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

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.

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.

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:

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.

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.

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.

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.

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”

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.