Successful Restructuring

Newsletter Q2 2005

Introduction
Why do companies get into difficulty?
Restructuring options
Conclusion

Introduction

Continuous growth in shareholder value remains the key business objective for private and public business enterprises. However, growing revenue and profitability year after year in fiercely competitive markets, is a challenge that few companies achieve on a consistent basis. Expansion through acquisition, whilst tempting for revenue growth, can lead to complex integration issues and periods of underperformance. The Compaq acquisition by HP in 2002 is a case in point, with the Chief Executive recently losing her position due to continuing underperformance.

Companies will therefore have periods where restructuring and business refocusing is required. It is crucial that the board of directors and the management team recognise the requirement to restructure, develop an executable plan and, if necessary, negotiate with creditors and shareholders. In cases where financing difficulties become apparent, the court based solutions of administration and/or insolvency can be avoided if the need for change is accepted.

In this newsletter we plan to analyse the restructuring process and highlight solutions to ensure a successful outcome.

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Why do companies get into difficulty?

There are several reasons why companies reach a situation where a refocusing, or a restructuring, is required. These include changes in the competitive environment and an inappropriate cost or capital structure.

Changing Market Dynamics

The globalisation of business has lead to a rapidly changing environment. The winners are the companies able to embrace these changes by reducing costs, whilst increasing the quality of their products and services to their customers. In the food retailing sector, both Wal Mart in the US and Tesco in the UK have used the latest technology to manage their supply chain and distribution networks, resulting in consistent lower prices for their customers. This has also allowed both companies to broaden their offering of products and services, thus expanding their addressable market from initially low cost foods to multi product offerings internationally. Companies that have been unable to adapt to these developments have lost market share and have been forced to restructure or to sell their businesses. In the US, Kmart was recently purchased by a hedge fund intent on an aggressive restructuring. In the UK, food retailers including Sainsbury, Morrison/Safeway and Marks & Spencer have been forced to change their management teams and their strategies in an attempt to regain market share. The constant threat of a hostile bid retains the management focus.

Capital Structure

In a low interest rate environment, there is a tendency for companies to leverage their balance sheets as the cost of debt is significantly lower than the cost of equity. Finance theory also highlights the advantages of holding a certain amount of debt on a company balance sheet to benefit from the tax shield effect of interest payments. Furthermore, the leverage buy-out specialists have found that a significant amount of debt on the balance sheet matched with the necessary incentives, focuses the attention of the management team to cut costs ruthlessly, expand the company’s markets and repay debt as rapidly as possible.

However, in a competitive environment, with declining revenues and profitability, inappropriate amounts of debt on the balance sheet requires rapid action. The telecom sector in the last 3 years has had to contend with over leveraged balance sheets following the excesses of the 1990’s. Companies such as France Telecom, Deutsche Telecom, Global Crossing, Energis and Marconi have had to sell assets, merge with competitors and/or, indeed, restructure through a court based procedure such as Chapter 11 in the US to redress their inappropriate capital structures.

Cost Structure

Companies that are unable to reduce their costs in comparison with their competitors will rapidly lose profitability. Maintaining a flexible cost base in rapidly changing market conditions is an important goal for companies. The ability to outsource production and services provides a company with the opportunity of converting fixed into variable costs. There are of course limitations to outsourcing, particularly in the areas where companies need to develop and maintain their competitive edge, such as product development. However, the cost advantages versus the potential loss of control of certain aspects of the business have to be considered carefully. Dell has been able to redefine the PC hardware business through direct marketing to consumers. The company has employed the latest technology to manage their distribution systems and suppliers, resulting in very low inventory levels. Dell is now a $100 billion company, built over 20 years, in a fiercely competitive market, through organic growth and no acquisitions. Compaq, which initially had a dominant position in the PC hardware market, was unable to transform its expensive distribution structure. HP acquired the company in 2002 and restructuring the two unprofitable PC hardware businesses has been, until now, unsuccessful.

