It has been said that turnaround professionals can turn around absolutely any company, regardless of its financial condition, as long as they have enough money and enough time. Of course, it is seldom the case that sufficient time and money for a turnaround are readily available when a crisis manager first arrives on the scene. Inevitably, additional resources are required. However, lenders and other stakeholders had already begun showing a sharply declining appetite for a long turnaround process even before the Great Recession.
Therefore, once a turnaround professional has been able to stabilize a company’s situation sufficiently to begin determining the strategic alternatives available to the business, the focus shifts to identifying the risks and resources attendant to each alternative. There may be a turnaround plan formulated that is blindingly brilliant, but the time and resources necessary to accomplish it simply aren’t available. Lenders seem willing to rent their money only to a sure bet, owners are loathe to put chips back on the table, and funds quickly lose interest if there are no earnings before interest, taxes, depreciation, and amortization (EBITDA) to multiply for a valuation.
So, when is a turnaround complete? When can the turnaround professional declare victory and go home? While the goalposts have clearly moved, the turnaround process is still all about risk. It is through understanding, identifying, reducing, managing, and monitoring risk that the turnaround process occurs.
A first step is understanding the root causes, not the eventual symptoms, of the company’s problems. For example, a heart attack is not the root cause of death; it is a symptom of underlying disease, heredity, or a set of lifestyle choices. For a turnaround to be successful, there must be a reasonable belief that the root causes of the company’s problems are understood and have been or are being adequately addressed. “We can do better!” is not a turnaround strategy. There are no risk-free strategies; there is just risk management—or a lack of it.
Typically, the root causes of a company’s problems stem from an insufficient response to the risks facing the business. An optimal outcome of the corporate renewal process, whether an actual turnaround and survival of the business in its historical form or a downsizing, sale, or orderly liquidation that preserves value, requires an understanding of the company’s problems in the context of risk. A number of risks must be addressed in the turnaround process.
Financial Risk. The most conventional and well-understood type of risk is financial risk, involving issues such as whether cash flow will be sufficient, the capital structure involves too much leverage, and the company can meet its obligations as they fall due and inspire stakeholders to support the company financially. If there is to be an injection of new debt or equity, the assessment of financial risk requires a determination of how much is really at stake and how much more might have to be committed if—as inevitably seems to occur—the future does not proceed as projected.
For how long will the new debt or equity capital be committed, and what milestones have been defined to provide measurability and accountability to the process? What is the cost of the capital being utilized, and what rate of return is required by its providers? Have the maturities of sources and uses of capital been properly matched? The landscape is littered with the corpses of businesses that borrowed short-term to finance long-term projects.
Distressed businesses, even when they are recovering and are in turnaround mode, are inherently more unpredictable and therefore more risky than companies that are not under such duress. Providers of capital may take more than the usual amount of time for due diligence, even as a business continues to teeter. The rate of return they require will perforce be higher, and they will likely require that the company have excess cash or loan availability—“dry powder”—to meet contingencies, which effectively increases the cost of capital to the business.
Accounting Risk. The information used by a turnaround professional is in the language of accounting, and accounting risk involves issues such as whether a company’s systems and controls are adequate and the information that they produce is reliable. This may be a function of the level of scrutiny provided by outside auditors (e.g., audit vs. review) and whether there have been GAAP and revenue recognition issues.
Past accounting reports notwithstanding, history may be less relevant, inasmuch as substantial change is implicit in the turnaround plan. More important may be accounting trend analysis that will feed into future projections. Turnaround professionals concern themselves with the quality of a company’s earnings and whether there are potentially overstated assets or unreported liabilities, and they must confirm that systems and controls are up to speed. Because any turnaround plan is predicated on the future being different than the past, the projections and forecasts that provide the road map for the turnaround should have clearly stated assumptions that have been stress-tested and sensitivity-analyzed.
Cash will still be king, but metrics such as pipeline and contract balance reports will be as important as projected profit and loss. The valuation of a business—both present and projected—is also expressed in the language of accounting, and if there has been a buyout as part of the turnaround, there is a danger of future fraudulent conveyance claims. Just as with financial risk, accounting risk can determine ultimate outcomes.
Market Risk. A company’s future depends on selling its products or services, and there is market risk involving whether overall demand will continue or grow and whether existing customers will remain loyal or defect to competitors. The products or services may be dependent on technology and intellectual property advantages, so there is risk concerning the competitiveness and defensibility of the company’s offerings.
On what does the turnaround plan depend: market growth, increasing market share, key customers? Concentration in sales can be a two-edged sword: how many turnaround professionals have seen their clients’ margins evaporate as their bargaining power shifts when they take on behemoth customers like Wal-Mart? Is future success dependent on fashions and trends? An assessment of market risk is key to declaring a turnaround successful.
Organizational Risk. The key assets of most businesses go home every evening. Organizational risk is inherent in whether the management team will remain intact and be capable of implementing the company’s plans successfully. Who is a turnaround professional counting on and what is the person being depended upon to do? How ready are the company’s people, down to the plant level, for what lies ahead? How well do managers understand the company’s strategy and vision? How have the company’s problems affected the organization’s morale and ability to execute? Have there been key layoffs or defections, and did former key individuals join competitors and take key relationships with them? Are compensation and incentives appropriately designed to obtain the performance desired, or should these be reset—e.g., to reward “hitting singles”—thereby reducing risk?
Businesses do not operate in a vacuum and are susceptible to economic and political risks in the countries in which they operate. They also encounter regulatory risk, in that federal, state, and local governments having jurisdiction over a company’s operations may pass new laws and regulations that affect the business, or they may begin enforcing old laws and regulations differently. And legal risk may involve the outcome of pending or threatened litigation, as well as such issues as whether intellectual property claims can be upheld or defended, whether competitors might infringe or claim they have been infringed upon, etc. The national pastime isn’t baseball—it’s litigation.
Each of the foregoing types of risk must be considered systematically so that turnaround professionals can accurately gauge their progress and know when the corporate renewal process has been successful. Risks can never be eliminated altogether. But if they have been completely identified and understood, effectively reduced or contained, and are being aggressively managed and monitored, then a judgment that the turnaround process has progressed is more reliable.