TFG | Addressing the fundamental lack of available risk capital that can be applied quickly in a financially distressed business

Outline of This Chapter

The approach taken is to

1. Explain the theory of turnaround finance, and
2. Then set out the practical steps that need to be taken to raise turnaround finance.

Who Should Be Interested in Turnaround Finance

The following chart illustrates the parties who are involved in Turnaround Finance.

Raising Turnaround Finance is Hard!

It is important to understand that raising adequate Turnaround Finance is not easy. Therefore, it is important to understand the realities of the challenge, and adopt a disciplined approach.

Definition of Turnarounds

Turnarounds involve saving an insolvent or potentially insolvent business from terminal insolvency and returning the business to a stable financial and operational position.

This is achieved at the same time as maximising creditors’ interests and, wherever possible, the interests of employees, managers and owners (shareholders).

Turnarounds are achieved by a combination of financial, crisis management, restructuring and insolvency skills and experience.
For the purpose of this article, turnarounds include the turnaround of both under performing businesses that are merely not achieving their full potential, and businesses that are either insolvent or potentially insolvent.

Definition of Turnaround Finance

The vast majority of successful turnarounds require new or replacement finance.

Turnaround finance is defined as being any type of finance that is introduced during the turnaround process.

Explanation of the Components of a Turnaround

It is very important to stress that although turnaround finance is a fundamentally important component of a turnaround, turnarounds can rarely (if ever) be completed by just injecting additional money. Turnaround finance is therefore a crucial part of the cocktail required to affect a viable and sustainable turnaround.

It is intended to illustrate only the key components of a turnaround by the following simple illustration comparing turnarounds to a three legged stool. Without all three legs being firmly in place it is likely that the stool will collapse – meaning that the turnaround will ultimately fail.

Immediate Viability

The key issue in (most) turnarounds is that the business must have viability. This means that there must be a clearly structured business plan to achieve commercial viability by generating immediate operating cash flows and positive EBITDA (Earnings Before Interest, Tax, Depreciation and Amortisation).

Without this basic fundamental requirement it is likely that the turnaround will fail – regardless of how solidly the other components have been completed.

It is perhaps obvious to state that unless viability can be demonstrated or proven it will be extremely unlikely that turnaround finance will be raised.

In addition, a prudent principle of assessing the turnaround is to draw up a “bridge” statement to illustrate how the business can be turned around from its current negative EBITDA to the targeted positive EBITDA.

Restructuring and Insolvency

It is normal to have to restructure the company’s balance sheet in a turnaround. The nature of this will vary depending on the characteristics of the turnaround. However, in broad terms this can be done:

• informally – meaning without the formalities of the Insolvency Act procedures;
• formally – meaning carried out via one of the Insolvency Act procedures.

The focus of this article is turnarounds and not insolvency.

However, it is stressed that there are many examples of turnarounds that involve insolvency procedures. For example, Canary Wharf went into administration and 10 years on it is a thriving business. The insolvency procedure (administration) was very successfully used to act as a key component of the turnaround.

Whilst it is recognised that insolvency may not mean that the business completely ceases to trade, it is probably fair to say that using an insolvency procedure in a turnaround is (by its very nature) the very last resort.

A brief summary of these procedures is included in Appendix 4 to this chapter. It is however stressed that restructuring has become a very specialised area which is littered with pitfalls for the layman. Therefore, specialist advice should always be sought.

Turnaround Finance

Turnaround Finance – the topic of this chapter – is a crucial part of turnarounds which are invariably extremely cash hungry.

Management

The fact that the business has experienced difficulties is (almost always) as a result of a flaw in the management team and the business plan. This should be recognised as a “truth”. Therefore, initiating the management changes and revolutionising the company’s business plan are overwhelming important issues. Without this, raising turnaround finance may be impossible.

Summary

Anyone considering structuring a turnaround finance deal must both consider the finance in isolation and must focus on the key issues of:

Different Character of Turnarounds and Turnaround Finance

Turnarounds will involve different sizes of businesses with different financial and operational problems. Therefore, the type of finance, turnaround advisor and options available will necessarily be very different in each individual turnaround.

This problem is recognised, but this section merely attempts to outline the principles of turnaround finance. The available options and solutions will change depending on the size and nature of the transaction.

Different Principles of Turnaround Finance

All providers of finance need to assess the risks of any financial transaction. The normal going concern issues must still be considered in a turnaround environment. However, only the additional issues of a turnaround are considered in this chapter.

