In today’s deteriorating economic landscape, where public and private companies alike are being stripped of their once healthy valuations, there’s at least one group of investors that stands to benefit handsomely from their troubles: Turnaround buyout specialists.
Unlike leveraged buyout firms, who look for stable companies with healthy cash flow and experienced management teams, turnaround specialists hunt for underperforming companies with over-leveraged balance sheets and ailing management teams.
Given the current downturn, buyout pros who manage turnaround funds say their current deal flow is somewhere between “fabulous” and “spectacular.” Factors that have helped to turn the tides of deal flow in their favor include a large increase in the number of companies underperforming in their respective industries as well as an increase in the number of companies under siege by creditors and defaulting on their debt.
Oftentimes, the targets of turnaround buyout firms are the corporate orphans that are “underfed” and ignored by their parent companies, and in some cases on the brink of filing for Chapter 11 bankruptcy protection, sources say. In other cases, the targets are underperforming companies in another private equity firm’s portfolio.
Failed LBOs No More
One such firm that seeks to invest in failed LBOs of other private equity firms is Questor Management Co. Since 1995, the New York-based firm has specialized in turnaround and distressed investments of troubled companies in other firms’ portfolios. And in the current economic climate, the firm is seeing a lot of portfolio companies not meeting expectations, says Henry Drucker, a partner at Questor Management. “We see opportunities to partner in the investments of other financial buyers that may be a little over-leveraged and also need some turnaround expertise, where we can apply both our capital and our turnaround initiative,” Drucker adds. “You have a group of firms like Apollo Advisors and Oaktree Capital Management LLC that are buying debt of companies that are failed LBOs where the equity already has no value. We could do that, but we’re trying to buy whole companies, not just the debt. We want to get involved while there still is equity value – even though the company may be over-leveraged and requires turnaround initiatives – and where we can inject capital and right size the balance sheet while providing an opportunity for the other private equity firm as well as ourselves.”
Drucker points to Questor’s partnership with Thayer Capital in the turnaround of publicly-traded Aegis Communications Group as a prime example of the firm’s strategy. After watching Aegis’ share price drop from $3 to $1 in a year, Thayer Capital in August 1999 sought to bring in Questor to help resuscitate the operation. At the time, the industry was suffering from high employee turnover and the company had too much debt to be supported by the business, says Drucker. So Drucker and his deal team set out to replace five members of the management team and make a $50 million convertible preferred investment that was injected directly into the company to repay debt and provide availability for other strategic initiatives such as an Internet strategy.
Drucker notes that while Thayer Capital’s equity was diluted by Questor’s investment, Thayer maintained an equity ownership in the company and it thus became a win-win situation for both firms. “We knew we had solid potential because other companies in the same industry were performing far better,” Drucker says. “That’s really our motive, to try and fix companies within industries that otherwise offer great investment potential. We greatly improved the company as reflected in the public documents.” He declined to give further details.
“There is so much money chasing plain-vanilla deals that we don’t just want to get involved in a bid-them-up type of scenario,” says Michael Madden, a partner at Questor. “We’re trying to carve out a niche for ourselves and create a competitive advantage for ourselves because we’re doing things that nobody else can do.”
Madden adds that the firm is currently looking at deals in the health-care and electrical utility sectors but declined to give further details.
