Month: September 2023

Refinancing a successful turnaround is a multi-step process. Often, management teams overlook some of the critical elements needed for the development of a turnaround plan. The best lender and/or financial partner is one that recognizes the importance of helping the borrower access outside professional support sooner than later.

Important Considerations in a Distressed Refinancing

The following considerations are critical to the process but vary upon the situation, the size of the business and the nature of capital structure:

1. Runway. Is there enough working capital availability and timeline to assess the situation, develop a plan, reconfigure the budget or projections, and work with management and advisors to complete a refinancing process? Often the existing lenders, particularly bank lenders, need to exit the relationship for various reasons. Finding options to extend the runway can be critical to a successful outcome.
2. Assessing and developing a turnaround plan. What are the underlying issues affecting the performance of the business and can they be fixed? Is there an agreed upon plan acceptable to management and creditors, particularly the secured lenders, that can be effectuated quickly to obtain improvements in profitability and working capital availability.
3. An agreed upon timeline with milestones. Critical to success is the ability to show progress in the turnaround and restructuring process.  Once the critical factors to success are identified, develop measurements, and begin implementation of improvements against a timeline and targeted values. These can be related to overhead cost reductions, gross margin improvements, and working capital management related to accounts receivable collections and inventory levels.  In addition to targeted and measurable improvements, the timeline also needs to include requirements for the preparation of refinancing support materials, the needs of investment banker or loan broker to go to market, and “Plan B” options if a successful refinancing is not possible.
4. Working with management and advisors. Management needs to buy into the operational turnaround and overall restructuring plan which may include a change in the capital structure, even ownership. As a restructuring professional, we need to know our limitations and when to bring in an investment banker and insolvency counsel to help with capital structure options and structuring; usually sooner is better than later to complete a successful process.

Management teams confuse the terminology. Turnaround and restructuring are two different concepts. Turnarounds are pre-insolvency and informal actions taken by the business usually focused on operational and working capital improvements. They are aimed at improving the business’s performance and avoiding insolvency. Restructuring, on the other hand, is a range of formal insolvency processes (in or out-of-court) aimed at helping businesses in severe financial distress. It involves a complex financial exercise in projecting the prospects of the business and its valuation, and balancing creditor needs for and rights to repayment. As an operationally focused financial advisor, we frequently help manage both paths simultaneously.

Case Study: Refinancing a Turnaround

The following may seem like an unusual situation to sophisticated lenders, management teams and private equity investors but it’s not. We find elements of the following situation occur more often than you’d expect. And it’s not a matter of size or sophistication. It’s a matter of short-term focus and balancing longer-term strategic objectives. What’s more important? Growth? Short-term profitability? Or building a sustainable business that encourages long-term value creation?  The best lender and/or financial partner is one that recognizes the importance of helping the borrower access outside professional support sooner than later.

Client Situation:

An underperforming $100 million revenue family business was placed at further risk through a recent move to a new and bigger facility, acquisition of new processing equipment, loss of a major retail customer account, and an increase in raw materials costs.  And usually, it is a multiple of issues that were mismanaged.

• Our client company could not identify what was the source of operating losses, as they had increased product pricing and believed new equipment was making them more efficient. They could not explain what had happened to the incumbent lender, and both the lender and the shareholders were contemplating a liquidation.
• Not accustomed to breaking down their monthly financial and operating results and sharing information among the management team, they were unable to explain or agree on the sources of their profitability challenges. This was further compounded by a slow month-end closing and reporting process.  The Company didn’t want to invest in updated financial and production reporting systems and preferred to put the money into new production machinery.
• The Company’s answer to a decrease in operating contribution was to focus on more sales and giving concessions on pricing to bring in incremental sales volumes. Meanwhile, gross profit margins declined, and the company continued to miss projections and break loan covenants.

Based on decades of experience involving production flows and taking a detailed walk-through of the business, most of the Company’s problems were obvious. The challenge was in convincing Company management about the source of their profitability challenges. (As an aside, we’ve seen these same issues in companies 10 times bigger, public, and family-held, and in multiple industries across automotive, paper products, metal fabrication, various consumer products, and food processing among others.)

