In an article that first appeared in the Winter 2017 issue of RECOVERY, Matthew Tait, Partner at BDO, and Matt Hill, Senior Associate at Osborne Clarke, put together a blueprint for practitioners considering turnaround work.
From a corporate’s perspective, the significant differences between ‘turnaround’, ‘restructuring’, and ‘insolvency’ can be unclear. However, the differences are important; not least for the practitioner who wishes to undertake mutually rewarding and potentially long-term client engagements.
The challenge in achieving clarity arises because the end points of insolvency and restructuring tend to be more certain when compared to turnaround. If ‘turnaround’ has a single definitional issue, it is that of the measurement of its delivery: the measurement of position, pace and progress.
Defining any concept is hard. When that concept (turnaround) relates to a series of inter-connected activities that may (or may not) share the same broad terminology and objectives as other concepts (eg restructuring), it becomes harder. To put it very broadly, restructuring re-cuts the cloth. Turnaround re-weaves the cloth. So, for the purposes of this article, we will use the following definitions:
Turnaround is the coordinated and measurable activity (eg operational, financial, legal) that addresses the underperformance of a business (or business unit) over an extended period with the objective of stabilising the business and securing, or increasing, value for its stakeholders. The extent to which both the ‘pace’ of turnaround and ‘progress’ is required will depend on the entity’s opening ‘position’.
Restructuring is more narrow, and defined as the specific actions that address financial risk, commonly with respect to debt. It does not address directly the interrelated activities of the business itself. Consequently, a business can be ‘restructured’ but still remain underperforming.
The objective of a turnaround (medium to long term) and a restructuring (short term) may be the same, eg the avoidance of an insolvency event. So, unsurprisingly, turnaround commonly involves some level
of restructuring. But the skills and approach differ greatly. Importantly, the need for turnaround has to be identified and agreed to by management as their participation is a critical success factor.
When are turnaround skills needed?
Many of the skills and experiences acquired by insolvency practitioners are transferable and valuable to the delivery of a successful turnaround. As always, the maximisation of the value of those skills requires practitioners to carefully consider the commitment of their resources. For turnaround, this commitment can be considerable and correlates strongly with the challenge of measurement. The skills of others (including turnaround professionals and other specialists) may also of course be required or desirable.
While not a unanimously held view, some more hawkish economists forecast that the UK economy will contract at some point next year and enter a recessionary phase. However, the adage that it takes three economists to predict a change rings true: one says ‘up’, one says ‘down’, one says ‘no change’. One is always right.
But what seems more certain is that the correlation between economic recession and the rates of corporate failure is not as strong as it once was.
The recent 0.25 per cent base rate increase (and the prospect of more) combined with historic levels of consumer debt would classically indicate a roll-on impact on many sectors eg retail, leisure and residential construction. However, it seems that other macro-economic and political factors will be of equal if not greater influence. It is the authors’ view that the weight of these other factors will mean that any relationship between interest rates, debt and insolvency is either broken or substantially diluted. In turn, practitioners may wish to think again as to the value of turnaround services.
Broadly, there are two other factors that practitioners may wish to consider:
- The inevitability of performance issues during the average corporate life-cycle. Even the most successful companies are likely to face performance issues at some stage. While the scale will differ, there will always be a demand for effective advice to help companies navigate choppy waters.
- The further development of and focus on corporate rescue. Next year marks the 15th anniversary of the coming into force of the Enterprise Act 2002. This had the promotion of corporate rescue at its heart through the prominence of administration over administrative receivership. It would be wrong to argue that it has achieved its higher aims but undoubtedly it led (through practice not statute) to accelerated merger and acquisition processes, the expansion of alternative funding providers and the growth of the ‘pre-pack’ sale. It seems probable that this focus will be maintained. By extension it is probable that increased attention is paid as to whether a business was simply put up for sale or was ‘turned around’ and then, from a more financially stable platform, presented to the market.
This focus on transparency is a corollary of the need for practitioners to demonstrate the delivery of stakeholder value. An ability to distinguish between engagements where entities are widely marketed compared to entities that have been ‘improved’ may become a valuable differentiator.
