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

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.