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— Industry Insight —
In these challenging economic times, private equity firms find they need to aggressively manage their underperforming investments or risk letting lenders dictate their future, or worse. In the last 12 months, thousands of private equity-sponsored middle-market companies have experienced significant declines in sales and margins as well as a loss of equity value. Many have tripped loan covenants and are barely generating enough cash for debt service. The damage will likely increase as the dramatic falloff in business continues into an uncertain 2010. Lender and PE sponsor patience is wearing thin, and both sides are staffing up their workout groups. With their own troubled numbers to manage, lenders must be more aggressive in dealing with problematic businesses and their PE sponsors. PE firms are ramping up their involvement in day-to-day portfolio company operations to protect against downside risk and improve financial outcomes. Clearly, the time for stepped-up action has come. In a business downturn, but especially in one as dramatic as this one, PE portfolio managers instinctively categorize their portfolios into tiers of performance. As the rankings descend, the pain level increases dramatically, with the worst performers dragging down overall fund performance and increasing risk.
By dividing performance into three simple groups -- the good, the trending bad and the ugly -- portfolio managers can plan the appropriate strategies and actions. Emphasized here will be the ugly. The good news is that there are meaningful opportunities for growth with the good, and with prompt action those trending bad can be recovered. The ugly will require an honest assessment of viability to put them on a path to maximize equity value. These portfolio companies have managed the economic decline and are well-positioned for the future. The new normal requires a continuous and relentless pursuit of operational improvement in order to survive, and the good companies realize this. Surviving is good -- but what about thriving? Being in a strong position today is a strategic advantage that can be leveraged with add-on acquisitions of weakened or distressed competitors. Growing market share at cheap prices is attractive, but acquisitions take a lot of work to identify, negotiate and close. Is it worth it? Why not just let the weak competitors fail and sit tight? To keep good companies healthy, acquisition of weak competitors is as much a defensive move as it is for growth. A drowning competitor can and will (in desperation) cut prices, dump product on the market and further damage your margins. Also consider the strategic implications of a healthy competitor acquiring a weak one on the cheap. Not good. Consider opening channels for business combination discussions with weak competitors while the acquisition window is open and before two competitors combine into a more formidable foe. Beware of extended merger integrations that distract the management team -- consider hiring an outside executive facilitator to plan and drive the integration to completion to increase the probability of capturing the expected synergies. Many recently good businesses are now in the trending bad column simply because of the economic environment or a combination of overexpansion, optimistic assessments of market growth and unsuccessful new products. Management teams that were well qualified in a high-growth environment are struggling to adapt to the changes required in a nongrowth, declining environment. They are in some level of denial, waiting for the big turn in the market, which leads to inaction. Experienced management teams can substantially underestimate the magnitude and speed of corrective action required to reverse negative-trending performance. If the PE firm delays corrective action too long -- the trending bad company can quickly turn ugly. The challenge for the PE firm is to quickly and thoughtfully right-size and streamline company operations to place the company on a path back to good while not damaging the company or the relationship with the recently good CEO. Most private equity firms rely heavily upon the CEO to lead the company and make the key decisions. CEOs are also generally positive and optimistic, a good attribute, but one that often sets the stage for too much "hope" in their forecasts. In a severe economic situation, they may lack the ability to recognize the required amount of change or the experience and negotiation skills to deal effectively with external stakeholders. Change requires serious energy and a new mindset together with a catalyst to drive change; often the portfolio manager must be this catalyst. Portfolio managers can and often do "roll up their sleeves" and camp out with the management team to carefully analyze the data, strategize options and then muscle through a marathon restructuring process. However, there are plenty of daily distractions that can dilute the effort (such as other needy portfolio companies). Portfolio managers can benefit from a focused, objective outsider that can bring fresh eyes to the problem. Regardless of