, but this has meant the transactions are more complex to untangle. You may have a very subordinated lender who has the leverage to stop a restructuring, so they have to be bought out. This may end up being too difficult for the banks, they may not have the time or the inclination and so may enforce the situation.”

Here again, the long period since the last proper recession has left banks and other lenders unprepared for the new realities. “People in their 20s and 30s have never experienced negative equity,” Coucher adds. “They’ve never seen a quarter of their friends being made redundant.”

Consequences of this unanticipated turn of events include hedge funds “retreating from the market” says Coucher, along with private equity houses buying back their own debt. “This is quite a new phenomenon,” she argues. “Banking documents don’t provide for it. There are some very large sponsors, such as KKR, who are buying back their debt at a discount, which means the banks are taking a hit. It also puts the private equity funds in a strong position.”

Capital overhang

Between 2003 and 2007 the word was circulating in the financial community of a “wall of money” sloshing around international markets, being put to use by private equity funds, hedge funds and investment banks. Although the past year has seen a sharply restricted credit environment, this “wall” has surely not vanished. For many investors, as long as they are solvent, it is simply a case of redirecting their strategy towards assets that are declining in value rather than rising, while hoping that they will rise in future.

For many, the markets have not yet dropped sufficiently to make it worth their while investing. At Alchemy Partners‘ Special Opportunities Fund, Ian Cash has a £300m fund ready to spend on distressed assets, but, he says: “We have yet to see the market really turn. There have been very few genuine opportunities so far in this cycle.” While recognising that property and retail are already in some trouble, Cash is biding his time. “Ultimately the downturn will pan out into all sectors,” he says. “Everything will be affected by sub-par growth.”

In contrast to some market commentators, Cash does not see the emergence of many new competitors for distressed assets. “The propensity for many lenders to put more money in is lower than people expect,” he says. “There is a lack of appetite or wherewithal to support businesses. Banks are so much weaker at this point in the cycle. Because of capital issues, they have very little risk capital, so they have a lower capacity to be patient and see things through. They’d like to, but they’re under-capitalised and I don’t think they’ll acquiesce in keeping the lights on. And the hedge funds have had their wings clipped, the banks have reduced the amount of leverage, so their capacity to fund investments is reduced.”

Equally, Cash does not envisage private equity sponsors putting more money into failing businesses, especially if they cannot get a guaranteed first secured lender status. He has noted large funds such as Blackstone set up credit opportunity funds to ‘take down stuck deals’, but thinks that company defaults will mean either single digit returns or complete losses. “I think there will be high teen percentages of defaults,” he predicts. Such a scenario is in itself discouraging to many investors, particularly those without restructuring or turnaround experience. “Most people walk away very quickly from distressed assets because they’re terrifying,” says Tony Groom at K2 Partners. “They’d rather put their money into gold or oil. In practice, investing in turnaround is too frightening for most people when they see they have to account for their losses.”

It all adds up to a potential bean feast for a company like Alchemy Special Opportunities, which has a business model specifically based on the prospect of defaults. “We buy in anticipation of default,” says Cash, almost bursting with pleasure at the prospect. “We’re being exceedingly patient and cautious,” he says. “This is a long-life, private equity-style fund, which will run through to 2012 or 2013. I think people still have a very benign attitude, but the outlook for special opportunities is much better than 12 months ago. The cycle will be prolonged and the price dislocation will be a lot deeper than people expect. We’re extremely excited.”

Shock and poor

Could it be that Cash’s forecasts are too good to be true, from his point of view, and too bad to be realistic, from a more general point of view? He certainly talks in almost apocalyptic terms about the coming crash, as though we have only seen the merest sliver of economic misfortune so far. “I think the level of write-off by private equity sponsors will be massive and shocking,” says Cash. “Particularly some of the bigger funds who’ve put enormous funds to work. If you look at the last 25 years, the percentage of capital invested by private equity in the last two years is huge.”

So what about the people whose business is to study turnaround patterns? Do they agree that we are in for a nourishing bloodbath? At the Turnaround Management Association, David Hole agrees that the banking crisis of confidence is a leading factor in today’s environment, alongside the consumer credit downturn, lack of liquidity and (a rarely spoken view) “poor leadership in government”, for example in its handling of the Northern Rock fiasco. He argues that the severity of the downturn will be influenced by how abruptly the banks act over the next six months. “If they change their credit criteria, and only deal with “good” customers in the next six months, it will give everybody a severe cold and cause an even more severe shock to property prices. I think they should take their time.”

