Turnarounds: is it worth it?

Ask a selection of limited partners and most will have a proportion of their funds allocated to special situations. With the current boom in buyout fund raising and the exuberant debt markets, limited partner interest in these investments continues to increase in anticipation of a generation of companies on the brink of default that may make for some good returns in the future. Angela Sormani takes a look at the case for private equity investing in turnarounds.

It is important to recognise the emerging distinction in terminology between turnaround, which more often than not means the return to health of an under-performing asset (often within a large corporate or a private equity portfolio business undergoing change) and restructuring, which is more the rescue and recovery of businesses which are close to insolvency or emerging from a formal insolvency process, although the two terms are often interchanged.

The first thing a limited partner will look at when considering its allocation to different forms of investment is of course track record and what sort of returns private equity firms have made from investing in turnarounds. But it is near impossible to find industry data on turnarounds or a private equity firm which will answer that question because each turnaround situation is so unique it is hard to benchmark.

Tony Groom, a former company doctor who now invests through K2 Partners, a turnaround private equity firm, says: “There is very little hard data on this subject to present to LPs if you want to market such a fund. Furthermore, investing in turnarounds is risky as they encompass a great many factors, many of which are highly complex. Generally investing in this area requires hands-on investors/managers.”

A way of comparing these deals and for LPs to gauge the success of these transactions is to look at how different firms make money on turnarounds. For instance, is cash injected as equity, a secured loan, an unsecured loan or via soft finance? Soft finance might be by providing a bank guarantee, underwriting other suppliers or providing free management services as some form of sweat equity. It could be a balance sheet restructuring carried out to finance the acquisition, such as via a whitewash or vendor finance, as was the case with Rover. It is also worth considering any change to the business model.

But this involves significant due diligence on a firm and its underlying investments. There are a few key areas an investor should investigate in these types of transactions. Firstly, if property is involved, will the landlord allow a continuation of the lease without hitting the firm with a rental increase? This may also occur with leases on equipment such as computers and machinery. Secondly, is the stock of the company free from the claims of unpaid suppliers?

Another potential problem is that former employees may approach the buyer of the business for compensation if they believe the administrator has mishandled their redundancies. Disgruntled ex-executives can be the most expensive, as they are likely to have lost the most. Employment law is an area that tends to put investors off turnaround-related investments and acquisitions. The main issue in employment is the restrictions in terminating employment contracts. The problem is that legislation is aimed at protecting the employees of solvent companies and it does not accommodate the concept of saving jobs for employees of companies in financial difficulties. Restrictions include the Redundancy Consultation and Notification procedure that imposes a protracted period of negotiation on employers; and the recently introduced EC Directive on Informing and Consulting Employees is likely to present problems. Such obligations mean failure by employers to follow the procedure before dismissing employees will result in the automatic assumption of unfair dismissal by an Employment Tribunal. The costs against the employer can be considerable, as high as £56,800 per employee, so it is easy to see why many firms are reluctant to invest in turnarounds.

Stefan Hepp of SCM Strategic Capital Management does allocate investment to special situations, but is understandably cautious about their investment remits: “We do invest in such funds, but as often in the private equity market, the labelling is somewhat blurred.” For example, US buyout fund Apollo, which is rumoured to be out marketing a US$6bn buyout fund, has built a reputation of investing successfully in companies that are facing difficult challenges in sectors such as media, retail, chemical, transport and manufacturing. But the firm would not describe itself as a distressed manager because it invests in all forms of buyouts. Plus there is the issue of at what stage a company is defined as distressed.

Hepp says: “Most of the money in buyouts has been made with buyout firms buying excellent assets with excellent management teams and helping them to grow and prosper further.” He adds that the group does not like to see too many complicated situations in its portfolio as complications often mean longer holding periods. “If, however, the economy turns into recession, there is a cyclical argument to focus more on distressed specialists, which we would do,” he says.

Tycho Sneyers and Alexandre Covello of alternative asset and fund-of-funds manager LGT Capital Partners are of a similar view. In its most recent European mid-market buyout fund-of-funds, the group expects to invest in at least two fund managers focusing on special situations and turnarounds. Sneyers says: “We’ve always been interested in distressed investments, both in the US and Europe, and should invest around 10% of our fund in distressed/special situations opportunities. Interesting distressed opportunities can be found in both good and bad times. However, we are seeing an increasing number of good opportunities in Europe due to the current economic condition and Asian competition impacting European businesses.”

One of the reasons turnaround investing is attractive is that there aren’t that many GPs operating in this market and so competition is less fierce. Alexandre Covello says: “Distressed and turnaround transactions provide good diversification within the portfolio, especially in a context of highly leveraged buyout transactions. Distressed transactions are time-consuming and can be riskier than more traditional buyouts though. It is a difficult strategy to execute, which requires specific skills. You can get good returns if you back talented managers with an in-depth understanding of local markets and regulatory environment. You don’t have many funds to choose from in this sector, however, and you have few managers who have experience. What you really look for are those teams with a good track record, similar characteristics to other buyout firms, but with expertise in the distressed field.”

