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:
- 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.
- 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.
- 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.
- 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.
