Rehabilitating underperforming investments - tips for the financial investor

Difficult times serve to highlight the importance of effectively monitoring investee company performance say John Toohey and Tony Mitchell of PricewaterhouseCoopers.

During the past year, venture capital and private equity funds have invested a significant amount of time and resources dealing with portfolio companies. Difficult times serve to highlight the importance of effectively monitoring investee company performance and identifying potential trouble spots in advance. When cash is tight and investors are being asked to inject additional funds, consideration needs to be given to the measures that may be taken within the investee company to preserve and even generate cash from the balance sheet. These short-term measures to stabilise a financial crisis must not adversely affect strategies that have been drawn up to focus on the longer-term rehabilitation of the portfolio company.

Financial investors will naturally be most concerned about providing additional funding to an under-performing/distressed portfolio company. A pragmatic approach therefore needs to be adopted in forming a view as to whether a turnaround opportunity clearly exists.

Generally speaking, companies that incur three or more years of consecutive losses will need to restructure themselves or they will be either forced into bankruptcy or will be taken over.

Corporate restructuring can consist of operational restructuring and/or financial restructuring. Operational restructuring involves changes to the way that a company conducts its business – process, markets, products, etc. Financial restructuring involves changes to a company's capital structure – typically debt to equity conversions, capital reduction etc.

Financial restructuring cases often involve situations where borrowers default under their obligations to commercial banks and/or bond/note holders and a debt and capital restructuring takes place in which shareholders' equity is significantly diluted (often by well over 50%). Given the nature of venture capital and private equity investments, a situation in which financial restructuring occurs is either rare (ie. in the case of venture capital investments where no borrowings are in place) or is likely to result in an extremely poor result for the investor (in cases such as buyouts where the senior debt providers will have a very well protected position viz-a-viz the equity providers).

In Asia, we have witnessed numerous instances of financial restructuring whereby the controlling shareholders continue to manage the affairs of the company post-restructuring, only for the company to enter into financial difficulty a second time. In many of these cases, few changes were actually made to the underlying business. In essence, operational restructuring had not been undertaken and the same weaknesses in the company were allowed to continue to exist.

Clearly, cases may exist where a company has a sound underlying business, but an inappropriate capital structure. For example, a business with an annual turnover of $10 million might support debt of $1 million but when turnover is only $5 million, the level of debt is simply too high. As a result, the debt level needs to be reduced.

To be successful, a restructuring should inevitably include an element of operational restructuring. This restructuring should be an integral part of any rehabilitation plan to turnaround the company's affairs.

In many corporate turnaround cases, new management are brought into the company to effect change. Indeed, it is questionable as to whether the management team that presided over the decline of the company is the right team to implement the strategies required to restore the company's health. Having said that, a management team that identifies the issues early and makes the decision to engage the support necessary to assist in developing a turnaround plan are to be applauded. Recently, we have seen several instances of private equity funds enforcing the removal of senior management and bringing in new personnel.

Financial investors are in a unique position to take a step back and look at a company from the outside. By insisting on effective and responsible financial controls and reporting and a structured corporate governance framework, warning signs of business decline will be displayed on a timely basis. A financial investor can then ask the right questions and act early to pre-empt the collapse of the company.

Crisis Stabilisation - Stopping the Bleeding

A company may be haemorrhaging due to various reasons. A critical position may be reached where creditors are bagging on the door and commence issuing writs and even winding up notices. These creditors are also insisting on either being paid all outstanding amounts before supplying further goods or services or at least are requiring that new orders are on a COD (cash on delivery) basis. So little cash remains in the business that there may be problems meeting payroll. In such an acute position, the prospects of stabilising the crisis and initiating a rehabilitation are not good, unless there is bank debt in the business and the bankers are willing to lend further cash to the company, which in turn is unlikely unless additional security is provided to the banks.

If a stabilisation strategy can, however, be implemented before the critical position mentioned above is reached, then there may be an opportunity for rehabilitation. Let us then take a situation where cash is very tight but creditors are either not yet proceeding with legal means to recover their debt or are willing to continue to provide credit terms on the supply of their goods or services.

The company should be looking to do the following:

  • A) extract as much cash as possible out of the current balance sheet
  • B) implement an immediate cost reduction programme
  • C) formulate a revised set of short-term cash flow projections (eg: 13 week rolling (by week) forecasts)

This crisis stabilisation path is all about surviving in the short term (the next few months if things are very bad) whilst a road map can be produced for longer term rehabilitation.