The Insolvency Service’s consultation last year, A Review of the Corporate Insolvency Framework, adds to the continuing trend towards corporate rescue, with a number of proposals put forward for consideration including the introduction of a preinsolvency moratorium for distressed businesses to offer protection when considering rescue options. That must include turnaround.
While each instruction is unique, in this article the authors will seek to describe in broad terms some of the considerations when advisers are contemplating a turnaround engagement with the aim of giving some experience-based guidance on the first stages, commitment and challenges.
The most common plea made to readers of articles of this nature is for practitioners to be ‘called in’ as early as possible. For turnaround, there are two significant problems with that. Why would an experienced management team make that call? And what are they calling about?
As turnaround is a stable for numerous specialisms, recognition of the issues and acceptance of a need is a ‘condition precedent’, to import some legal language. From recognition follows identification and definition.
The factors that appear to increase recognition and need are, in no particular order:
- The size (turnover or asset base) of the entity. While many entities can be ‘improved’, there is a cost, commitment and value impact of any turnaround that needs to be assessed on a cost/benefit basis.
- The involvement of a private equity or other sponsor whose position may be enhanced eg as a multiple of EBITDA.
- The governance structure eg the influence of non-executive directors.
- Whether the issues and the solutions are outside or within the control/influence of management. For example, a single ‘software as a service’ provider (wholly market dependent) may not be capable of turnaround. It is more likely to be restructured or refinanced.
- The level of existing (or likely) engagement of key stakeholders. For example, a medium-sized residential builder will likely require the support of reluctant but critical suppliers.
Once recognition has been achieved, quantification of the value of the need is required. This is commonly referred to as the ‘diagnostic’. This is the first stage of measurement and provides the primary assessment of value versus cost; the latter often being front and centre in management’s thinking.
The practitioner’s transferable skills of rapid analysis, clear communication and assessment of alternative options come into play during the diagnostic phase. Commonly, stakeholders benefit from objective diagnosis and analysis particularly where there is a need to obtain a greater understanding of the potential consequences of a situation. Most importantly, the diagnostic stage identifies which, or in what combination, services are required. Again broadly, this will be a combination of the following elements:
- Operational improvement: being the detailed assessment of the efficiency of connected processes to identify and remove factors that increase cost or reduce profit.
- Working capital improvement: being the detailed assessment of the processes and policies that impact the conversion of activity into cash with the objective of removing factors that increase borrowing or reduce cash.
- Cost reduction: being the removal or reduction of unwarranted or unsupported costs without impacting the operational efficiency of the entity. Significant interaction with legal advisers is normally required as cost reduction is synonymous with head count reduction.
- Financial restructuring: as defined above and requiring legal advice.
- Governance structuring: not solely for the entity but for the turnaround itself.
- Strategic assessment: being a consideration of the market direction of the entity and the steps required to deliver any change.
Prioritisation must factor in the available time and current financial position. Gaining agreement as to the degree of urgency and size of the issues places a turnaround on a strong footing. Where the luxury of time is not available (and even when it is) a directional quantification and assessment of issues (value, cost, difficulty) and the high-level outlining of a turnaround process reassures management.
The greater the urgency of the situation, the greater the focus on immediate cost reduction and working capital efficiency. Cash stabilisation should involve careful consideration (and recording) of the directors’ legal duties particularly where the payment terms of creditors may be varied. Additionally, a review of the purchase ledger and the underlying contractual terms for payment may result in a fundamental change of collection policy. Both elements must be assessed in the context of the commercial needs of the entity but a clear and informed record of the decision-making process is prudent.
Turnarounds are difficult and experience peaks and troughs of progress. While it is common sense that an evidenced, reasonable decision is less likely to be found to be in breach of duties, that doesn’t mean it will never be challenged. Hindsight can be a capricious judge. It seems sensible that any decision that may interact with a director’s duties is subject to legal advice.
Only by fully understanding the company’s operations (and, where relevant, those of the wider group) will the practitioner be able to identify and address the various risks (and restraints) inherent in the company’s operations. This will involve understanding the markets in which the company operates and the manner in which it conducts business. In the case of the legal adviser, this will involve understanding any regulatory context, the contractual matrix underpinning the company’s business (including default terms), and the legal relationship with key stakeholders.
