Managing Corporate Turnarounds - Part II

Wednesday

Often when things go wrong, people are inclined to fire the management. However, in the real world, things are hardly ever that simple. Firing management, like anything in turnarounds, is decided on whether or not this action will speed up or slow down the turnaround. Besides packages given to executives on exit, there is also a great deal of institutional knowledge that they take with them. There is a counter balance to understanding the value they bring through their experience versus the inertia they create against the changes required. This is particularly true in SMEs as well as family owned enterprises where the institutional knowledge is often not formalized (pricing mechanics, customer relationships etc.)

Also, with the separation of the chairman and CEO roles, it is possible that a power divide coupled with an inappropriate strategy may have smart people being told to chase bad strategies. One remedy which is often used is an immunity period: the idea that employees in a turnaround situation have a window of opportunity to identify any potential problems. This allows an honest analysis of problems without reprimand and realigns expectations (Are we going to make the numbers? Are our margins as good as we expect? Are we doing things right? Are we doing the right things?) Because a new team is put into place to fix previously created problems, it is not appropriate to assign current problems to new management. However, eventually, whether or not these issues were created by you initially you will inevitably begin to wear them if you don’t fix them soon enough or don’t manage expectations of the company and all stakeholders.

Thursday

Like in any business strategy, there are two major things to keep in mind in a restructuring: operations and financing. For operations, it is necessary to check if the overall business strategy works (are people buying your product and do you have a viable business) and if you are able to profitably deliver (are our margins good or are we chasing low quality customers). Also from a financing perspective, it is important to understand the liquidity constraints of the enterprise. For example, what is an appropriate financing structure to keep the company alive while providing adequate and appropriate protection and returns to current and new capital providers?

One such useful tool is the paid-in-kind (PIK) security. It is a type of mezzanine high yield debt that doesn’t pay a coupon. Typically, these types of securities return 14 to 17%. They return higher than senior debt because they are subordinated but they don’t require cash payments which allow the company to maintain its liquidity for short period of time when it’s heavily cash strapped. However, what usually happens is this is coupled with a cash sweep. To use a structure like this in this circumstance is tantamount to saying: “We understand you are strapped for cash now, so you don’t have to pay us immediately, but we want an appropriate return for taking this risk that’s more similar to equity if things recover. However, we still want to be paid sooner rather than later and when you have any excess cash, you will give us everything you have and we’ll consider you less risky and ratchet down your interest rate to reflect the change in risk.”

Artistry with Dr. Hilary Austen

Tonight, there was a Rotman panel discussion hosted at the Savoy Hotel in London by our dean, Roger Martin, on “Artistry Unleashed: Pursuing Great Performance in Work and Life” written by Dr. Hilary Austen. They had a great discussion on how our current educational system seems to focus heavily on quantitative knowledge potentially at the expense of qualitative knowledge which, although by definition difficult to measure, plays an important role not just in decision making, but our ability to perform well in different environments.

Vetran integrative thinkers can probably also recognize the concept of model tension between these two ideas and can appreciate that the conversation between the panelists with Roger facilitating lead to interesting perspectives and topics being raised (eg. the role of analytical versus intuitive recognition for diagnosis performed by doctors).

Afterwards, there was a cocktail reception with the opportunity to speak with people connected to the Rotman community in London through a variety of different channels: students like myself, alumni, business partners, patrons of business publications etc.

Managing Corporate Turnarounds

This week, I’m taking a block week course (one week intensive following the 10 week standard course period) at LBS: Managing Corporate Turnarounds. So far this course has actually been really interesting, with us looking at business cases for salvaging distressed companies and learning about the mechanics and considerations of struggling businesses.

Unlike my undergraduate strategy course, which I nicknamed “doom and gloom” because the distressed companies in our cases never seemed to recover, this course talks about different cases that were successfully turned around using a variety of different techniques to improve operational efficiencies and use financial tools like LBOs to capture the upside.