Increased Risk

Any turnaround financing attracts considerably higher risk than financing a business that is a going concern. This is for the following reasons:

• The business has already proven that it is potentially very risky, potentially insolvent or actually insolvent. The degree of severity will depend on the individual circumstances. However, this means that even before the turnaround finance is introduced there is a fundamental problem.
  
• Turnaround finance is generally urgently required. This means that there are very significant time constraints. This causes very real problems for the financier to be able to:
  
  • identify the possibility and viability of providing finance;
    
  • complete the necessary due diligence (for the financier to be able to satisfy its own compliance criteria);
    
  • prepare and negotiate the legal documentation;
    
  • complete before an outside creditor takes action, or obtain creditor support.

These time constraints are a very important and constraining issue.

• The probability, rather than possibility, that a creditor will take action against the company. This will increase risk:
  • before the finance has been injected;
  • after the finance has been injected.

For example, it is possible (in a worst case scenario) to inject unsecured finance only to find the company’s bankers (who are secured by a fixed and floating charge) utilise the money to reduce the company’s overdraft and then appoint an administrative receiver.

However, it should be noted that in some scenarios the turnaround financier’s risk may be substantially reduced by the fact that both actual and contingent creditors may be either eliminated or ring-fenced, depending on the nature and type of restructuring.

There are also fundamentally higher legal risks. For example, it is possible to inject secured finance into a turnaround situation that may end up as an insolvency. Therefore, the creation of the security could create voidable security which is in itself a fraud on the company’s creditors.

Turnaround financiers (and turnaround specialists) can attract personal risk by acting as directors or shadow directors (either wittingly or unwittingly). In an insolvent situation, this can create the possibility that the individual financier can:

• be disqualified as a director; and
• be personally liable for the debts of the company as a result of any wrongful trading
  (and other legal matters).

Therefore, failure to act correctly in providing turnaround finance can be extremely costly on a personal basis.

In a turnaround scenario, there is considerably greater risk that lack of creditor support could jeopardise the provision of turnaround finance.

A schedule of the risks of key creditor action is included at Appendix 2 to this article.

Increased Required Rate of Return

Due to the possibility of materially increased risk, providers of turnaround finance will generally require materially higher rates of return.

Therefore, the deals will (generally) be structured to reflect this.

Increased Funding Requirements

Turnarounds commonly require a greater amount of finance than would be the case in a going concern financing.

The main reasons for this are as follows:

• The business’ sales performance may be negatively affected during the turnaround restructuring process, as management’s attention is diverted.
• Trade suppliers are often only willing to supply goods and services on a cash basis, if they have had their outstanding credit balances eliminated, deferred or compromised. This means that if a trading business enjoyed 30 day credit terms prior to the turnaround; the business may have to pay cash or a banker’s draft for future trade supplies. This can have a very significant effect on the business’ cashflow, depending on the nature of the business. Whilst it is possible that trade suppliers may only require cash payments in the first few months post restructuring, the effect of the lack of trade credit must be carefully examined when structuring the turnaround finance deal.
• Caution must also be paid to non-trade creditors withdrawing credit facilities, which may absorb cashflow and increase cash requirements. For example, this would include the company’s bankers unilaterally clawing back the company’s overdraft and (say) telecoms providers requiring deposits prior to continuing supplies.
• Where the restructuring deal involves elimination of, deferment of, or compromise with creditors (for example, in an informal compromise or a company voluntary arrangement), the company’s working capital can radically increase. The balance sheet instantly improves, and it is possible to assume that the receipts from trade debtors will automatically generate cash, which will therefore provide adequate internal funding. However, there is a timing difference while the debtors convert into cash. Therefore, additional cash is required to fund the “gap” period while debtors convert into cash.
• The turnaround can involve significant additional fees and expenses.

The effect of the above may mean that the cash required in a turnaround financing may be greater, at least in the immediate period following the restructuring.

Mitigating the Increased Risk of Turnaround Finance

In recognising the increased risk of providing turnaround finance, specialist providers should take steps to mitigate these additional risks.

Each type of finance will require different mitigation steps. However, in general the following can be considered.

Planning

Due to the abnormal time constraints, planning is absolutely essential. In particular, in the planning of the process and people availability.

Pre-prepared Procedures and Pre-packaged Deals

For a financier or an advisor who specialises in turnaround finance it is prudent to have pre-prepared procedures in the following areas:

• deal investigation and assessment;
• deal structures;
• due diligence;
• legal templates.

The need for pre-packaging is necessitated by the time pressures involved in turnarounds. However, there is a limitation to the extent of pre-packaging as each deal must be specifically tailored to the facts of the deal.

