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Turnarounds: an acquired taste

The restructuring landscape in Europe is going through great changes brought on by a combination of market conditions and legal and regulatory issues. While there is some pressure to adopt the US Chapter 11 method of restructuring, there is a natural resistance to change and the complexities of insolvency procedures across Europe present further obstacles to company rescue techniques. Where do the opportunities lie for private equity players in the restructuring universe? Angela Sormani takes a look at what private equity does and doesn’t do in turnarounds.

There are various types of activity for a private equity house when it comes to turnaround transactions. When a private equity firm acquires a company it should always have an exit plan. The first type of turnaround activity becomes necessary if management is off-budget and ruins this exit plan. But the sort of remedy applied at this stage is very different compared to the second type of scenario when a company goes from failing to meet expectations to making losses whereby equity is under water and in breach of breaking bank covenants. A third type of turnaround transaction would be when a private equity house buys a company that is already in trouble. With a company on the brink of insolvency, a private equity house active in the sector such as Alchemy will take complete control of the company and is hands on during the turnaround process. In this scenario the private equity firm will buy the company cheaply and then invest whatever resources it takes such as GP time and money to bring the company back to life. “This is an area where there is a lot of opportunity, but very few private equity players are bold enough to put equity in at that stage,” says David Lovett of financial advisory and restructuring consultancy Alix Partners.

Finally, overleveraged LBO transactions are also providing opportunities for turnaround specialists. Increasingly US private equity firms are moving into Europe and taking majority stakes in distressed companies by buying the debt portions of the business. The investor then uses its power as a holder of distressed debt to force a restructuring of the company and converts that debt to equity. This trend has come from the less traditional private equity players, who, by acquiring the distressed debt of a business, ensure they have a seat at the table in sale discussions and so can influence the outcome of a deal. Mark Spragg of management consultants Craig Corporate Management says: “There are many US turnaround practitioners coming over to lend their expertise following the American investment companies taking advantage of the move towards a rescue culture in the UK.” In Europe private equity houses are increasingly looking at these situations as opportunities to acquire fundamentally sound businesses where the sale is being driven by an inappropriate capital structure rather than operational failings. David Riddell, assistant director of Close Brother Corporate Finance, says: “The ability to move quickly and to provide certainty of funding is key in these situations and potential buyers can differentiate themselves in ways other than simply offering the highest price.”

Changing insolvency legislation in the UK looks set to affect the practice of restructuring and this in turn may encourage the emergence of a growing corporate rescue culture. Between 2002 and 2003 there was a 15% increase in bankruptcies across England and Wales. With a view to addressing this increase there has been a leaning towards an amendment of legislation to adopt a Chapter 11 type approach. Chapter 11 is part of the US Bankruptcy Code that contains the provisions for court-supervised reorganisation of debtor companies. The debtor maintains control of the business in a Chapter 11 proceeding and usually proposes a plan of reorganisation to keep its business alive and pay creditors over time. But the difficulties of importing US restructuring practices and applying them to Europe given the diversity of Europe’s insolvency and related legislation may prove too problematic.

Turnaround expert vs insolvency practitioner

Why call in a turnaround expert rather than an insolvency practitioner? An insolvency practitioner tends to carry out a standard insolvency review, looking at the profit & loss (P&L) and the short term forecast in relation to the security of the assets under their charge. Turnaround professionals on the other hand are generally engaged by unsecured stakeholders and shareholders. Their objective is to rebuild or recover value for these stakeholders. The turnaround professional therefore also has to look at the people, the markets and the potential of the company, in addition to convincing shareholders and other funders to support the company and turn it into a viable entity with a life of its own. Mark Spragg says: “You have to know how to build a company as well as right size it. For this you need strong financial skills, commercial awareness and the ability to make very quick decisions.”

But the definition of a turnaround in the private equity world is blurred. For many private equity players a turnaround situation is a company that is not making as much money as it should. Jon Moulton of Alchemy defines a turnaround as a business that is loss-making. Michael Langdon of turnaround specialist Rutland says: “In the US turnarounds are a defined asset term, a company which is in financial distress. But in Europe many firms don’t like to promote the term turnaround as the business they are acquiring may see it as a derogatory term. Most players talk about underperforming businesses or restructuring.”