Solution:

To begin, we downloaded detailed data from the Company’s databases, used data analytics involving both financial and operating data to evaluate trends from comparative historical performance, and evaluated product line and customer profitability.  Here is what we found:

• Customer buying patterns had shifted significantly without a corresponding change in production planning and pricing. Customers had shifted buying patterns as pricing increased, resulting in only half of the pricing increases taking effect as well as a build-up in finished goods and raw material inventories because management was slow to react.
• Labor content had increased significantly in key products even with new production machinery, as the Company had focused on total labor cost and not on expected unit labor costs across product lines. Consequently, as some products were produced more efficiently with new equipment, the labor content shifted to other products that were not being closely monitored.  They were also not optimizing workflow movement of materials and labor to equipment and the movement to finished goods and shipping.
• Temp labor was being extensively used and then, as time passed, temp labor had become permanent and floor managers could not tell the difference. This was compounded with production and indirect labor expecting regular overtime which, without tight production planning, drove labor costs higher by 15% to 20%. It’s become a mantra in many companies that “skilled labor is hard to get, so we need to guarantee the temp labor a full work week.”  And somehow, these are always the companies that have busted covenants and are struggling with working capital needs.
• Machine downtime and production changeover time was much higher than expected. In order to save money, management held off on upgrades and repairs which resulted in reduced throughput. Lack of proper production planning resulted in inefficient short production runs, higher material usage (content) costs, and frequent changeovers.

After a lot of denial and objections from management and blame-sharing, they ultimately recognized the data and analytics that told the story. They immediately began adopting the simple changes that supported an immediate and significant swing in profitability to support a refinancing. The longer-term change management process is still ongoing. But importantly, having supportable data that is tied to specific actions and showing progress in financial performance improvement is an important part of the story for lenders to support critical adjustments to covenants.

We assisted in implementing the change process and helped complete the refinancing to a new lender. Importantly, we were able to track and demonstrate improved performance to support the financial bridge and prepare a quality earnings analysis to help lenders with their underwriting process.

Continuing Challenge:

Striving to become “best in class” and optimum business practices is not always easy. In many businesses, owners and/or long-term entrenched management will cherry pick improvement options and not deal with some of the more challenging changes needed. Most recently, COVID and supply chain disruptions have been the common excuse for not taking direct and immediate action. It’s particularly more difficult when family members are involved or in institutional-grade businesses where long-term management teams have become entrenched in historical practices that do not work anymore. Volatility in commodity pricing and recurring challenges in supply chain disruption require a more refined approach.

What does not work: “This is the way we’ve always done it and it supported the needs of the business, so why change now?” For many industries it takes a basic level of effort to operate a business sufficiently to reach a 10% EBITDA margin and just get by to support a seasonal line of credit. Pushing for a higher EBITDA margin of 15% or 20% means regularly making difficult choices to: 1) reduce costs (often in headcount); 2) more closely manage production targets; 3) redesign workflows to attain efficiencies and increase production yields; 4) approach customers to reset pricing and terms; and 5) become internally accountable to monitor progress against agreed upon targets. The reality for many companies requiring heavy capital expenditure investment is that 7% or 10% EBITDA is insufficient to meet the longer-term viability and operating needs of the business. Taking the opportunity to attain optimum and best-in-class performance will increase legacy value, but it is a choice. And the choice is satisfaction with the status quo or the willingness to disrupt comfortable practices that don’t achieve the needed results.

After 30-plus years of experience restructuring companies large and small, I have found benchmarking to be a simple and common technique that is often overlooked. As outsiders looking in, we can usually figure out the nature of the problem(s) quickly and the potential value improvement. Getting buy-in from the company’s management team, owners and shareholders requires the concrete validation that benchmarking provides. In addition, benchmarking can help support and monitor the profitability and working capital improvements needed to reset loan covenants and value-driven EBITDA targets.

Distressed companies often find themselves navigating stormy financial waters, facing challenges such as declining revenues, dwindling profit margins, and operational inefficiencies. This usually results in breaking covenants, tightening availability, and hard-to-correct loan defaults. However, amidst the turmoil, benchmarking serves as a valuable tool that can provide a lifeline.   Leveraging it as a tool to support the change-management process can be the beacon of hope for distressed companies seeking to regain lost value.

Understanding Distressed Companies

Distressed companies typically experience one or more of the following issues:

1. Financial turmoil: This includes falling revenues, mounting debts, cash flow problems, and shrinking profitability.
2. Operational inefficiencies: Cumbersome processes, excessive costs, low productivity, or quality issues can significantly impact financial performance.
3. Loss of market share: Fierce competition can erode market share and pricing power, squeezing profit margins.
4. Unfocused leadership and strategy: Leadership problems, a lack of strategic direction, or insufficient innovation can all contribute to distress.
5. Stakeholder concerns: Investors, lenders, creditors, and employees may express worry about the company’s viability, creating additional pressure.

