Over the years, our firm has been involved in many turnaround engagements involving the private equity community. Recently, we have been asked to perform due diligence prior to investment by reviewing key operating assumptions. Our normal crisis venue helps us focus on the integrity of the financial assumptions, especially cash and the effectiveness of financial and operating systems, as well as management's effectiveness and ability to perform to plan.

The seeds of the next wave of turnarounds are being sown now with the increased M&A activity. It is timely to suggest that investors at least consider certain actions to mitigate the problems of the next downturn. This article highlights certain problems we have found in the past, as well as the process used to address those and other turnaround issues.

Common Problems Found in Troubled Companies Controlled by Private Equity Firms

We purposely chose examples of troubled situations, which lead to eventual liquidation or sale with little going to equity to emphasize the downside.

1. Lack of effective or accurate accounting systems (including systems conversions). Probably the most interesting case here involved a very large payroll-processing organization whose accounting system and a portion of its payroll operating system were wiped out when converting to a new system. The third-party service company performing the conversion failed to make a timely backup and then copied the blank database over the existing database, wiping out all records. We were called in to this company, with revenues approaching $2 billion, after initial attempts to recover the data failed. The company was literally running blind. Control over operations was regained by first operating the company on a bank-balance basis. Three times a day, the balances were updated and we could decide what could be paid. Spreadsheets were built to provide near-term cash projections and visibility, while the accounting problems were addressed. Within several weeks, we were able to develop the primary accounting and control reports to run the business. Despite the Herculean efforts of all involved, the damage to the company was done. It was fatally wounded as it lost customer confidence, and the investors properly chose not to continue funding losses caused by customer defections and conducted a wind-down.

2. Roll-ups. The troubled roll-ups we see generally result from failure to maintain standards during the roll-up period, generating deals just to do deals and a failure to consolidate the acquisitions. Several years ago, we were called into a regional paint manufacturer with operations in five states and little in the way of effective consolidation. Each of the operations was profitable prior to the acquisition, but was losing money when we entered. There was no real rationale for the purchase of several of the companies other than the flawed business plan submitted to the equity sponsor. The business pieces were sold, leaving creditors with a substantial shortfall.

3. Inept management. Problems caused by inept management are the largest single source of assignments. One common theme is lack of attention to detail. I remember walking through one factory and finding an incredibly inefficient operation. When I asked the general manager about what he had done, he told me that he brought it up to the plant manager several years ago. He had not followed up. The business was eventually sold.

4. Waiting too late to address serious problems. Problems do not solve themselves. They must be addressed on a timely basis, or they will begin to drain financial resources, leading to other problems and eventual enterprise failure.

We have generally found private equity investors very insightful in understanding the problems facing their investments. Unfortunately for them, they generally do not have the time or the resources to focus on such specific operational problems and bring them to a successful resolution. The investor should make an early decision to either direct the necessary internal resources to address the problem themselves, or retain an independent third party, free of preconceived notions or political baggage, to attack and resolve the issues.

The investor should take care to avoid becoming so active a participant that they lose the legal protections afforded them on the investor or board levels. The risk of liability increases as one moves from being a passive investor to a director and then to an officer status. These classifications can be deemed by actions alone and are not dependent on formal board resolutions. Especially troublesome is the potential liability (generally for payroll-related items) an investor brings to his fund when he crosses the line and becomes involved in management.

Addressing the Problems: The Turnaround Process

The remainder of this article discusses the five stages of a turnaround and provides insight into the distinct aspects of each stage from a board of directors vantage point. The process follows the corporate-governance model, reflecting a director's point of view. The areas of most immediate interest to an investor are addressed in the three critical success questions for a turnaround:

1. Can one or more viable core businesses be identified, or can the existing businesses be fixed?
2. Are adequate human or organizational resources available, or can they be obtained in a timely and cost-efficient fashion?
3. Is adequate bridge financing in place or can it be obtained within the required timeframe?

While those questions are key in determining whether a business can or should be saved, it is essential that an investor also analyze a company's prospects beyond making sure that a plan is in place. The plan must be executable, and it must lead to a recovery higher than that produced through a liquidation or sale of the business.

The Stages of a Turnaround

The five distinct stages of a turnaround are: management change, situation analysis, emergency action, business restructuring and return to normal.

