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

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.

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.

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.

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.

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