A Tale of Two Economies It Was the Best of Times It Was the Worst of Times
Reflecting on the last 15 years, the insolvency community has experienced a Dickensesque tribute to superlatives and metaphor. Driven in large part by forces of the economy, the insolvency community dealing with American businesses had flourished in the wake of financial instability and is now reeling from the expansion of the economy.
During the early Reagan years, the U.S. economy was rebounding from two oil embargoes, modest increases in gross domestic product, increases in the federal deficit, inflation in the double-digit range, interest levels as high as 21 percent and an excessive burden on taxpayers. While the solution was painful, and contributed to the 16-month recession of 1981 and 1982, government policy focused on reducing inflation and taxes and expanding the economy.
Since 1982, the United States has enjoyed unprecedented growth. The gross domestic product has increased from $3.2 trillion to $7.6 trillion. During the same period, inflation has averaged just 3.2 percent. But what established the "best of times" for the insolvency community was the period between 1983 and 1989 where leveraged buyout activity mushroomed from less than $3 billion annually to more than $30 billion in 1987, and higher in 1988 and 1989.
The typical leveraged buyout consisted of a small group of investors that purchased a public company from its shareholders in order to take it private. In the late 1980s, leveraged buyouts were structured so that most of the purchasing price, sometimes as much as 90 percent (although some clients appeared to be over 100 percent leveraged), was borrowed with the assets of the acquired company used as collateral for the new debt obligations. The newly private company's focus was on improving cash flow and reducing the heavy debt burden. In addition, debt was also repaid through sale of portions of the company. Upon revitalization, the company was often taken public by the investors.
In the early 1970s, only a few large insurance companies invested in small leveraged buyouts. But as the "go-go" years of the 1980s unfolded, many more institutions became major investors, and the size of the transactions increased dramatically. Enormous funds were formed to provide dollars for leveraged buyouts and attracted various participants, including bank holding company subsidiaries, insurance companies, corporate and state pension funds, college endowment funds, individuals and foreign investors.
But not until the fall of 1989 did lenders and investors begin to assess more seriously the economic assumptions and financial structure of many of the leveraged buy-outs. Many of the early equity investments were quite profitable. However, by late 1989, the operating performance of several buyouts failed to meet expectations. The acquisition market was jolted when a few companies involved in highly leveraged transactions defaulted on bond issues and sought bankruptcy protection. Other companies seeking to prevent default, reached agreement with bondholders to restructure their debt. (But here again, the financial restructuring did not address underlying business difficulties, often providing the insolvency community with a second chance one year later.)
Consequently, leveraged buyout activity waned in 1990 in light of these bankruptcies. The unraveling of these highly leveraged acquisitions and their vulnerability to adverse economic developments as the economy weakened, led investors and lenders to be much more cautious in extending funds. Commercial banks and insurance companies also faced greater scrutiny and stricter standards on their portfolios from regulators.
Companies were subjected to a credit squeeze and increases in the prime rate, both of which disturbed the bottom line. As a result, business failures nearly doubled from 1989 to 1992, according to Dun & Bradstreet, posting 50,361 and 97,069 failures, respectively, and the insolvency community flourished with a level of business bankruptcies not seen since the mid-1980s.
While the leveraged buyout era provided opportunities for insolvency practitioners to enjoy the best of times, it was, however, not necessarily so for the public. During 1992 unemployment rose to 7.4 percent, the highest level since the recession of the early 1980s, and gross domestic product slowed in 1991 and 1992, indicating a mild recession could be on the horizon. That presumption was incorrect and after only one quarter of gross domestic product decline, the economy proceeded to churn positive numbers again.
Inside the Numbers
What lent to the practitioner's success in the 1980s is not all gone today. Buyout activity, for one, continues in the 1990s, but is largely done through equity participations. Learning from lessons past, investors are facilitating the transactions through equity, therefore alleviating pressure on the balance sheet and cash flows.
Overall, corporate profits today continue to climb, from $365 billion in 1990 to $654 billion in 1996, and personal income is up 38 percent during the same period. By all indications, the effects of profits are the result of smarter management and increased investment in technology. Corporate America has been investing heavily in new capital goods, spending $603 billion in 1996 versus $550 billion in 1994. The result is increased productivity, up nearly 3 percent already in 1997. When comparing that to last year's one percent and the one-tenth of a percent gains for the preceding three years, it's easy to understand the rise in corporate profits and cash flows.
So where lies the "turnaround" for the insolvency practitioner? Interestingly, varying views permeate the forecasts, but many consider the lack of credit standards in recent years as being the first source of business.
It was said in 1995 that the easing of credit standards would reveal troubled or insolvent companies in 1996; the same was said in 1996 about this year, and is still said today. The truth is, given the enormous amount of liquidity in the capital markets, that private placements and debt facilities will continue at their frenzied pace because of the state of the economy.
There are no signs of a recession in today's climate. In fact, unemployment is at historic lows—under 5 percent, gross domestic product is increasing, the Federal deficit is diminishing, consumer confidence is rising and inflation continues at about 3 percent. Short of a global event causing havoc on the international economy, such as the oil embargoes did in the 1970s, reliance should not be placed on an economic downturn.
Additional support of a positive outlook came in a July 1997 release of The Conference Board's Measure of Business Confidence. This survey of corporate executives indicated that "more than 70 percent of…business leaders [CEOs] say their profits will rise over the next year." Further, the statement cited "rising market demand…as the driving force in the profit outlook." The business leaders surveyed also said that cost reductions were mostly responsible for the rise in profits, followed by technological improvements and price increases.
Outlook and Action
Much of what was done in Corporate America (and done quite well) is being addressed in the insolvency community, i.e., "right-size" to reflect a changing paradigm. The large cases are for the most part behind us, and the larger insolvency practices have correctly downsized to address this reduced volume. And, if you accept the economic forecast, together with the unprecedented amounts of liquidity, you'll be wise to heed the advice.
Although we are in our seventh year of expansion, traditional economic cycle "thinking" is long past. This truly is a new paradigm. Short of an economic surprise of global proportions, the American economy will continue to grow, providing U.S. corporations with continued profits and cash flows.
The turnaround professional will need to sell more strategic thinking rather than a crisis focus to secure debtor clients. The accountants and attorneys can and should participate in a number of services that parallel a growth economy, i.e., mergers and acquisitions, loan origination, strategic planning and investment banking.
With reflection on our economy of years past and consideration of future prospects, this "best of times" scenario will, most likely, be sustained. If that's the case, then, the "worst of times" really aren't so bad for the alert insolvency practitioner.