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Restructuring options

The first task for the board of directors and for the senior management team is to accept that there is a requirement to restructure the business. Private equity firms, due to their effective monitoring role of management, can often force change in a company’s management team and accelerate a restructuring more rapidly than in a public company situation. In some cases, a change of senior management is required in order to refocus the business, as occurred at IBM in the early 1990’s. Lou Gerstner, an outsider, successfully led the transformation of the business from a focus on hardware to one on services.

In any case, the commitment of the senior management team must be secured as early as possible in the process and an executable short to medium term plan must be put in place with clearly identifiable targets.

Cost Cutting

Stage One of the restructuring process is for the company to cut costs and to redeploy resources as rapidly as possible. Once the decision on the direction of the company has been taken, the disposal of surplus assets needs to be executed. Whilst a rapid sale reduces the proceeds, a structured auction with sufficient competitive tension ensures that a market price is obtained for the assets. In the situation where assets are required for the future business, it may be possible to remove them from the balance sheet through sale and leaseback transactions, or through the formation of joint ventures and alliances with partners.

Throughout this process, it is essential to reduce the uncertainty for employees through constant communication. A well executed cost reduction plan needs to include careful management of the free cash flow generated by the business.

Negotiating with Creditors and Shareholders

With an over-geared balance sheet and falling profitability, early discussions with creditors and shareholders are essential in order to develop a realistic workout plan. Whilst shareholders may be unwilling to inject further funds into an ailing business, creditors will be keen to avoid, as far as possible, a court based administration and insolvency procedure due to the high costs involved. With a credible plan and management team, convincing creditors to accept significant reductions in their repayments is an achievable objective.

Deals can be structured creatively to include short term payment holidays or balloon payments, once the business has been transformed. Equity sweeteners also can be added to provide creditors with upside potential in return for a lengthening of the repayment period, the injection of further debt and/or the reduction of liabilities. As long as creditors have the confidence that the restructuring plan is achievable, there are many alternative financial structures that can be negotiated between a willing management team and creditor group.

Merger into another Firm

During the restructuring and asset sale process it may become apparent that a full sale, or merger of a business, either to a competitor, or to a financial investor is required. The existing business either can be fully absorbed into another company in a similar sector to generate synergy benefits, or can be retained as an independent subsidiary under new direction. In either case, such a strategic transaction is transformational for the business and provides a catalyst for the successful restructuring of the business.

A Formal Restructuring

In the situation where a more drastic financial restructuring is required and there are too many disparate creditors, it can be impossible to negotiate a restructuring without a formal process. In the UK and in the US there are two main methods:

• Administration or Chapter 11

This is a formal supervised modification of claims on a business. The aim in these situations is to preserve the business as a going concern, or to sell the business. Creditor claims are frozen and in many cases a radical restructuring plan is put in place. The aim of the process is to preserve as much value for the creditors as possible, often to the detriment of the equity holders.

The administration/Chapter 11 process has been used in certain circumstances by aggressive management teams in the UK and in the US to force creditors to accept write-offs of their loans. However, the administration process also has negative consequences for the business and often leads to customers and suppliers renegotiating, or cancelling their contracts. This often impacts negatively on the future viability of the business.

• Liquidation or Insolvency

The most drastic situation for a business is liquidation, or insolvency, where the business effectively ceases to exist and a court appointed liquidator disposes of the assets and makes a distribution to creditors according to their level of security. Shareholders and unsecured creditors will invariably receive little or no payment in this situation.

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Conclusion

Financial distress is costly for creditors and shareholders and prompt action at an early stage is essential to achieve a successful outcome. Close communication between the management key shareholders and creditors is necessary in order to avoid a court based procedure with the detrimental effect of the business.

Obtaining the necessary financial and legal advice at an early stage can assist a management team in developing a plan that is achievable and provides the necessary confidence to the key creditors and shareholders.

The views expressed in this newsletter are those of DC Dwek Corporate Finance Limited and are provided for information purposes only.

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