By Stephen Schmeltekopf, Partner
The most talked about topic among distressed investors is ongoing economic expansion. The discussion of when the next recession will begin is a hot topic to any TMA member, none more so than the distressed investing community.
According to the National Bureau of Economic Research, the average expansion cycle is nearly 39 months, while the average contraction cycle is 18 months. A friend recently joked that the U.S. is 11 years into a four-year cycle. He was right. As this is being written, the U.S. economic expansion stands at 129 months and counting. The economic blues from the Great Recession seem to have almost completely faded from memory in the U.S.
Distressed investing can take many forms, from senior secured credit down the capital stack to unsecured minority equity. The keys to distressed investing that follow are biased by the perspective of a control equity investor.
For a distressed investor, the timing of an economic cycle significantly affects investment returns. Knowing the micro and macro cycles is key to the start of a solid investment.
Following the Great Recession, the U.S. building products sector (excluding forest products) was hemorrhaging by mid-2012. An investment made into the Building Products Industrials Sector Index (GSPBUI) on December 31, 2009, fell 48% by the end of September 2011, while the S&P 500 Index went up 3.27% during that period. Building in the United States stopped when capital dried up. The sector was hit much harder than the broader economy. However, by midsummer 2016 the Building Products Index outperformed the S&P by 90% over the same period, +188% and +98%, respectively.
There are buying opportunities for the distressed investor in all cycles, although the deals might be hard to handle and difficult to find. There are often negative trends within a robust domestic expansion, as demonstrated in the agriculture or oilfield services sectors. Timing matters.
A common philosophy of the distressed investor is that “you make your money on the buy.” One finds real value where others have been unable to and buys based upon current enterprise value, not the future value. Companies stumble for countless reasons, including leverage, fraud, sanctions, product recalls, family dynamics, etc. Investors can turn around companies by uncorking hidden value.
Value can be found in many places but particularly in rationalizing business lines. Insufficient cost accounting is a common symptom that plagues midmarket manufacturers. Companies rationalize continuing to sell a product because that’s what they have always done. Metrics used to analyze the true contribution below gross margin may not exist. Frequently, the lowest margin sales take the most SG&A resources, particularly in a turnaround.
An organizational restructure will reinvigorate a team to take a company to the next level. In a distressed business, employees will be shuffled into jobs to backfill, not necessarily based upon ability. Value may be unlocked in underutilized assets, such as past due receivables, stale inventory, ancillary real estate, or intellectual property. If those assets can be redirected (turned into cash) to help hire a lean manufacturing guru, for example, that’s finding value.
The distressed investor looks for multiple angles for an outsized return. Heading to the Super Bowl with a strong offense is great plan. If a team has good special teams and a stonewall defense, however, that may be enough to overcome an opponent’s offensive strengths and win the game. The same works for investing—avoid the binary outcome. Imagine a turnaround totally predicated on winning one large contract from a customer—the “I need a miracle” thesis. That’s the only exit door.
Successful distressed investors make their bets based on high probability outcomes. Doubling revenue in the first year isn’t highly probable. An investor should find initiatives that can be controlled and measured—growing EBITDA margins to 80% of industry peers seems reasonable and obtainable, for example. One should find as many legitimate improvement angles as rationally possible. The more levers the investor has, the higher the probability of success.
Options might include investing in best-in-class manufacturing, selling or outsourcing unproductive product lines, discontinuing distracting initiatives, making key leadership hires, or buying a struggling competitor. If none of the options prove fruitful, it may simply have been a bad investment. This happens; distressed investing is a high-risk strategy. Distressed investors protect downside and hopefully maintain some recovery in a going-concern sale or asset liquidation. In the event of an emergency landing, the nearest exit door may be located behind you.
Many distressed investors understand that all turnarounds are hard to handle. Turnarounds take longer and cost more than the Excel model shows 100% of the time. There must be a keen sense of calls on the cash flow. If every dollar is spoken for between revolver interest, mezzanine debt, vendor payments, capex, and management fees, there is little cash for contingency. Keeping debt in check and overequitizing the balance sheet is the best way to ensure enough runway to effectuate the business plan. Liquidity is king.
Executive leadership generally dominates the preclosing compensation discussions. It is middle management and hourly employees who must be compensated to match to long-term goals of the investor. When a thoughtful, goal-based incentive plan is rolled out to the entire organization, the results can be astonishing.
The metrics must be achievable, the resources made available, and the incentive plan clearly communicated. When times are tough, incentives can be the reinstatement of benefits, a fresh coat of paint in the breakroom, or a Friday afternoon pizza party. When liquidity is available, good investors plan monthly and quarterly cash bonuses. It must be an extremely thoughtful plan, touching on each team within the entire organization, from engineers to dock workers. This process can be painfully slow to map out on the first go-around but is well worth the effort. If the investor wins, everyone should win.
Trust but Verify.
For distressed investors due diligence is frequently a run for the roses. Pressure from lenders, sellers, vendors, and customers can overwhelm a process. Distressed investors must focus on due diligence workstreams. Benefits, insurance, and environmental due diligence are generally areas an investor may outsource and stay at 20,000 feet. If a collective bargaining agreement is in place, the investor will soon be deep into benefits. Each situation will dictate flying high or at the treetops.
The key for distressed investors is identifying the constituents that will be key partners post-closing, such as creditors, executives, minority investors, labor, suppliers, and regulators. Investors know that their maximum negotiating leverage occurs preclosing. They will endeavor to obtain binding contracts for the critical stakeholders. Investors cannot trust that all parties will behave post-closing.
Further, distressed investors are stepping into an employee group that is emotionally shaken, so there is a tendency to give management space and become a passenger. Successful investors know they must become the operator and sweat the details, from the smallest line item in the borrowing base certificate to the accounting clerk’s name. To get to the promised land, an investor must pay attention—trust but verify.
Originally published on Journal of Corporate Renewal (JCR), the official publication of the Turnaround Management Association (TMA). https://turnaround.org/jcr/2020/01/six-keys-successful-distressed-investing