Extracting Cash from the Balance Sheet

Cash cannot be realised from liability balances, apart form draw downs on banking facilities and obtaining credit from creditors. What we are looking at here is converting assets into cash expeditiously. Areas that can be looked at include inventory, receivables and fixed assets.

Cost Reduction Programmes

It should not generally be too difficult to reduce overall operating costs by between 5% and 10% in the short term, without any real detrimental impact on business operations. Care should, however, be taken in substantially reducing costs which relate to future rather than present revenue streams. For example, cutting marketing and product development expenditures now may impact upon the roll out of products in the future which might become an integral part of the rehabilitation plan. It is thus important to have one eye on likely aspects of the recovery plan before it is actually defined.

Short Term Projections

It becomes particularly important to have up to date reliable information on the short term cash flow outlook of the company. Cash flow forecasts should be prepared on a weekly basis and extend out for a period of 13 weeks. The forecasts should be rolling. In other words, they should be prepared each week and cover the next 13 weeks. Achieving this level of forecasting requires discipline. It also requires that the basic raw material is on hand. Bank statements should be received daily so that reliable bank reconciliations can be prepared weekly which tie in with the opening cash position in the forecasts. The person with designated responsibility for the cash flow forecast needs to be in daily contact with account managers and personnel who are able to provide proper figures on estimated collections from customers.

Mistakes more often than not are made on the cash inflows side and in particular, we find that overly simplistic assumptions on the timing of cash receipts are made.

Sales personnel can be most reluctant to have to make a call to customers encouraging them to pay their accounts, particularly so where no part of their remuneration is tied to collections rather than simply sales. It is often surprising to find out how easy it is to improve the collection cycle with little effort - all it takes is a bit of thinking and then identification of the right communication channels.

Rehabilitation Plans - Identifying Turnaround Opportunities

In order to formulate a rehabilitation plan, it is necessary to undertake a critical review of markets and products. A look at customer and product profitability is especially important. In meetings with management, be it the CFO, CEO or sales/marketing director, there are some good questions that can asked in order to determine whether the team is on top of this area. Some questions that might be posed include: What contributions are each of your Top 10 customers making, in nominal and percentage terms? What is your hurdle contribution rate for new products? For products introduced 2 years ago, what contributions are they now making? What process is there to weed out customers and products which do not achieve the company's hurdle contribution?

These questions are fine if the company actually looks at contribution in its decision making on customers and products. Management may argue that having such formal and objective analysis is not necessary and that intuition together with some basic analysis of sales figures etc is sufficient to ensure appropriate decisions are made. Fine, but with the business in decline, management are no longer in a position to make such comments.

The 80:20 rule would suggest that 20% of customers and 20% of products would contribute to 80% of profitability.

In many businesses we have looked at, goods were sold to customers based on expectations of a significant future business relationship and these goods were actually sold at or below the real cost of sale. Three years down the track, however, a frank discussion with the customer might reveal that there was never an intention on the part of this customer to expand the relationship with the company.

Customers require serving (sales and marketing teams, account managers etc) and there is an opportunity cost to this. Resources could be spent on determining which customers are really likely to lead to improved profits over the medium term.

A regular (at least annual) review of customers should be performed. Such a review might focus on:

  • Historical sales
  • Pricing and collection history
  • 'Real' contribution to financial performance
  • Pragmatic projection of future sales possibilities

As for customers, a similar critical review of the company's existing product range should be performed. We have seen businesses being particularly focused on developing new product ranges, however, we have not so often seen good subsequent analysis of product success, measured in terms of benefits to the company's contribution line or bottom line.

By cutting out loss making product ranges, immediate direct cost reductions can be made and management and employee time can be freed up to concentrate on increasing the penetration of profitable existing products into enhanced profitable customer bases as well as identifying winning products for the future.

For a successful rehabilitation to occur, the top line will inevitably need to be improved. Revenue enhancement strategies must be put in place, however, not at the expense of profitable growth.

John Toohey
Partner, PricewaterhouseCoopers
Corporate Finance & Recovery group
Hong Kong.

Tony Mitchell
Associate Director PricewaterhouseCoopers
Transaction Services group
Hong Kong.

 

This article was published in Asian Financial Law Briefing.