Turnarounds of Private Equity Portfolio Companies

<p>Over the years, our firm
has been involved in many turnaround engagements involving the
private
equity community. Recently, we have been asked to perform due
diligence
prior to investment by reviewing key operating assumptions. Our
normal
crisis venue helps us focus on the integrity of the financial
assumptions,
especially cash and the effectiveness of financial and operating
systems,
as well as management's effectiveness and ability to perform to
plan.

</p><p>The seeds of the next wave of turnarounds are being
sown now with the increased M&amp;A activity. It is timely to
suggest that
investors at least consider certain actions to mitigate the problems
of the
next downturn. This article highlights certain problems we have
found in
the past, as well as the process used to address those and other
turnaround
issues.

</p><h4>Common Problems Found in Troubled Companies Controlled by
Private Equity Firms</h4>

<p>We purposely chose examples of troubled situations,
which lead to eventual liquidation or sale with little going to
equity to
emphasize the downside.

</p><p><i>1. Lack of effective or accurate accounting systems (including
systems conversions).</i> Probably the most interesting case here
involved a
very large payroll-processing organization whose accounting system
and a
portion of its payroll operating system were wiped out when
converting to a
new system. The third-party service company performing the
conversion
failed to make a timely backup and then copied the blank database
over the
existing database, wiping out all records. We were called in to this

company, with revenues approaching $2 billion, after initial
attempts to
recover the data failed. The company was literally running blind.
Control
over operations was regained by first operating the company on a
bank-balance basis. Three times a day, the balances were updated and
we
could decide what could be paid. Spreadsheets were built to provide
near-term cash projections and visibility, while the accounting
problems
were addressed. Within several weeks, we were able to develop the
primary
accounting and control reports to run the business. Despite the
Herculean
efforts of all involved, the damage to the company was done. It was
fatally
wounded as it lost customer confidence, and the investors properly
chose
not to continue funding losses caused by customer defections and
conducted
a wind-down.

</p><p><i>2. Roll-ups.</i> The troubled roll-ups we see generally result
from failure
to maintain standards during the roll-up period, generating deals
just to
do deals and a failure to consolidate the acquisitions. Several
years ago,
we were called into a regional paint manufacturer with operations in
five
states and little in the way of effective consolidation. Each of the

operations was profitable prior to the acquisition, but was losing
money
when we entered. There was no real rationale for the purchase of
several of
the companies other than the flawed business plan submitted to the
equity
sponsor. The business pieces were sold, leaving creditors with a
substantial shortfall.

</p><p><i>3. Inept management.</i> Problems caused by inept management
are the largest
single source of assignments. One common theme is lack of attention
to
detail. I remember walking through one factory and finding an
incredibly
inefficient operation. When I asked the general manager about what
he had
done, he told me that he brought it up to the plant manager several
years
ago. He had not followed up. The business was eventually sold.

</p><p><i>4. Waiting too late to
address serious problems.</i> Problems do not
solve themselves. They must be addressed on a timely basis, or they
will
begin to drain financial resources, leading to other problems and
eventual
enterprise failure.

</p><p></p><center><img src="/AM/images/journal/feature2chart904.gif" alt="" align="middle" height="310" hspace="5" vspace="5" width="600"></center>

<p>We have generally found private equity investors very
insightful in understanding the problems facing their investments.
Unfortunately for them, they generally do not have the time or the
resources to focus on such specific operational problems and bring
them to
a successful resolution. The investor should make an early decision
to
either direct the necessary internal resources to address the
problem
themselves, or retain an independent third party, free of
preconceived
notions or political baggage, to attack and resolve the issues.

</p><p>The investor should take care to avoid becoming so
active a participant that they lose the legal protections afforded
them on
the investor or board levels. The risk of liability increases as one
moves
from being a passive investor to a director and then to an officer
status.
These classifications can be deemed by actions alone and are not
dependent
on formal board resolutions. Especially troublesome is the potential

liability (generally for payroll-related items) an investor brings
to his
fund when he crosses the line and becomes involved in management.

</p><h4>Addressing the Problems: The Turnaround Process</h4>

<p>The remainder of this article discusses the five
stages of a turnaround and provides insight into the distinct
aspects of
each stage from a board of directors vantage point. The process
follows the
corporate-governance model, reflecting a director's point of view.
The areas of most immediate interest to an investor are addressed in
the
three critical success questions for a turnaround:

</p><ol>
<li>Can one or more viable core businesses be
identified, or can the existing businesses be fixed?

</li><li>Are adequate human or organizational resources
available, or can they be obtained in a timely and cost-efficient
fashion?

</li><li>Is adequate bridge financing in place or can it be
obtained within the required timeframe?
</li></ol>

<p>While those questions are key in determining whether a
business can or should be saved, it is essential that an investor
also
analyze a company's prospects beyond making sure that a plan is in
place. The plan must be executable, and it must lead to a recovery
higher
than that produced through a liquidation or sale of the business.

</p><h4>The Stages of a Turnaround</h4>

<p>The five distinct stages of a turnaround are:
management change, situation analysis, emergency action, business
restructuring and return to normal.

