by Duncan Bourne , Stephen M. Welborn
Certain private-equity (PE) groups in the distressed investing sector manage "all weather funds.” They invest in companies at all points of their business life cycle, in good times and bad, generally targeting investments in situations in which the PE firm possesses specific industry and operational expertise.
For these firms, distressed situations can provide the setting for attractive returns. Because of the heightened risk associated with distress, ensuring that the target distressed business has long-term value, can be turned around, and will generate significant positive return on the capital needed to acquire the business and fund the turnaround are essential elements to the distressed investing process.
Restructuring and corporate renewal capabilities, either in-house or provided by outside professionals, provide significant value in understanding risk and quickly executing a distressed transaction. However, even in distressed situations, the most important ingredient to significant additional value creation is post-acquisition performance improvement. The authors’ firm’s experience at Senco Brands, Inc., is an example of this type of distressed investing.
Recession, Management Missteps
Senco Brands designs and manufactures battery- and air-powered hand tools and fasteners, including nails, staples, and screws. Applications for the company’s products and services vary but are principally used in wood-to-wood, wood-to-steel, and steel-to-concrete applications, with a focus on high-end finish and trim work.
The company had been an industry leader for 60 years. It was number one or two in its primary applications and had a globally recognized brand and a very diverse customer and end-user base. Its customers participate in residential construction, mobile home, and furniture manufacturing, among other industries. Senco guns and fasteners are found in nearly every manufacturing environment in which wood-to-wood fasteners are used. As such, its sales are 90 percent correlated to residential housing starts.
In 2007 and 2008 Senco’s end markets declined severely, putting a great amount of pressure on the company. But Senco had other difficulties that made the downturn even more problematic for the company. During the housing boom, Senco had taken its eye off the ball in many strategic and tactical areas. It had underinvested for years. It had five CEOs in the prior decade who had been told to sell off valuable operating units to generate maximum cash dividends to multigenerational family owners. Further, the company’s pension plans were significantly underfunded.
As the housing crisis intensified in 2008 and early 2009, management had begun to reduce staff. While it was the right thing to do under the circumstances, the move consumed a great deal of cash because of a very generous severance policy and the fact that many employees had worked at the company for years. Management had also been making early attempts at leaning-out its manufacturing facilities, but these efforts proved to be too little, too late.
Moreover, Senco had entered into an unfortunate steel sourcing agreement at the top of the market in mid 2008. Despite increasingly finite cash resources, management doggedly continued to honor this disastrous agreement, paying its supplier under terms of the agreement well after steel prices had plummeted. This ultimately cost the company $13 million in much-needed cash. Management stretched other vendors to meet these overpriced steel payments, further weakening the business. It caused interruptions in supply, reduced customer fill rates to below danger levels, and strained customer relationships, jeopardizing the company’s future.
In early 2009, with availability on its revolver nearly gone and literally unable to make a payroll, the company agreed with its lenders to put the business up for sale.
From Distress to Opportunity
Just a few weeks after Senco hired investment bankers to fast track a sale, it executed an asset purchase agreement with a PE firm as stalking horse in a Section 363 sale process and filed for bankruptcy the next day.
The PE firm saw in Senco classic red flags of an undermanaged company in distress: revolving-door CEOs, weak ownership, dysfunctional management processes, underinvestment in manufacturing, and slow reaction to economic disruption, among others. With a company in this state of disrepair and a housing market that had fallen 75 percent from its peak, why would anyone invest?
From the investor’s perspective, all of the company’s problems had a “story” that could be understood. Based on its in-house turnaround experience with distressed and underperforming companies, the firm believed that Senco was a turnaround in the making — all these stories had endings that were reasonably identifiable. Some of the issues had begun to be addressed but needed to be institutionalized. Some of the challenges could be addressed in bankruptcy, while others could be remedied post-acquisition.
As a market leader with strong customer loyalty and brand recognition, Senco represented a significant investment opportunity. Despite its miscues, Senco remained highly positioned in the finish and trim space, and maintained an exceptionally strong brand name and a comprehensive product portfolio. The channel mix was still broad, with highly loyal customers who were still “emotionally” invested in the company’s products. Further, despite its financial difficulties, the company had continued to invest in research and development (R&D) during the downturn, focusing on innovation and new product development. This would prove critical to hitting the market post-bankruptcy with new, innovative products.
The Acquisition Process
Value creation is a journey, not a destination. It is a process, not an event. The recipe for success with this type of investment starts in due diligence and ends upon exit, with value added throughout the journey.
To begin, an understanding of the ecosystem of a business—processes executed by people, mediated by systems—is required. In Senco’s case, diligence focused in each of these areas, with an assessment of what was working and what wasn’t, and development of subsequent plans for execution.
To meet the tight time frame, the investment firm used a SWAT team approach, complementing its limited personnel with outside consultants from the corporate renewal industry. Since the firm needed to prepare quickly for improvement initiatives available to the company during the bankruptcy, two teams were deployed — one on-site at the company and another in Chicago.