The Role of Benchmarking in Distressed Company Recovery

Benchmarking is a systematic process where a company compares its performance metrics, practices, and results against industry leaders, competitors, or its own levels of optimum historical performance. Benchmarking can include multiple initiatives such as: 1i) internal (best historical performance by department, location, or product line); 2) competitive (competitor comparison); 3) functional (areas such as supply chain, customer service); and 4) strategic(market opportunities, use of technology, and innovative strategies). Internal and functional benchmarking are not as common but can provide practical short-term solutions. Internal benchmarking involves comparing your Company’s different departments or units with each other. It’s particularly useful when you want to improve processes within the organization. Functional benchmarking looks at specific functions or processes within your organization and compares them with those of other companies, even if they aren’t direct competitors. This can provide insights into best practices in areas like supply chain management or customer service.

1. Benchmarking – Identifying performance gaps: In any form, benchmarking helps companies pinpoint areas where they are lagging competitors, industry leaders or their own historical top performance. Frequently, a company’s best performance was based on increasing revenues before additional headcount and capacity were added, which drove short-term efficiencies. But the performance was not sustainable because there was no consistent use of metrics to monitor value drivers. Often, there is a tendency to build production for peaks, causing excess capacity.By examining critical key performance indicators (KPIs) such as for revenue growth, profit margins, operational efficiency and key working capital measures, a company can discern specific weaknesses that need urgent attention.

1. Setting achievable goals: Once performance gaps are identified, distressed companies can set realistic improvement objectives based on agreed-upon target benchmarks. These benchmarks serve as tangible targets to strive for, offering a clear path to recovery. Realistic targets can also be used to support budgets, projections, and cash flow forecasts.  The first step is collecting data on a company’s historical performance and the performance of its chosen benchmarks. This may require internal data collection, surveys, or market research.
2. Prioritizing improvement efforts: Not all aspects of a distressed company need equal attention. Benchmarking assists management in setting priorities and focusing their efforts on the most critical areas that require enhancement. This ensures that limited resources are utilized where they will have the greatest impact. In a turnaround, the focus is often cash management with a particular emphasis on working capital management over inventory levels, accounts receivable, extended payment terms, and the order-to-cash cycle. In addition, top-level cost saving opportunities can be identified in relation to overtime and other payroll costs.
3. Focusing on best of class: Best of class is attainable and should be a benchmark to exceed. How you differentiate your business through quality, customer service, efficient production, or supply chain management needs to be top of mind. Benchmarking enables companies to learn from industry leaders and competitors who have successfully tackled similar problems. This information is often available through public company reporting and/or can be purchased cost-effectively through industry groups. By studying best practices and strategies, distressed companies can adapt and apply these successful approaches to their own unique situation.
4. Monitoring progress: Build a scorecard that can be shared at all levels. Define internal and external metrics for comparison. Beginning with simple high-level metrics that can be further refined can be as simple as revenue per employee or by production and indirect, units produced per labor hour by location or product line, or percentage scrap by product line. These simple metrics will show if labor costs are increasing or if equipment is not operating efficiently. Other basics like Days Inventory Outstanding (DIO) and Days Sales Outstanding (DSO) can quickly identify impacts on working capital. But when the economy has been good and companies have been doing well for a long time, they forget about monitoring the basics.Many companies (including large and small, public, investor-owned, and privately held) do not flag issues until after the financial reporting cycles have passed, which can be 60 days or more. The best companies and management teams I’ve worked with receive daily and weekly flash reports.  They receive end-of-day and/or early morning texts and emails.

1. Boosting morale and motivation: Measure, monitor and provide feedback. When issues are identified, provide help and support, utilize cross-functional teams to create and celebrate wins. Many people are trained in special programs for quality management, but too often, effective implementation never happens. Witnessing tangible progress in closing performance gaps can boost morale and motivate employees. This sense of purpose and accomplishment helps counteract the negative effects of distress, fostering a more positive and productive work environment.

Conclusion

Benchmarking is an effective tool for most companies. But, in a more highly distressed or turnaround situation, benchmarking will help all interested parties develop comfort that there is a realistic go-forward path to recapturing value, including lenders (bank, non-bank and mezzanine) and investors (whether public, private equity or closely held). And very importantly, as a turnaround practitioner, it helps to support an effective restructuring plan supporting revised budgets projections and rolling cash flow forecasts to get the buy-in of important external parties.

Benchmarking is not just a tool for survival but a means to thrive.  Comparing a company’s performance and practices to industry leaders can identify weaknesses, set realistic goals, and implement strategies for improvement. It’s a dynamic process that requires ongoing commitment and adaptation, but the rewards in terms of increased efficiency, enhanced quality, and financial stability can be well worth the effort.

If a company is in distress, benchmarking can provide its roadmap to recovery.