Righting Rite Aid
Although not a pure turnaround buyout shop, Los Angeles-based Leonard Green & Partners is another firm known for its turnaround plays. The firm’s most notable turnaround investment is its investment in Rite Aid. In October 1999, Leonard Green committed $300 million to revitalize the ailing drugstore chain. Rite Aid’s troubles began with its acquisition sprees of Thrifty Payless Holdings Inc. done by Leonard Green for $1.4 billion, which led to the assumption of $890 million in debt, and PCS Health Systems, a pharmacy benefits management company, for $1.5 billion, which the company could not finance on a permanent basis. The company’s other problems included allegations of financial mismanagement and subsequent class action lawsuits. At the time, Founding Partner Leonard Green said, “I believe…that issues arose from Rite Aid’s attempting to do too much too quickly, particularly in its fast-paced acquisition program…”
Leonard Green stepped in and began implementing executive changes as well as hiring Deloitte & Touche and law firm Swidler, Berlin, Shereff, Friedman LLP to right size its financial matters. Changes came slowly but surely for the company. Last May, the company announced that all of the lenders in its existing $1.3 billion and $1 billion syndicated credit facilities, led by J.P. Morgan Chase & Co., agreed to extend the maturity of its credit facilities to August 2002. More recently, the company announced that it will reduce its debt by approximately $726.4 million with proceeds from the sale of 5.4 million shares of AdvancePCS common stock, the repayment of Advance PCS senior subordinated notes and the exchange of approximately $279.3 million of debt for common stock in exchange offers.
“We’re contrarian investors and we always have been,” says Peter Nolan, a partner at Leonard Green. “When everyone was out doing tech, Internet and telecom deals, we were buying traditional businesses…and that has led to us to do restructuring deals because we feel that we have a particular expertise in those deals. They scare corporate investors and they scare off most financial investors, so we’re willing to play in that arena.”
Perhaps the year’s most notable turnaround firm is Sun Capital Partners, which recently won Buyouts’ first small deal of the year award for its turnaround investment in Genicom LLC (Buyouts Feb. 5, p. 48). Rodger Krouse, a managing director at Sun Capital, says his firm began investing in turnaround opportunities after not being able to close any deals in the first two years of its existence. “We found that we were too conservative in valuations, and it wasn’t until we found some companies that were strong franchises but had problems that we were able to get deals done,” he says. “From that point on, we’ve focused on turnaround companies by staffing up in a fashion where half of our professionals are operators, because we feel that if you’re going to do turnarounds, it is very important to not only have the operating mindset but to have the personnel to operate.”
Krouse says the firm prefers “mundane” businesses such as manufacturing companies that may have the right strategy and vision but are not executing well. “What we like to do first is cut whatever fat there is, which includes personnel and non-personnel costs. Then we try to fix the business with our operational expertise, which means improving fill rates, quality, product development time, reducing manufacturing cycles, bringing production offshore and improving sales and rep forces. Then we like to focus on increasing revenues and new product development.”
Krouse says his firm posts an average 90% IRR for its investors, noting the firm’s 1997 purchase of Nailite International Inc., a manufacturer of specialty siding product line, from a New York-based buyout firm as an example. “In the case of Nailite, we improved everything from the phone system to order entries and fill rates, and decreased the order cycle from 16 weeks down to three days. We also introduced new products for the first time in 10 years, and that’s how we nearly doubled sales and tripled profitability within three years,” Krouse says.
Krouse adds that deal flow for his firm is the best it has ever been partly because of the slowing economy and partly because there are more large, multinational companies that want to focus on their core business and get rid of non-performing divisions.
Risks & Rewards
Sources say that in competitive situations, turnaround firms fare well against strategic buyers because sellers tend to think there’s a higher certainty of closing the deal with financial buyers. Turnaround pros also say that targets can be had for multiples between 4 times and 5 times Ebitda. “Most of the other firms are looking for good companies and management, and that’s a very wise way to invest,” Drucker says. “The problem is, you’re paying a very high price while competing against everybody else, who is looking at the same assets.”
However, sources say their firms will not win any popularity contests given their history of replacing management teams. Krouse admits that Sun Capital has a history of replacing management more often than other buyout firms. “There are a lot of risks in turnarounds because you’re coming into a company and an industry that you don’t have a long history with and either augmenting or replacing management who have spent their entire careers there,” he says.
“The hardest aspect of a turnaround investment is making an appropriate assessment of risk,” Madden says. “We try and get situations where the company is not yet in bankruptcy, and where there is a space in the curve when a company is performing well to when it goes to bankruptcy and that is our sweet spot.”