For private equity practitioners it would be fair to say turnaround transactions are an acquired taste. And many private equity firms say they offer turnaround funding in very loose terms. Langdon says: “Many private equity houses will look at a turnaround only if they’ve got a buy-in team to place with the company. Rutland will buy into certain situations with incomplete management in place and is not frightened to buy that business and address the management already in place. We could go into a situation which is a mess and take a view to sort out the management during the early months of ownership.”

But there are some mainstream private equity players that do dip into such transactions where they feel they can add value. For example, Permira earlier this year successfully sold its investments in demedis and Euro Dental Holding to Henry Schein Inc. The combined businesses were bought for £255m. demedis and Euro Dental Holdings are one company with one management structure. Permira’s investment in demedis resulted at the end of 1997 when the firm bought Siemens dental division. At that time the division consisted of two businesses: demedis and Sirona. Permira bought the combined business for $431.9m and gave a 15% stake to management. Sirona was sold in November 2003 to EQT in a secondary buyout for some £417.5m.

The Sirona and demedis business was split soon after being bought by Permira. While Sirona performed well, demedis did not. Much time was spent by Permira in turning that situation around and in 2000 demedis was effectively used as a platform to buy Muller & Weygandt, a market leader in the mail order dental distribution business in Germany, and Krugg, a leader in the Italian dental market. Muller & Weygandt was bought in early 2000 and Krugg in the summer of the same year. The transaction, for legal and tax reasons, was not structured as a buy-and-build but as a separate acquisition, known as Euro Dental Holdings, by Permira. From day one, however, both demedis and Euro Dental Holdings operated as one combined company.

Few will risk salvage or write-off situations. Jon Moulton says: “It is a small industry and there are a very limited number of private equity players who decide to tackle turnarounds. Also, most of the turnarounds done in this industry are not deliberate.” Moulton estimates around 20% of Alchemy’s portfolio by volume and 15% by value are turnaround transactions.

For a private equity deal to work as a turnaround it needs three factors, according to Moulton. First, you need a company worth rescuing; an owner willing to cede control and the company must need new capital. “Many companies don’t actually need new capital,” says Moulton. “They just need to reassure the banks that they will be repaid in a certain timeframe.”

It is a small universe with not much competition for deals due to the high risk factor. Moulton estimates less than £200m was invested in turnaround situations in the UK last year. Mark Spragg says: “It is hard to get accurate figures for this sector especially because a lot of the time these deals are undisclosed. You don’t want to shout about the fact that you’re going in to turn something around.” And while the turnaround of a loss-making business can be a costly exercise, most turnarounds don’t involve a high purchase price. Alchemy, for example, might buy a business for a few pounds and then invest between £10m and £30m to sort it out.

Turnarounds are not sector driven, but critical mass is important. Simon Wildig of Close Brothers Private Equity (CBPE) says: “There is a preference in turnaround situations to be dealing with larger businesses than average because more often than not you have to shed part of that business. Manufacturing is a popular option because if you get involved in a business that does not work out then you have sizeable assets you can dispose of to realise cash.”

The rule of thumb as a private equity player, says Wildig is to launch into a turnaround with an experienced management team and business plan. “You can usually tell within the first 12 months whether a business is going to take off. But if you’ve got to take drastic action, it’s better to do it quickly.”

The fundamentals, he says, are to make sure you buy a business that is tough enough to take the knocking and make sure you acquire it at the right price. “It is very important that you don’t over-pay for something in the turnaround market. The risks are that much higher and if you overpay on a turnaround you are likely to lose money.”

Wildig cites CBPE’s MBO of UK-based speciality chemical division Aroma & Fine Chemicals as the type of turnaround transaction the firm might undertake. CBPE acquired the business in December 2001 from its then parent US-based International Flavors and Fragrances (IFF.) IFF had to make a decision to either manage the loss-making business itself, close down the business or sell it to a financial buyer. In the end, selling the business was the most viable option. CBPE bought the business and the management team and set about restructuring it. In its first full year of trading Aroma & Fine Chemicals generated turnover of around £20m. Wildig says: “The hard work has now been done. The team had to literally reconstruct the business from scratch. Sales are now up and the turnaround has been very successful.”