We’ve also had great guest speakers come talk about their specific experiences and their perspective on different aspects of turning companies around (shedding assets for cash, improving operations, recovering debt, how to identify target companies etc.) One of our requirements in class is to summarize some key learnings from the class, and in a similar fashion to the Latin America study tour which had a similar component, I plan on using this blog to jot a few notes for me to recall later as I compile my thoughts:

Monday

In turning a company around, it is important to understand where control lies. Since equity is flirting with bankruptcy, it may lose control to the debt holders. Some debt investors may be holding “grenades”, the intent to liquidate their holdings ASAP when a trigger event happens (broken covenants, default etc), and may not be interested in salvaging the company, even if there is potential to recover equity value because they just want to unwind their positions.

Companies need to have good strategies when it comes to M&A, otherwise they can fall victim of a vicious cycle: accretive acquisitions increase EPS (albeit in an inorganic manner) and can give false impressions of growth, which could potentially boost the P/E multiple. A higher P/E multiple gives the company expensive equity which it can use as a better transaction currency for buying other companies (low P/E) and still be accretive. This is a vicious cycle if the M&A is not well integrated with substantial delivery of synergies and/or overpays for targets. This typically occurs in new industries where there are a limited number of potential buyers (targets with low P/Es as there is no other mechanism for exit) and the industry is consolidating into larger players (large strategic buyers displace financial buyers niche shopping).

Another version of the problem above is when companies which are asset-light use M&A as a backdoor for raising leverage. Services companies cannot raise leverage in a traditional manner because they have neither hard assets nor collateral to borrow against, so they can acquire companies which have higher leverage ratios to boost their own ratios. Also, this type of reckless acquisition can divert focus from the core business. In turning around companies which have fallen along this path, one of the immediate remedies is to spin off non-core assets for cash.

Tuesday

When you are on the buyside for any company (not just distressed companies for turnaround), it is important to have multiple targets in the pipe, not just for the more obvious negotiation leverage points, but to prevent yourself from getting too much deal heat over one deal and to avoid negotiating against yourself and your emotions.

Negotiating a transaction involves much more than a “price”. There are terms of payment, the structure of the compensation, workouts, milestones, terms and conditions. A price which is seemingly too high can be restructured to be paid out overtime so that the undiscounted amount remains the same, but the risk and cash outflows can be spread over a longer period with the appropriate covenants and milestones.

Travelling in Europe

The bizarre truth is that it’s actually cheaper to visit other parts of Europe than it is to stay in London. With the end of the term (and MBA program) upon us, many students (exchange especially) are planning a variety of trips before the academic program is over.

(Shown above: Bull fight, La Plaza de Toros de Las Ventas, Madrid, Spain)

So far this week, I’ve been to Madrid, Spain and Bordeaux, France. I'm travelling with a few students from LBS and we are driving down the coast of the south of France and into northern Spain, visiting coastal towns as we make our way down and are currently San Sebastian, Spain. My French has been a bit rusty, but enough to decipher menus, make orders, ask directions and generally get around. It has been almost 5 years since my CFES days.

(Shown above: Chateau Margaux, Bordeaux, France)

(Shown below: San Sebastian, Spain)

Having visited Lisbon, Portugal and Rome, Italy there is only one other country I need to visit to collect my PIGS set: I plan on visiting Greece in early April for my final block week course: Service Management Field trip, a consulting project based in Thessaloniki, Greece.

I have always enjoyed Greek mythology, especially after reading the Odyssey in high school which was one of my favourite books of all time. I will certainly enjoy spending time in Athens visiting some of the ancient ruins. Greece is also home to many famous mathematicians and philosophers that derived such elegant concepts such as the approximation of pi or the golden ratio. I'm really looking forward to the trip.

Emerging Markets - China

We just completed our final presentation in the Emerging Markets class taught by Linda Yueh at LBS. Our group chose China, and we did a cross section of important business factors and how they affect investment decisions and mechanisms into the country. While the presentation was performed by myself and my classmate Tim, the other team members contributed greatly to the material and their preparation was reflective in the cohesive and comprehensive story we presented. It was easy to present the highly refined material to create an investment thesis branching across a broad range of industries and tell a story about how specific companies would benefit or be hindered by government regulations and financial market mechanisms.