Quality of Information

In all financing transactions caution should be paid to the quality and reliability of the company’s financial information. However, this is particularly important in the case of turnaround finance.

For example, it is common that when a company becomes distressed management are too busy fire-fighting to focus on producing quality financial information. Another extremely common example is where financial reporting is so poor that it may in itself have contributed to the company’s financial problems.

Therefore, particular attention should be paid to the company’s financial information, and additional due diligence steps should be taken to verify the reliability and accuracy of the information.

After the restructuring it is essential to ensure that quality systems, financial controls and reporting are maintained and/or implemented.

Additional Risk Assessment for the Turnaround

Additional risk assessment is required over and above a normal going concern investment. This should deal with the additional risk factors outlined in “Increased Risk” above.

Additional Negotiations

In normal going concern financing it is “usual” only to have to negotiate the finance deal with the directors and the shareholders.

However, in turnarounds the creditors are often more important than the directors/shareholders (although not always). It is therefore extremely important to identify:

• Which creditors are likely to take action and whether that action will have a material affect on the outcome of the turnaround.

  For example, this will include identifying:

  • If the company’s bankers with a floating charge will continue to support, or will the bankers make a formal demand and appoint an administrative receiver.
  • What outstanding judgements and winding up petitions there are?
  • Whether the landlord will exercise distraint.
  • The level of support of employees.
  • Which creditors are crucial to the ongoing trading of the business, and whether immediate non-payment will have an adverse impact on the company’s ability to trade?

Having established the importance of the relevant creditors it is important to consider them in the structure of the turnaround financing. How the creditors are dealt with will depend on the financial circumstances of the deal, and the quantum and character of the finance available. However, in many turnarounds, either management or independent advisors of the financiers will need to be involved in negotiations with the key creditors. This is peculiar to turnaround finance and is rarely required in normal going concern financing.

It is very important to stress that negotiations may take considerable time. Time is a luxury most turnarounds cannot afford. Therefore, it is essential to consider the negotiation time when structuring the proposed deal.

Identifying the Cause of the Financial Failure and Implementing Fundamental Commercial Changes

It is absolutely essential to identify the cause of pending financial failure and to implement a workable and realistic plan to prevent the failure recurring.

From the financier’s point of view this should be management’s responsibility and therefore should be included in the company’s business plan.

As it is such an important area, it may be prudent to ensure that failure to implement the agreed changes will result in default of the financing agreements. Therefore, this should be incorporated in the legal documents.

Maximising the Security and Security Cover

Given the increased risk of turnaround finance, it is important to maximise the security and security cover. This is consistent with the approach taken in going concern financing – however, in turnarounds there are additional issues to consider.

It may be that it is possible to rank ahead of existing secured creditors by creating a Deed of Priority or Inter-creditor Agreement between the new finance and the existing debt providers of the business.

Alternatively, it may be necessary to accept a position ranking pari passu with the existing secured creditor(s).

These positions will only be possible with approval of the secured creditor(s) concerned. This will involve negotiation. Furthermore, the deal clearly must accommodate the interests of the secured creditor(s).

Caution must be paid to ensuring that the taking of security does not create the possibility that the security may be subsequently set aside and declared voidable. The law relating to insolvency is complex and is discussed below. Therefore, specialist legal advice is essential.

Different types of finance may be more able to create full security cover. There are types of finance e.g. debt factoring, which offer security which normal traditional financing does not give.

Mitigating the Legal Risks

There are very significant additional legal risks of providing turnaround finance. This is because in a turnaround situation the company is insolvent or potentially insolvent at the time of introducing new finance.

Simply put, the legislation attempts to protect existing creditors from having their interests prejudiced.

The law is extremely complex and it is outside the scope of this chapter to address the detail of the legislation. However, there are broad areas where turnaround financiers should be extremely cautious.

Voidability

It is possible that the transaction or security may be voidable, causing monies to be repaid to an insolvent state.

Personal Liability

It is possible for the turnaround financier as a director (or being deemed to be a shadow director) to become jointly and severally liable for the company’s debts.

Misconduct

A turnaround financier could, as a director or shadow director, be disqualified from acting as a director.

Litigation

It is possible to act in such a way so as to attract litigation from the directors, the company and/or the company’s creditors and shareholders.

It is stressed that all the above concerns can be minimised by the appropriate structuring of the deal. Nevertheless, this is an extremely complex and potentially very risky area and specialist professional advice should be taken.