who assumes the change agent role, the CEO must accept the need to implement change immediately. Weaker CEOs may resist outside help; strong CEOs typically welcome it because they are confident in their abilities and know that if they lead the third-party-validated change efforts, they will control their destiny. Who should be the catalyst for change? PE firms should consider the highest and best deployment of their internal resources to build and protect portfolio value. Is it best for the portfolio manager to work on acquisitions? Refinancings? Process improvements? Restructuring? And with which companies? Temporarily augmenting and supporting the management team with experienced outside experts to assess, plan and implement change is money well spent. It may be just what is required to lift a trending bad company back to the good and maintain the effectiveness of the portfolio manager. Ugly portfolio companies are a frustrating drag on the portfolio. The missed forecasts, tripped covenants, nervous lenders, burning cash and repeated re-forecasting consume a disproportionate amount of a portfolio manager's -- and the company's -- valuable time and energy. The problem is that at a certain point, even after incremental improvements made by the portfolio manager and management, ugly companies will need major surgery such as substantial layoffs, product line rationalization and cessation, and releasing executives including the CEO. These are the most difficult decisions and the easiest to delay. Why? PE firms often delay intervention in portfolio companies for multiple quarters based on some very sound reasons including: (1) The CEO has a historically good track record, and bringing in outside help may damage the relationship; (2) the belief that the CEO's special industry knowledge is not easily duplicable and their key relationships should not be disturbed; (3) the belief that replacing the CEO will take too long and cost too much, and that truly fixing the company will take too long. Delay is rationalized as "riding the horse you know," even if the horse is pulling the wagon off the cliff. Lastly, current fundraising activities can dissuade actions that may expose poor performers. Ultimately, the ugly truth cannot be ignored. The hardest part of facing the ugly truth is honestly assessing the ultimate viability of the ugly company to determine if a revitalization, quick sale or a wind-down strategy should be pursued. Revitalization will likely require dramatic resizing or other extreme measures to insure survivability. A fast-track assessment can help predict survivability and the incremental investment required. Alternatively, an accelerated sale scenario may be best where all efforts are focused on immediate right-sizing and minimizing cash burn while exploring a rapid exit. Finally, as a last resort, the decision to wind down and stop the bleeding is difficult but may be necessary. For ugly companies, facing any of these challenging options requires tough and thoughtful realism. Making the right decision at the right time is priceless. Here are some suggested actions: Bring in reinforcements. PE firms are rightfully wary of "experts" that tell them what they already know and are not fully equipped to lead the solution execution process. Consider turnaround firms that are stacked deep with former C-level executives who can quickly and objectively evaluate businesses in an unbiased manner, and who fully understand distressed organizational execution including taking an interim C-suite position, if required. Often, hiring a turnaround firm and putting a plan in motion will be the ticket to gaining lender forbearance, creditor concessions and buying time for recovery or a controlled exit. Many turnaround firms will want long-term commitments prior to demonstrating their value. But ask for a rapid yet deep (three to six weeks) "drill down" assessment into the ugly truth. Require deliverables that include a baseline forecast (with the hope removed), an extended cash forecast and executable alternatives with specific targets and timelines. If you like the approach and analysis, engage them, but link a portion of their fees to achieving the improvement targets. Surviving the ugly is a combination of thoughtfully, but rapidly, removing massive amounts of operating costs with bringing in new sources of revenue. Act now. The longer you wait the deeper the hole becomes and the more difficult it is to correct declining performance. Finally, test the ugly company CEO to embrace the need for change, and if he declines help, that is your signal to pull the plug and put in a temporary CRO. Change is nearly impossible when the leader will not accept that change and accept that help is needed. The balance of 2009 and 2010 promises to be a time of great change for many PE portfolio companies. The challenge for PE firms is to go on the offensive with their portfolios, strengthening the good, bolstering the trending bad and attacking the ugly. Russ Lambert is a managing director at Turnpoint Advisors LLC. Comments
From: Garrette,
Posted on:
September 29, 2009 2:32 AM
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