In recompense for the high risk inherent in these deals, the returns can be stellar. Alchemy’s acquisition of AG Stanley is such an example. AG Stanley operated as a decorating and soft furnishings retailer under the brands FADS and Homestyle.

The business was purchased from The Boots Group in August 1997 for a nominal sum and Alchemy invested £3m into the new company. In the year of acquisition AG Stanley recorded a loss before tax of £12m on a turnover of £109m.

A new management team was brought into the company and began a vigorous turnaround programme. This included both cost cutting and altering the product mix. By the time of exit, the company had been returned to profitability, making £2.2m on a turnover of £104m. During the course of ownership, and subsequent sale, of the company, the investors realised over £43m. Alchemy achieved a multiple of 12.5x and an IRR in excess of 500% on its investment.

Bryan Green, insolvency lawyer at law firm Salans, says: “If you do it right, the returns are huge. A lot of people see the returns being huge and believe they can do it. But the truth of the market is most people can’t. That’s why there are relatively few players out there.” He adds: “You could define turnaround specialists as lenders of last resort and so they charge a very high price. And rightly so as the alternative is often the business goes bust.”

Part of the process

But in reality private equity plays only a small part in the restructuring universe. Since the last recession, European companies’ financing sources have become more diversified and complex with a shift from reliance on just one or two clearing banks towards capital markets financing with high yield bond issues, private placements and securitisation.

Turnaround specialists cover a wide spectrum including: independent company chairmen and chief executives (sometimes known as company doctors); other independent company executives providing specific skills within a turnaround team, for example finance, operations, manufacturing, industry expertise etc; specialist advisors on turnaround from a wide range of accountancy and consulting firms; senior representatives from a variety of stakeholders specialising in turnaround, including bankers, institutional investors, asset lenders; and finally venture capitalists.

The players

There are various parties’ needs to be taken into account in a turnaround. The key players are the company itself, the banks, the bondholders and the equity holders. Each of these groups has its own lawyers, accountants, auditors, financial advisers and brokers. AlixPartners and Alvarez & Marsal are two such financial advisory and restructuring consultancies involved in the process. According to David Lovett, head of AlixPartner’s London office, in the past few years a new role, that of the chief restructuring officer (CRO), has emerged due to the increasing number of parties involved in a restructuring. The CRO’s role is to bring all parties to consensual agreement; a hard task. As financial structures become more complicated the need to appoint a CRO in a restructuring situation will grow.

Of the qualities you need to do a successful turnaround Michael Langdon of Rutland says: “A certain amount of luck and an ability not to get deflected by short-term issues. Most importantly you need a clear view of what should be the right strategic focus of the business you are investing in. You have to have the determination to put in the changes and you need a clarity of where you are trying to end up.”

Deal flow for these transactions comes from word-of-mouth, contacts in the industry and financial intermediaries, according to Langdon. He anticipates growing opportunities. “The low interest rate environment has meant that while businesses are underperforming they have not been under acute financial pressure. It will be interesting to see if interest rates rise if that will throw up more opportunities.”

Rutland looks at deals with an enterprise value of between £20m and £100m and has a £210m fund which focuses on companies with mature products or services that are facing strategic challenges, may be underperforming or in need of restructuring or entering a period of change. The fund has made five investments to date and is just under 50% invested. Rutland had a notable success in 2002 with Edinburgh Woollen Mill (EWM), which it bought and sold within two years.

Bank of Scotland Integrated Finance acquired Rutland Fund Management’s stake in EWM Group via a secondary buyout worth £67.5m. Rutland acquired the business in 2001 for £49m from Grampian Holdings as part of a larger deal including the disposal of 24 EWM properties to a separate buyer. Grampian, which changed its name to Malcom Group, sold the chain to focus on its transport business. In May 2002 a bank refinancing meant Rutland received £12.3m in partial repayment of its original investment, bringing the total exit value to around £80m. Rutland had doubled its £22.5m investment in 18 months.