Hole agrees that the complexity of lending arrangements has increased, making turnarounds more complex, but sees a leading role for members of his association, since they can advise lenders on the best way to improve their position under shareholder or credit agreements. “When you buy a distressed asset, you have to be pretty astute about where you end up. Lenders are all vying for position and sorting out the pecking order requires a lot of skill. These skills come from the restructuring profession rather than the insolvency profession.” In some cases, because there has been so little experience of recession and downturn, it may be up to the restructuring professional to educate the banker or lender in what the regulatory or legal position is, according to Hole.

Whether insolvency or restructuring becomes the modus operandi of the European business world in the coming months may depend on factors outside the control of business managers, banks, sponsors or other lenders: the whims of the market. Should oil prices continue to rocket, stock markets plummet or unemployment go through the roof, the best laid plans of restructuring experts may turn to dust. On the other hand, for so many reasons (globalisation, the efficiency of the internet age, the self-corrections of a market economy…) this downturn may be shallow enough to afford most businesses a soft landing and re-launch. By the law of averages, it’s likely to be worse than the crash but not as bad as the Great Depression. My money’s on an early 1990s-style experience, with John Major played by Gordon Brown.


A closer look

The distressed market is set to see a lot more acitivity in the coming months and years. Here are some examples of successful restructuring deals in the UK and Europe.

Europe has been mercifully free of major, large-scale restructurings for several years, with the exception of the long-running saga of Eurotunnel, which finally seems to have reached calmer waters after years of financial engineering. Of the current crop of prospects, property services group Erinaceous (meaning “like a hedgehog”) is held up for scrutiny, since the asset is clearly ripe for dismembering, but little has so far happened. “The bank lenders have decided to retain the core assets, because the market is too unstable, so they’re probably going to wait for a couple of years,” says Ken Baird at Freshfields law firm.

This plan clearly demonstrates that conditions are not as bad as they could become. Businesses are not being traded in fire sales because they have to be, but are being nurtured and kept on hold in anticipation of better days. “There’s nothing pushing companies over the edge,” says Tony Groom at K2 Partners.

At Swedish private equity company EQT, Håkan Johansson notes that conditions for turnarounds across Europe are improving. “We have six portfolio companies, all for ‘special situations’, but not all pure restructurings,” he says. One of the companies invested in is Strauss Innovation, a chain with more than 100 stores across Germany, selling home improvements and men’s and women’s apparel. EQT negotiated with a club of banks to put in fresh money to carry out restructuring, scaling down the chain’s activities and introducing a more “value for money” approach. “We find this interesting because budget shops will benefit in a recession,” says Johansson.

French quoted engine cooler manufacturer Valeo had operated across passenger cars, trucks and industrial plant, but EQT decided to sell the truck and industrial side and concentrate on the passenger cars business. “This was a restructuring based on the outlook in the automobile industry and the pressure on fuel prices and getting more fuel-efficient cars. It wasn’t a distressed situation, it was getting out of things which are not core to the business,” says Johansson. He notes that several Swedish banks are gearing up their work out departments in expectation of a wave of restructuring. “The downturn is different this time, in terms of industries,” he says. “Last time it was just e-commerce, but this time it’s broader, across more sectors.”

At Endless, Garry Wilson and his colleagues have completed three deals for distressed assets, despite what he calls a “disconnect” between what he’s prepared to pay and what vendors believe their businesses are worth. “We bought some underperforming Amco assets, including property, plastics and drilling bits, so that the company could concentrate on its core business,” says Wilson. Amco will now focus on its structural steel and engineering business, it announced in April this year. “It was a change in the company’s shareholder attitude,” says Wilson. They saw the credit crisis unfold and decided to dispose of non-core assets. Differing economic circumstances make you reassess your business model.”

Endless has also dipped its toe into retail investment, taking a stake in The Works, a chain of bargain bookstores across the UK. “It was suffering from lower consumer spending and went into administration,” says Wilson, who slimmed the operation down from 300 to 220 stores, removing those that were dragging down performance. He expects to see a number of retail chains end up in administration and investors come in to buy their debt and restructure them. The example of The Works goes to show that bargain retailers do not necessarily profit from a downturn.

Endless then invested in a third business, St Neots, a printing and packaging company. “This was an opportunistic buyout driven by tax deadlines,” he says. Endless was set up in 2005 to invest in distressed assets because Wilson didn’t think there were enough people around who understood the market. He had been frustrated in the 1990s by seeing companies that were fundamentally sound but which ran out of cash. He now draws a distinction between so-called “turnaround” specialists who invest in companies that are making £10m when they should be making £100m. “Whereas if you term it a loss-making business, not many people are prepared to go there.”

Wilson expects to make further investments in the UK, particularly in property-related companies and retail.