Paul Cartwright of UK turnaround specialist Rutland anticipates an increasing interest from LPs in this type of investment. “We had a lot of interest from LPs when we raised our fund four years ago, but since then I imagine demand has increased.” He puts this down to the fact that the LPs experienced in private equity investing know where they are with the traditional, established UK mid-market funds, which for them are a fairly reliable investment. “Many LPs are increasingly looking for private equity funds in the mid-market where there’s an added value aspect and obviously turnarounds is an area where, as a private equity investor, you can add some value and give the LPs something different to conventional mid-market funds. I hear a lot of the UK mid-market funds talking about added value, which suggests they may be feeling pressure from LPs that that is what they are now looking for.”

Rutland’s first fund, which is two-thirds invested, is UK-focused. The type of businesses the firm looks at have enterprise values of £100m or more, and also have overseas operations. Cartwright says the firm does receive calls from intermediaries with situations in Continental Europe. There appear to be the deals available, but few in the way of private equity players with European grounded turnaround expertise.

Cartwright says: “A number of people are looking at this market because there has been a huge appetite from the banks and there have been some racy deals. I think there may be some casualties, banks putting a squeeze on credit and therefore more opportunities for funds like ours will arise.”

Last year did not see many private equity-backed turnarounds in the UK. This may be partly to do with the changes in pension fund regulation, which has scared off many private equity buyers following the well-documented, failed WH Smith and M&S bids.

The main obstacle is trustees asking for top-up pension fund contributions as part of any acquisition. The impact on turnaround transactions has been significant. Tony Groom says: “The issue is that in the past you could generally ignore any shortfall to the pension fund when buying a company, especially if an insolvency tool was to be used to restructure the balance sheet since the pension fund is an unsecured creditor.” Since the Pensions Act 2004 came into force two critical issues now impact on turnaround-related acquisitions. The valuation of final salary schemes has changed from Minimum Funding Requirement basis to a Buy Out basis significantly increasing the pension fund’s claim. For example, the change of basis for valuing the unsecured claim by the trustees of the pension fund following the insolvency of manufacturer of asbestos products Turner & Newall is reported to have increased from £19m to £875m, a huge difference.

Another hindrance to investing in turnarounds across Europe is that there are different regulatory issues in each country so you have to focus on local players who know the law in their country. There are a few players who have expressed interest in Europe, but it is still problematic because there isn’t harmonisation, in particular with insolvency legislation. It is also time-consuming and a more risky business than plain vanilla buyouts, so experienced managers in that niche are rare to find.

Dennis Levine, chief executive of Burdale Financial, which is active on the debt side and has restructured deals of underperforming private equity-backed portfolio companies in the past, says: “Private equity and turnaround don’t generally go well together. It’s not common practice. From the debt side, we’re not seeing many private equity houses coming into deals other than one or two UK funds and a number of American hedge funds. Most private equity houses aren’t prepared to go into a turnaround as they say it’s too risky. There’s a shortage of money for turnarounds in this space.”

He cites the Rover downfall as an example. Some credible buyers have put forward proposals for Rover assets, with the MG Sports car model attracting most interest, but any sale as a going concern seems unlikely and private equity buyers are cautious. Tony Groom says of the carmaker’s current situation: “Turning around Rover would be a legal nightmare for anyone. At the moment there are two airfields full of cars with a question mark over who the legal owner is. And that is just the beginning. In a turnaround, so many things are going on.”

Finding the right team

Finding the right GPs to invest in turnarounds is essential. Most private equity funds investing in turnarounds are in the US, with just a handful of trademark names operating in Europe (see table.) This seems surprising given the increasing activity of restructuring groups of the investment banks such as Close Brothers Corporate Finance, not to mention whole departments at accountancy firms focused on this area.

There are two types of professionals who do well in the turnaround space: those with good analytical skills who can break down financial statements and analyse a company’s cash flow to see where the problems are and those with strong operational skills, which allow them to understand whether and where repairs are possible.

Tony Groom says: “Most specialists in this field have at least ten to 15 years experience of turnaround plus commercial experience from whatever activity they came from. It probably takes about ten years to acquire the experience you need to operate in this space. As a lawyer, for example, you might have the legal knowledge, but you wouldn’t have enough experience about operational, organisational, financial or management issues. You need sufficient understanding about all these other aspects.”

Groom defines the required skill: “You need strong leadership, new managers with the organisational and financial skills to turn the situation around and you need backers who understand the risks and market. The people involved in turnaround work have all lost money at some stage or other and most have deep scars, you only learn by making mistakes. It’s those investing in this market who have lost their shirt who are those that understand it.”

As many private equity firms do not possess the experience to turn around a business on the brink of insolvency, one way to facilitate the management process is through the employment of interim managers. These managers are able to operate at a premium in the different European countries where restructuring laws and working practices differ widely and require expert local knowledge. These executives also see turnaround and restructuring as potential opportunities to obtain equity positions on a successful outcome, giving them a greater incentive to rescue a business.