Types of Turnaround Finance Available

There is a wide range of turnaround finance available. Each provider will have its own requirements, target internal rates of returns (IRRs) and security requirements.

A summary of the types of turnaround finance is attached in Appendix 5 to this chapter.

In addition, this is discussed in full on the section on “Raising Turnaround Finance: The Practical Reality”

Types of Turnarounds that Require Turnaround Finance

There are a wide variety of turnarounds that require financing. Examples of these have been included in Appendix 4 to this chapter.

It is important to stress that there are a very wide variety of techniques and the appendix only demonstrates the more common ones.

The illustrative list includes turnarounds that are affected using an insolvency procedure. This may strike some readers as surprising as they may believe that insolvency equates with “corporate death”.
However, there is a very long history of great business being bought out of insolvency and subsequently creating substantial value.

In recent years the insolvency legislation has changed to facilitate turnarounds. So too has the culture of banks and insolvency specialists. It could be validly argued that this change has been too limited. However, the rescue and turnaround culture is becoming far more sophisticated and progressive and it is likely that this will continue. We should expect very radical developments in this field.

Introduction

Objective

Having discussed the theory of turnaround finance, the section of this chapter aims to illustrate a practical work programme to assist raising turnaround finance.

It is written from the view point of a turnaround specialist advising a company requiring turnaround finance. However, it is equally applicable for the company’s management or existing providers of finance who may be assisting management to obtain additional finance.

Presumption of Distress

For the purpose of this chapter, it is assumed that the company undertaking the turnaround is actually or potentially financially distressed.

Whilst it is common place it is not the rule. For example, it is possible that an under performing company has excess cash resources, in which case turnaround finance is not an issue.

The Practical Reality: Raising Turnaround Finance is Hard

Raising turnaround finance is very hard because of the increased risks as addressed in the previous chapter, and the (normally) very significant time constraints.

However, it is important to stress that with a disciplined and focused approach it is very achievable.

Raising Debt is Easier Than Equity

In a turnaround; raising debt is considerably easier than raising equity. There are a number of reasons for this.

• Since the peak of the UK recession in 1992, there has been an explosion of secondary debt providers who specialise in “asset based lending” (ABL) to SME’s.The way the asset based lenders structure their security means that they focus on:
  • Specific assets such as debtors, stock etc
  • nterest cover rather than repayment as the facilities “revolve”.

This means that this type of finance is ideally suited for turnarounds.

An illustration of the growth of asset based finance GE Capital was established in the UK in 1998 with 4 people and no funds applied. By 2001 it had applied £500m of funds, and its employees had grown to 200.

What is especially interesting is the profile of the lending. The typical recipients of G E Capital funds have turnovers of between £10m and £20m and approximately 70% are turnarounds.

This type of financing simply was not available in the early 1990s.

In summary, asset based lending is available for turnarounds and very importantly appropriate for turnarounds.

• However, the reverse is true when it comes to turnaround equity – there is very limited turnaround equity available.The reason for this is that:
  • There are only a handful of equity providers in turnaround situations who are specialists in turnarounds.Of these providers, the nature of equity provision is that they do a relatively small number of deals every year.Therefore, a small number of equity providers doing a few deals each year mean that (relative to that demand for turnaround equity) there are a very small number of equity deals done.

    It is also crucial to understand that not only is it hard to raise turnaround equity but is hard to get a good deal without material dilution of the opening equity position.

  • There are nevertheless, many business angles, corporate investors and generalist private equity providers who may be keen to do deals.However, they are often not the best starting point when raising turnaround equity because:
  • • The distressed nature of the funding requirement can put many would be investors off.
    • The short and condensed time requirements are often too pressurised for a non-specialist.
    • This means that it is impossible for them to satisfactorily complete the transaction because of the due diligence requirements.
  • There are merits in approaching a financially strong trade competitor. This because a trade competitor can rapidly get into the guts of the business. However, extreme caution should be exercised when approaching a competitor as the competitor may use the distressed position as a “fishing trip” to hijack customers, employees and other key business intangibles.

If a trade competitor is to be approached it is important that it is for sound strategic reasons.

Tactical Approach to Raising Turnaround Finance

Given the above, it is important to have a very structured approach to raising turnaround finance.

Step #1 Establish what assets are available for asset based lending (ABL)
Step #2 Establish the possibility of raising equity
Step #3 Establish the immediate application of funds
Step #4 Establish the creditors compromise if required

The above approach is illustrated by the examples given below. Before doing so it is important to emphasise

Asset Based Lending Depends on Valuations

As discussed above, ABL is based on the premise that the advances will be based on the valuation of the assets in the event of a terminal insolvency.