Healthcare is a prime example of a sector where deep understanding of the regulatory environment is critical. For example, a restructuring of the employee base will require an understanding of at least: employment law; regulatory standards of both staffing levels and qualifications; the potentially personal impact of safeguarding breaches; and the individual rights of the service users.
Crucial to understanding the situation and being able to formulate options for a successful turnaround is an identification of the key stakeholders and their respective interests. Such stakeholders might include:
Directors/management: where the directors are also founders of the business, the emotional investment might mean that they are reluctant to face the reality of the company’s problems. Directors might also be concerned that their position is vulnerable, particularly in circumstances where further support has been recruited to address problems.
The directors also need to be alive to issues faced in group structures, particularly where there are common directors across group companies and where the potential for conflicts will be greater.
Employees: turnarounds are not secret. Employees will be aware. Employees often have the best ideas. At a fundamental level, employees will deliver the turnaround through changes to the way they work.
Inevitably, they will be concerned for their position, especially if the company needs to streamline its operations and cut costs. Key employees who are essential for implementing a successful turnaround might be considering their options, and the entity will be at pains to ensure that they are motivated to remain with the business.
Lenders: lenders may be looking at their exposure and, in particular, whether there are undrawn commitments that might increase their exposure or ondemand facilities, such as overdrafts, which they wish to reduce or cancel. They may also be considering whether or not they remain supportive of the business or whether they wish to exit the lending relationship.
A key issue is that a provider of debt can only be repaid their capital, interest and contractual charges. In effect, there is no upside. Rarely is motivating a lender by emphasising the potential for a loss the best plan. Certainly, it does not achieve buy-in.
Shareholders/investors: as identified above, shareholders (private equity or individuals) will ultimately be looking to preserve and enhance or restore equity value. Their support might be crucial for achieving the turnaround, for example by providing further investment, support functions or expertise. If the shareholders are not willing to invest further, are they willing for others to invest in the business either alongside them (dilution) or by selling their investment?
Suppliers: suppliers might be concerned about the potential loss of a customer if the company ultimately fails. They may also be concerned about credit risk and might look to reduce credit terms or introduce retention of title provisions governing when title to supplies passes. If the business is reliant on credit insurance, then the relationship with credit insurers will require focus.
Customers: consideration may have to be given as to how to drive demand if this is a key aspect of the turnaround plan. Certain customers may be heavily reliant on the company and the goods or services it provides. If these cannot be readily obtained elsewhere then the customer may be a potential source of support during the turnaround process.
A common role for the practitioner will be to support management (directly or indirectly) in engaging effectively with key stakeholders on behalf of the company and providing them with information appropriate to their needs. This is drawn from the agreed platform of information, being the detailed financial assessment and resulting model against which progress is measured. Such stakeholders will themselves often be understandably concerned about the situation and their own positions.
Stabilisation is not solely achieved through working capital management. It is a broader concept of the point at which there is:
- an agreed platform of financial information confirming the ‘start point’ and financial objective
- a detailed plan aggregating and prioritising the discrete activities (or ‘workstreams’) required to deliver the objective and identify interdependencies
- an agreed governance, control and reporting structure to monitor and measure the pace and progress of the plan
- clarity as to the roles and requirements (including timescales) for individuals and teams responsible for delivering the workstreams
- a clear communication strategy
- a workable measurement metric for pace, progress and reward, not just for the turnaround practitioner but the wider team.
As part of the wider process the practitioner will guide management (who are often stressed and lack experience of such situtations), helping them to focus on the critical issues and to move quickly and decisively, and while the practitioner may end up undertaking the management role directly, he or she will often find themselves in the unfamiliar position of supporting, but not leading, the management team and seeking to resolve conflicts or competing priorities among them.
There is no average length of a turnaround and, for believers in the ideal of continuous improvement, there shouldn’t be an end. For any practitioner, commercially, there has to be an end point. It is perhaps one of the indications of a successful turnaround that a practitioner can end their engagement in the safe knowledge that positive change has been embedded. If the engagement is correctly commenced, that possibility is greatly increased.
This article first appeared in the Winter 2017 issue of RECOVERY.