The Chicago team coordinated the due diligence for the quality of earnings, voice of the customer, environmental, legal, insurance, etc., all of which were performed in a limited but thorough, extremely fast-tracked process; prepared an investment thesis; and negotiated the asset purchase agreement. The on-site team worked with company management and with outside performance improvement and restructuring advisors to formulate the investment thesis, the action steps to be implemented immediately post-petition and, later on, the 100-day plan.
The PE firm leveraged its hands-on knowledge and understanding of the bankruptcy process to move quickly, preserve enterprise value, and take advantage of bankruptcy to make a better business. For example, the on-site team tore apart the company’s debtor-in-possession (DIP) budget and identified multiple shortcomings. Among other things, the company’s plan was essentially a liquidation of its inventories, which placed unacceptable risk on the business. It would delay the company’s turnaround post-close while it waited for tools being shipped from Asia. More importantly, it would further exacerbate already dangerously low fill rates, putting important customer relationships at risk.
As a countermeasure, to support the company’s cash needs and preserve a business worth acquiring, the PE firm agreed to participate in the DIP loan with the prepetition lenders. This vastly improved the business’ ability to make domestic and international purchases of raw materials, parts, and finished goods. It also greatly improved the prepetition lenders’ certainty of closing the deal and helped create a relatively cooperative bankruptcy process while preserving key customer relationships.
While waiting out the 363 process, the on-site team assisted management with executing performance improvement initiatives made possible by the bankruptcy filing. These included firming up domestic and foreign vendor relations, advising on post-close production agreements, renegotiating leases and executory contracts, eliminating restrictive joint venture and distribution agreements, implementing faster improvement at local production and distribution facilities, and consolidating unneeded locations and operations.
The PE firm worked closely with its bankruptcy counsel to set priorities and time lines. It also assisted the company in using its own restructuring advisors better and helped identify real estate brokers and logistics specialists to execute needed initiatives. These turnaround initiatives in bankruptcy, unknown to the Senco management team at the time, proved invaluable.
After the bankruptcy filing and up to the date of the 363 auction, the PE firm’s on-site team performed significant additional work with management to devise a 100-day plan. This process emanated from the prepetition diligence, which provided the initial draft of continued post-acquisition value creation initiatives.
The 100-day plan was the roadmap prioritizing tactical execution during the critical period exiting bankruptcy and also provided visibility and accountability for both the company and investors during this sensitive time for the business. As such, it enabled management to stay focused on the “precious few” — objectives vital to the company — and set reportable measures of success for each. It allowed for reward and recognition of what was working, while course-correcting for areas that weren’t.
Some key elements of the 100-day plan and their results were:
Achieve organizational efficiencies: Resulted in $1 million in annual cost savings.
Reduce backorders: Decreased to $500,000 from $2.2 million.
Negotiate vendor terms: Days payable outstanding (DPO) increased from five to 25 days.
Re-energize sales: A “We’re Back” initiative regained more than $1.3 million of business lost during the bankruptcy.
Return to standard production/sourcing levels: Rebalancing resulted in the reduction of 34 temporary manufacturing positions.
Develop financial reports and measurements: Key performance measurements were identified and regularly reported on.
While the first 100 days are absolutely critical, the value creation journey certainly doesn’t stop there. A culture of continuous improvement must be created. In Senco’s case, that process started during the first 100 days and continues today.
One of the first areas to address was the need to adjust the leadership team to meet the needs of the business going forward. The concept of continuous improvement starts with the CEO, and becomes a part of the culture. During the first six months post-close, the PE firm introduced a new CEO, CFO, and COO, all of whom were practitioners of continuous improvement. The new team immediately prepared an analysis of the company’s strengths, weaknesses, opportunities, and threats (SWOT), and identified several key areas that needed to be addressed.
Working with a large consulting firm’s sourcing team, the company put together a new steel procurement and sourcing process, and subsequently put out to bid and executed a new steel purchasing contract, saving millions of dollars per year. Following a SKU rationalization project, the company engaged a price-management consulting firm and completely revamped its pricing strategy in the market, helping to optimize its margins.
On the information technology side, the company analyzed and subsequently installed a new enterprise resource planning (ERP) system, which not only continues to provide better and more efficient information, but also eliminated a number of back-office positions.
Continuous improvement in the plant remains critical. The new COO hired a black-belt lean specialist to optimize plant operations. This resulted in higher quality and lower cost, in addition to making operations more efficient and flexible. As an added benefit, Senco freed up enough space to consolidate four outside distribution centers into the plant, saving millions of dollars per year. This reduced inventories while making overall shipping operations more efficient and timely.
Through collaboration with legal and financial advisors and a range of performance improvement specialists from the corporate renewal community, the PE firm was able to establish an investment thesis, save the business, and subsequently implement a series of improvement initiatives toward a very successful outcome. In short, Senco nailed its turnaround.