Rutland implemented significant changes within the business including improvements to the supply chain management, distribution, investment in new warehousing and the introduction of the EWM brand. The company reported improved performance in the year to January 2002, with operating profit up to £15.5m from £10.5m in 2001.

Restructuring as an exit route

Much of the deal flow in the turnaround space has been coming from the private equity players themselves. According to Mark Spragg: “Turnaround work comes from a variety of sources with a large proportion coming from the private equity players. This tends to be underperforming investments in portfolios that require either a change or a strengthening of the management team in the investee company.” Several groups have surfaced over the past years taking advantage of underperforming private equity portfolios. Among these are IRRfc and Nova Capital Management in the UK and Techinvest Beteiligungsgesellschaft, formerly ERGO Equity Partner, in Germany. These groups have a particular focus on management mandates for struggling or unwanted funds and portfolios.

Many of the banks such as Clydesdale, Lloyds and Royal Bank of Scotland have also set up departments to deal with underperforming businesses within their client base. “Offering such specialist department for clients at risk takes the emotion out of the situation by passing the situation onto a specific department to deal with it,” says Spragg.

David Riddell of Close Brothers Corporate Finance explains how companies that have been the subject of a leveraged buyout may fall into financial distress. “In order to maximise equity returns, private equity houses seek to introduce significant financial leverage into transactions. Inevitably, a few of these highly leveraged buyouts will need to be restructured when actual performance falls below initial expectations. When this happens private equity houses need to decide whether they want to invest more money to support a financial restructuring or engineer a graceful exit,” he says.

As the European private equity and debt capital markets have developed in recent years, leveraged buyout structures have become more complex with the increasing use of mezzanine finance, high yield bonds and securitisations as well as traditional senior debt funding. As a result leverage ratios have risen and the number of stakeholders has increased. This increasing complexity may have made restructurings more difficult but it is also creating opportunities for new investments.

Riddell says: “When an investee company becomes distressed the private equity sponsor is often faced with a new investment decision. Even if the sponsor has written off its equity investment and decided that it does not want to make a further investment the lenders are likely to have significant sums of money at risk. As a result, private equity houses may still invest significant management time in restructurings in order to preserve relationships with the bank and debt capital markets that are critical to their business models.”

An example he cites is the restructuring of international manufacturing company Brunner Mond, a public-to-private backed by CVC Capital Partners and Citicorp Venture Capital in 2000. The shareholders decided to exit this investment as their investment strategy had changed since the time of the original deal. But both firms invested significant time to ensure the restructuring was successful and the position of the senior banks and bondholders were safeguarded.

But the private equity firm may also take a different view. For example, in the restructuring of Polestar, private equity backer Investcorp made the decision to back the business and invest new money. “In stressed or distressed situations new money is at a premium and the party that agrees to invest is likely to take control of the shape of the restructuring,” says Riddell. “The private equity sponsor usually has first mover advantage. They tend to be closer to the business than bondholders (for example, they often have a representative on the board) and if they decide to put new money in they can control the restructuring process.” Many bondholders do not have the ability or the desire to commit new money in a restructuring. In addition, bondholders may be reluctant to provide the hands-on management these businesses frequently require once the restructuring has completed. Bondholders are ultimately looking to monetise their investment and so they may not be long-term investors in the way traditional private equity houses are.

Peter Fitzsimmons of Alix Partners predicts an increase in the number of restructurings. “The reason for this is because there is an enormous amount of private equity money investing in Europe. Companies that are over-leveraged in particular are prime targets for restructuring as many of these may have problems with their capital structure in the future. Often the management team is fine and the cash flow is positive, it’s just that the performance is not sufficient to cover the higher level of debt. The push for additional cash becomes key and necessary to meet the new financial obligations,” he says.

Turnaround specialists are always busy; there are always companies that need help. But Jon Moulton concludes that this is not an area for the faint-hearted. “It is a very hard end of the business but you can make very good returns on very small amounts of money. Unless you walk into a good turnaround situation and have the management and expertise to turn the company round, you walk into the probability of a rapid write-off and a lot of players are scared of that. The key issues are you need new money, the management has to cede control, and the company has to be worth rescuing.”