Guy Eastman, European investment director for private equity of fund-of-funds manager SVG Capital, sees some synergies between a traditional mid-market private equity fund manager and a turnaround fund manager. It is just a case of transferring those skills. “Why would an experienced private equity manager who has a record of sourcing and leading a large buyout, not be skilled at investing in an overleveraged company facing a tougher trading environment and have the skills to introduce new management to help turn the business around? Investing in a distressed environment requires the same raw material set to investing in a boom, with the crucial differences that leverage multiples are lower, debt harder to source and entry prices cheaper; the basic deal leadership skill and ability to work with good management are similar.”

Hedge funds on the prowl

Hedge funds have been dominating the headlines recently as a competitive threat to private equity funds in this space. And because the market is not over-crowded for these transactions in Europe, US hedge funds are filling the gap.

The mindset of a hedge fund manager lends itself more to a turnaround transaction. Private equity funds have nearly always invested at the equity level ranking behind third-party debt and look at turnarounds as an equity opportunity rather than just acquiring debt in a poorly performing business at a discount. By contrast, many hedge funds are willing to invest at all levels of the capital structure including secured and unsecured debt as well as derivative instruments.

The phenomenon that has attracted hedge funds to Europe is the increasing trend of debt providers to trade their debt or to work with distressed funders to rescue problem deals. Hedge funds are no doubt conscious of the multiples of EBITDA/ free cash flow presently being offered by debt providers to private equity funds and as things tighten up there will be failures that will attract the hedge funds to these deals. This trend has already started, but the feeding frenzy could begin in the next two to three years, predicts Timothy Spangler of law firm Berwin Leighton Paisner.

Frances McLeman of the law firm agrees: “Hedge funds are constantly on the lookout for asset classes that show a better return. In the US, the usual sort of fund looking to invest in these situations is a debt trading fund rather than those who want to acquire the equity. The debt is more tradable than the equity as the equity takes longer to show a result.”

Stefan Hepp sees a possible convergence of the two asset classes. “Indeed, the debt side of the distressed market is something where hedge fund players have been active for a long time and it is a hedge fund segment in its own right. Whether it is a threat to the private equity industry I do not know, but it is certainly an area where private equity firms and hedge funds are very likely to meet, in co-operation, as providers of various levels of the financing structure or, in some cases, as competitors.”

Antonio Alvarez III of global turnaround firm Alvarez & Marsal sees hedge funds as continuing to move up the value chain and in doing so they begin to encroach on the space traditionally held by private equity firms. He says: “The notion of private equity in a turnaround situation is an interesting definition. A distressed hedge fund is not acting as a private equity fund, but I do see more hedge funds in this space that are acting more like private equity-minded players. In the past, private equity firms had shorter holding periods and now these have got longer and the hedge funds are getting more involved in the decision-making process and key hiring decisions.”

His main rationale for this argument is that hedge funds offer greater rewards and sooner. They are also willing to take a minority position and are more willing to go into a hostile situation. Hedge funds can also provide their own leverage and possibly refinance afterwards and their mindset has more acceptance of risk and volatility than that of a private equity fund. Many hedge funds have roots in the US and their view is that there is less competition in Europe and so the returns should be better. For this reason, many US hedge funds are taking their business model and exploiting it in Europe.

“Hedge funds are also a provider of a new money source in distressed situations, which will allow for more corporate rescues and value preservation. In that sense, it is a good thing,” adds Alvarez.

Timothy Spangler summarises what you need to invest in a turnaround situation. “For turnaround situations to become a recognisable strategy in the market, you need three things. First, talented managers who understand the opportunities. Second, enough investors who are confident enough to allocate money to that strategy. If you find enough managers and GPs with talent it will only take time for them to build an enticing track record for themselves. And finally you need the stock to invest in, and whether this will come to the market remains to be seen.”

But for those private equity firms whose favourite parts of the FT are the advertisements for businesses for sale there will always be opportunities and, more often than not, there will always be a buyer for these businesses and someone who believes they can make a turn on the deal.

In receivership?

A turnaround can be defined as a company which may be underperforming, in need of restructuring or entering a period of change. This can on occasion involve receivership situations, which was the case with Rutland’s purchase of Uskmouth Power Station in July 2004. Uskmouth was a largely dormant asset that had been in receivership for more than two years, a 360MW power station in South Wales whose former owners had spent around £120m on a debt-funded refurbishment. The company had no meaningful trading record, no operating licences and no administrative or management infrastructure. What it did have was good asset underpinning, strategic potential and the ability to supply a recovering UK energy market.

Price is always a key factor, but a receiver is equally concerned about timing of payment, including an understanding that warranties are not available. This sort of situation often requires all-equity financing on day one, with the objective of refinancing at a later stage.

Having secured Uskmouth for a fraction of the original refurbishment cost, Rutland had to move quickly to establish a sound operational infrastructure under the direction of an experienced industry team. A strong balance sheet was also key because of the necessity to establish trading and credit relationships with suppliers and customers. This has been done and Uskmouth is now being re-established as a sound operating power station and Rutland is planning the next strategic move for the business.