</p><p>The Turnaround Matrix at left summarizes the
objectives for each stage, as well as the actions required in each
of the
business's functional areas. The process provides a framework to
focus on important issues that must be addressed in an orderly
fashion. It
is far easier to convince stakeholders to buy into a suitable course
of
action once they understand there is a robust process in place.

</p><h4>Stage 1: Management-change Phase</h4>

<p>From the perspectives of the board of directors,
investors and the senior lenders, the key task to be completed early
in a
turnaround is to put in place a top management team that embraces
the need
for change and corporate renewal, while being capable and qualified
to
champion the turnaround process. Incompetent individuals and those
who are
resistant to change have caused the failures of many businesses and
must be
removed. Changes can be made to the team later, but the best results
come
from swift and decisive actions once the proper management,
possessing the
necessary skill sets, are in place.

</p><p>A board should consider hiring an experienced
turnaround specialist, corporate lawyer and/or an investment banker
to help
with the process. The turnaround professional may act as either an
advisor
or become part of the management team, depending on the inherent
skill sets
of the current management team.

</p><p>Because the board is "betting the
company" on a course of action, it has an obligation to all
stakeholders to make sure capable people are in place to advise and
assist
in the turnaround process.

</p><h4>Stage 2: Situation-analysis Phase</h4>

<p>The objective of the situation analysis stage is to
determine the severity of the situation and whether a turnaround is
reasonable and practical. Initial fact-finding includes interviews
with
management and employees and detailed analyses of key functional
areas in
finance, sales and marketing, manufacturing and operations,
engineering,
and research and development.

</p><p>This stage culminates in the formulation of a
preliminary action plan to address the most pressing problems. The
board
must look for a plan that it finds satisfactory and achievable, and
that
has the buy-in of management, employees and senior lenders. All
parties
must understand that changes in the plan may be necessary as new
facts
become known.

</p><p>During the recent economic downturn, the need for
thorough situation analysis has become even more important. The
increased
difficulties of the current environment presented by issues such as
rapid
technological obsolescence, decreases in residual value of fixed
assets,
compressed timeframes for turnarounds due to internal lender
pressures,
foreign competition and lack of sales visibility require the board
to
ensure that both key short-term and long-term issues are addressed.

</p><h4>Stage 3: Emergency-action Phase</h4>

<p>The objective of the emergency-action phase is to
gain control of the situation, achieving at least a break-even cash
flow.
It is especially important that this stage be executed properly. An
investor needs to ensure that cash flow is stabilized and assets
needed for
long-term viability remain unimpaired.

</p><p>This stage is characterized by the classic actions
frequently identified with turnaround managers: layoffs,
cost-cutting,
plant closings and abandoning unprofitable product lines or
locations,
while accelerating high-potential opportunities. The status quo is
challenged, and those who actively participate in the plan are
rewarded,
while those who are unwilling to change are sanctioned. Frequently,
the
turnaround professional must provide quick corrective surgery in
order to
save the company operationally or prepare it for a sale as a going
concern.
If these corrective actions are not deep enough, the board of
directors may
be left with no alternative other than liquidation.

</p><p>As turnaround managers, we frequently hear myths
involving turnarounds. "If I only had more money, everything would
be
just fine," or "We will grow (sell) our way out of the
problems." Both beliefs are fatally flawed. An investor who hears
rationalizations such as these should guard his purse strings.

</p><h4>Stage 4: Business-restructuring Phase</h4>

<p>The objective of the business-restructuring phase is
to enhance profitability through operational changes and to
restructure the
business to achieve increased profitability and return on assets.
While
this may be the most difficult stage, it is also the most important.

</p><p>In this stage, the emphasis changes from cash to
profits. The "heavy lifting" that occurred during the emergency
action stage gives way to developing the management team. If this
stage of
a turnaround is not successful, odds are that the company will
revert to
crisis. The company must concentrate on continued profitability and
improved operating efficiencies.

</p><p>In our opinion, the business-restructuring stage is
the most troublesome. Although the crisis portion of the turnaround
has
passed, the company remains fragile. Constant vigilance must be
maintained
to prevent backsliding. If a company that just recently came through
a
crisis slips back, its chances of success shrink dramatically. A
second
crisis will cost the company its credibility with the outside world,

further strain already depleted financial resources and, perhaps
most
importantly, dilute the focus and trust of its employees.

</p><h4>Stage 5: Return to Normal</h4>

<p>The objective of this stage is to institutionalize a
permanent change in corporate culture to focus the company on
profits and
return on investment. This is the growth stage and is the time in
the
firm's life cycle that investors and the board typically excel.

</p><hr>
<h3>Footnotes</h3>

<p>^{<small><a href="1">1</a></small>} Thomas D.
Hays III is a Certified Turnaround Professional and a principal of
NachmanHaysBrownstein Inc. He has provided leadership as interim
Chief
Executive Officer, chairman or advisor to the board in a wide
variety of
companies both private and public. <a href="#1a">Return to
article</a>

</p><p>^{<small><a href="2">2</a></small>} Terrance P.
Morgan is a Certified Turnaround Professional and a managing
director of
NachmanHaysBrownstein Inc.'s Cleveland Office. Mr. Morgan has been
involved in more than 40 engagements with distressed companies over
the
last six years. <a href="#2a">Return to article</a>