Tim did a great job going into the details of the domestic business environment with some personal anecdotes from some of our team members’ recent trip to China. JEMBAs (aka January intake Executive MBAs) at LBS are required to a week intensive in a foreign country and three of our JEMBA team members visited China together.

I think we represented the hard work and analysis of our team well.

Planned Obsolescence

With the last week of the core 10 week period upon us at LBS, things have dramatically started to pick up. I have my final exam for Behavioural Finance on Thursday which promises to be challenging.

I've also got a final PEVC assignment due in-class tomorrow where our take home individual case will also be released. Also, tomorrow, I have a big presentation for Emerging Markets with the final group and individual papers due by the 18th.

What a roller coaster it's been, not just here but in the MBA program in general. It seems like not too long ago, I was stepping into Rotman for the first time. After taking a look back at this blog, I've realized how much I've enjoyed my time at Rotman. And with the end of the program so near, it's time to plan wrapping up of all the loose ends.

I have two more classes left, block week courses (one week intensives) which I'll be taking between now and the end of April. However, this provides me with ample opportunity to take advantage of the easy access to Europe and as such I'm planning trips with some of the fellow exchange students between now and when I leave. My last two classes are Managing Corporate Turnarounds (last week of March) and Service Management Field trip, a consulting project where our class will be in Greece (jokingly referred to as "exchange on exchange") which will be my final class of the MBA program.

I'll continue to blog as interesting ideas pop up in the last few classes and probably put up a few nice pictures from my travels, but I expect that I'll put up a final post around the end of April as I head back to Toronto.

FEI Competition

Apparently, our final round presentation for the Financial Executives International Case Competition is now available online. Unfortunately, I can't embed it into the blog, but I can include the link below:

http://www.feicanada.org/cfo-tv.php?vid=22&page=2

Enjoy!

KKR at LBS - Socially Responsible Private Equity

Just now, we had the inaugural talk for the Socially Responsible Private Equity talk given by Ken Mehlman, KKR's Global Head of Public Affairs. He was the Chairman of the United States Republican Party, campaign manager for President George W. Bush's re-election campaign, and White House Political Director. He was also a classmate of Barack Obama at Harvard Law.

He gave a great talk on how social responsibility is integral to sustainability of a business, especially one with patient capital in PE. One point he made which I thought was particularly poignant seemed to echo the ideas of Integrative Thinking. He said that there are generally two common models with regards to social responsibility:

1. Corporate CSR – Where a company makes contributions to organizations outside of its operations that show it cares.
2. It focuses solely on strong operations and generating business returns to the bottom line without much consideration for social responsibility.

He mentioned that KKR takes a third approach, and that it integrates social responsibility not just at some abstract corporate or portfolio level, but right down to the alignment of its operations to produce. Examples of this would include involving a broader definition of stakeholders versus shareholders such as environmental agencies and unions in determining the best course of action for a company’s future operations and how it should be run.

Besides some of the insightful deal war stories, future PE trends and industry knowledge he shared, he also gave great advice on what he thought it took to be successful which was well received by the crowd.

There were a host of excellent questions asked by the crowd in the Q&A session as well as the cocktail reception following. I’m looking forward to the next event hosted by the PEVC club.

MAJUP

The past few weeks have been pretty busy with a variety of events. LBS hosted its first combined TMT conference with the technology and media club on Friday Feb 25th with speakers on topics such as new revenue streams for IPTV and the forecast for cloud computing. There was one particularly interesting speaker who equated using cloud computing to storing informational currency in a bank. While you appear to be giving up control in the form of a physical box hosted on site, the security and convenience of cloud computing is similar to withdrawing money from an ATM.

That weekend I had some friends from Barcelona visiting (they were going to pursue careers in the TMT space) and they also had the fortune to stay for Tattoo, a school wide celebration of cultural diversity with artistic and gastronomic displays. The entire school was set up with tents as students prepared food native to their homelands wearing traditional dress and putting on performances to display their artistic talents.

This past weekend was spent in Lisbon. With exams coming up, it was a good opportunity for the exchange students to have one big go at a trip before many of us run off at the end of the 10 week term period. Time seems to have flown by as we are already in March.