Each ABL’s advance requirements are different and each deal will have its individual complexities so a formula approach is potentially flawed, but the table below is a useful starting point to understanding how an ABL financing can be structured.

The Importance of Valuers in Asset Based Lending

Independent valuers are crucially important for asset based lenders. The independent valuers establish the realisable value of the asset – this provides the basis of the advance.

There are 2 types of valuations that are predominantly used in turnaround finance. These are set out by the Royal Institute of Chartered Surveyors.

Due to the fact that valuers are so important when raising finance in a turnaround it is (usually) a procedural prerequisite to get valuations. In doing so it is important to ensure that the independent valuer is either on the proposed lenders panel or is acceptable to the lender.

It is common to get valuations prior to contacting lenders to establish the shape and structure of the deal. This is demonstrated in the illustration below.

For clarity, valuers should only be used in the valuation of physical assets or property.

The ABL will assess the recoverable value of debtors themselves. However, valuers are occasionally used to value intangibles such as goodwill. It is submitted that chartered surveyors are not the most appropriate professionals to do this. Invariably the best people to provide business valuations are professional accountants or corporate finance houses who specialise in this area. In addition, very few (if any) asset based lenders will provide funds using goodwill as security.

Finally, to re-emphasise it is the (professionally and independently assessed) realisation valuation that is crucial. The accounting net book values have no relevance at all in asset based funding.

Illustrative Case Study

Satisfying the Turnaround Financiers Requirements

To obtain adequate turnaround finance, it is important to structure the deals to ensure that the turnaround financier’s requirements are satisfied.
Clearly, there are no rules that can be set out but the table below attempts to summarise the principal issues that will count for each type of financier.

There are clear differences between all possible funding sources, but it is clear equity providers are the most demanding. To illustrate this:

* Equity providers will normally provide their “equity” as a combination of debt and equity. The debt portion will (normally) be subrogated in repayment and security to the primary debt lender.
However, the equity provider will still consider the possible security in assessing the risk/return issues.

* The equity provider will therefore want to earn interest on the debt.

* The equity provider will want the debt to be repaid.

* The equity provider will search for a cheap equity entry point as well as a realistic and attainable exit.
* Therefore, there are lots of additional hurdles to jump through to satisfy equity providers. But the most fundamental issue is to communicate and satisfy all types of providers that: The business is viable and that the turnaround can be demonstrated in substance. This is commonly done by using a “bridge statement” (see appendix 1).
* The required management changes will be implemented. This is a huge area that can not be covered by this article. It is essential to emphasise that financiers require these changes to be addressed and implemented concurrently to providing more cash. The difficulty is communicating this to them within the time frame required.

Getting Turnaround Finance Deals Done: Structured Approach in a Very Short Time Period

The chart below illustrates the type of work flow that is required by both the company’s management and the professional advisor to get a turnaround finance deal done, bearing in mind the very real time pressures.

In explanation of the above chart, here are a number of points worth making.

The pre-action or pre-engagement period can be both very short or quite long before initiating action. Some assignments only get going after many (often tortured) meetings. Others spring into action as a result of an urgent phone call on a Sunday evening.

Although this chapter focuses on turnaround finance, it is axiomatic that the refinancing can only be meaningful if it is done concurrently with the management changes and new game plan, and (if appropriate) the restructuring of creditors.

It is a great mistake to work on one aspect only – the finance follows the management changes (not the other way round).

Communication in these deals is everything. Many deals go badly wrong due to poor communication. The chart above illustrated the key players that must be communicated with in a turnaround finance deal. The relative importance of each player will vary on each deal. However, the key is to identify their relative importance at an early stage and structure the work and communication focus accordingly.

Turnaround finance deals constantly change. This makes it difficult at times but all parties need to be as flexible as possible to get these deals done.

Sources of Turnaround Finance

As this is a relatively specialised area, newcomers to turnaround finance may not know who to approach.
The various categories of finance providers are included in the website www.turnaroundfinance.com

Appendix 1 – Illustrative Bridge Statement

Appendix 2 – Risk of key creditor action

Appendix 3 – Legal Risks in Turnaround Finance

Appendix 4 – Explanation of the Types of Turnarounds and Insolvency Procedures that may require Turnaround Finance

Important Note: at the time of writing there are possible legislative changes that may abolish administrative receivership

Appendix 5 – Types of Available Turnaround Finance