The Turnaround Matrix at left summarizes the objectives for each stage, as well as the actions required in each of the business's functional areas. The process provides a framework to focus on important issues that must be addressed in an orderly fashion. It is far easier to convince stakeholders to buy into a suitable course of action once they understand there is a robust process in place.

Stage 1: Management-change Phase

From the perspectives of the board of directors, investors and the senior lenders, the key task to be completed early in a turnaround is to put in place a top management team that embraces the need for change and corporate renewal, while being capable and qualified to champion the turnaround process. Incompetent individuals and those who are resistant to change have caused the failures of many businesses and must be removed. Changes can be made to the team later, but the best results come from swift and decisive actions once the proper management, possessing the necessary skill sets, are in place.

A board should consider hiring an experienced turnaround specialist, corporate lawyer and/or an investment banker to help with the process. The turnaround professional may act as either an advisor or become part of the management team, depending on the inherent skill sets of the current management team.

Because the board is "betting the company" on a course of action, it has an obligation to all stakeholders to make sure capable people are in place to advise and assist in the turnaround process.

Stage 2: Situation-analysis Phase

The objective of the situation analysis stage is to determine the severity of the situation and whether a turnaround is reasonable and practical. Initial fact-finding includes interviews with management and employees and detailed analyses of key functional areas in finance, sales and marketing, manufacturing and operations, engineering, and research and development.

This stage culminates in the formulation of a preliminary action plan to address the most pressing problems. The board must look for a plan that it finds satisfactory and achievable, and that has the buy-in of management, employees and senior lenders. All parties must understand that changes in the plan may be necessary as new facts become known.

During the recent economic downturn, the need for thorough situation analysis has become even more important. The increased difficulties of the current environment presented by issues such as rapid technological obsolescence, decreases in residual value of fixed assets, compressed timeframes for turnarounds due to internal lender pressures, foreign competition and lack of sales visibility require the board to ensure that both key short-term and long-term issues are addressed.

Stage 3: Emergency-action Phase

The objective of the emergency-action phase is to gain control of the situation, achieving at least a break-even cash flow. It is especially important that this stage be executed properly. An investor needs to ensure that cash flow is stabilized and assets needed for long-term viability remain unimpaired.

This stage is characterized by the classic actions frequently identified with turnaround managers: layoffs, cost-cutting, plant closings and abandoning unprofitable product lines or locations, while accelerating high-potential opportunities. The status quo is challenged, and those who actively participate in the plan are rewarded, while those who are unwilling to change are sanctioned. Frequently, the turnaround professional must provide quick corrective surgery in order to save the company operationally or prepare it for a sale as a going concern. If these corrective actions are not deep enough, the board of directors may be left with no alternative other than liquidation.

As turnaround managers, we frequently hear myths involving turnarounds. "If I only had more money, everything would be just fine," or "We will grow (sell) our way out of the problems." Both beliefs are fatally flawed. An investor who hears rationalizations such as these should guard his purse strings.

Stage 4: Business-restructuring Phase

The objective of the business-restructuring phase is to enhance profitability through operational changes and to restructure the business to achieve increased profitability and return on assets. While this may be the most difficult stage, it is also the most important.

In this stage, the emphasis changes from cash to profits. The "heavy lifting" that occurred during the emergency action stage gives way to developing the management team. If this stage of a turnaround is not successful, odds are that the company will revert to crisis. The company must concentrate on continued profitability and improved operating efficiencies.

In our opinion, the business-restructuring stage is the most troublesome. Although the crisis portion of the turnaround has passed, the company remains fragile. Constant vigilance must be maintained to prevent backsliding. If a company that just recently came through a crisis slips back, its chances of success shrink dramatically. A second crisis will cost the company its credibility with the outside world, further strain already depleted financial resources and, perhaps most importantly, dilute the focus and trust of its employees.

Stage 5: Return to Normal

The objective of this stage is to institutionalize a permanent change in corporate culture to focus the company on profits and return on investment. This is the growth stage and is the time in the firm's life cycle that investors and the board typically excel.

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Footnotes

¹ Thomas D. Hays III is a Certified Turnaround Professional and a principal of NachmanHaysBrownstein Inc. He has provided leadership as interim Chief Executive Officer, chairman or advisor to the board in a wide variety of companies both private and public. Return to article

² Terrance P. Morgan is a Certified Turnaround Professional and a managing director of NachmanHaysBrownstein Inc.'s Cleveland Office. Mr. Morgan has been involved in more than 40 engagements with distressed companies over the last six years. Return to article