Duck Soup and Other Ingredients of Chapter 11

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Nov 2000

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In a previous article in Turnaround Topics, I indicated that "with the exception of litigation-driven defensive
filings, chapter 11 inevitably arises from some failure of company management and its board of directors
to effectively guide the business operations and assets under their control. Events leading to economic
failure are generally well understood and seem obvious, particularly in hindsight. They all involve some
inability to recognize and respond to one of the following factors, frequently compounded by the amount
of existing debt."<a name="1">1</a> I then listed several factors on which management needed to be vigilant.

Business investment requires faith. Faith that capital invested will generate a positive return. Faith that
capital will be used to manufacture a better, price-competitive product. Faith that this product will actually
be purchased, that prospective customers will know about it and will think it is needed in the first place.

This is hardly an encouraging scenario for going into business and putting millions of dollars at risk.
But businesses do this every day. They do this by reinvesting profits in working capital, plants and
equipment, personnel, advertising, product development, etc. Further, businesses also look to expand into
new markets, offer new products, establish new distribution networks, enter into strategic relationships, and
acquire other companies. They do all of this instead of returning profits to their owners through dividends
or stock buybacks or even liquidating the enterprise.

Therefore, business management today is a function of managing existing risks, identifying new
opportunities, and delivering value from both. Perhaps we should be surprised that in pursuing these efforts
to deliver value, more businesses don't fail.

However, not all faith in business is rewarded. Some enterprises, by virtue of the very products and
services they offer, will not find a market and will fail. Others will experience too much competition and
will not be able to survive because of pricing pressure or insufficient sales volumes. Even the successful
ones, companies with positive operating margins, will find other pitfalls that may imperil their long-term
success. Here is a list of some of those ingredients.

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The most pressing problem a company has to address is unanticipated losses that it cannot easily explain.
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<h3>Key Ingredients—Betting the Ranch</h3>

1. My competition won't accommodate my new initiatives. So many business strategies are built on an
assumption of growth. But growth has two potential components—systemic and company-specific.
Everything else being equal, with systemic growth a company should expect its revenues to grow in
correlation to overall economic activity. When growth plans are predicated on new company-specific
initiatives, such as new product introductions, product extensions, additional capital expenditures or new
manufacturing facilities, many businesses default to optimistic scenarios that often fail to incorporate the
potential reactions of competitors, which may blunt or completely neuter such initiatives. In addition, they
frequently fail to acknowledge how difficult it is to achieve and maintain a growth rate in excess of the
systemic growth rate of the economy. Nevertheless, many companies allocate excess amounts of capital
and other resources to new initiatives without a full appreciation of the risks being assumed and a realistic
assessment of the potential returns.

2. I need to be bigger. Companies capable of increasing revenues in excess of the economy's systemic
growth rate are usually awarded higher valuation multiples than companies experiencing lower or more
systemic levels of growth. This is due in large part to the supposition (usually correct) that greater revenues
produce greater profits, and companies with greater levels of profitability are more valuable. Moreover,
Wall Street investors strongly favor large capitalization companies. One consequence is that many
companies decide that top-line revenue growth is critical and, to the extent that new company initiatives
may not produce the desired growth rates, pursue acquisitions to achieve this objective.

Acquisitions may serve to expand product lines, improve distribution, remove competitive threats or
cross-sell complementary products. However, in pursing acquisitions as a vehicle for growth, many
companies pay too much for acquisition targets, rationalizing the transaction price based on rosy
assumptions regarding future synergies and cost savings, among others.

3. I need more capital. Capital availability is a function of supply and demand based on both
macroeconomic trends and specific investment opportunities. Access to capital is an extremely limiting
factor for many businesses. At the right cost and availability, every business would use additional capital
to develop all the business opportunities available provided that the return would exceed the cost of the
capital on a risk-adjusted basis.

Companies seek to deploy capital as it becomes available and develop opportunities accordingly.
Conversely, as business opportunities arise, capital may become more readily available. The problem,
as noted above, is that availability of capital may fund opportunities that are not as judicious or robust
as contemplated, or support managements that are not as talented in implementing new initiatives or
integrating acquisitions as they are in conceiving them.

The negative effects of misdeploying capital are magnified when the capital is in the form of debt, with
its burdens of interest and principal repayments. Leverage cuts both ways. When plans succeed, the
leverage permits substantial returns on equity. When plans fail, debt-holders frequently replace
equity-holders as owners of the company. For example, the past decade has enabled many companies to
access the burgeoning high-yield market as a source of debt capital. High-yield long-term debt replaced
short-term debt obligations, extended amortization requirements, funded acquisitions and new business
ventures, or established reserves for future initiatives—all with the belief that the new capital will fuel
additional growth.

The "I need to be bigger" and "I need more capital" syndromes are mutually reinforcing. They are
typically linked with the expectation that with enough growth, high debt burdens will be affordable and can
eventually be retired or refinanced. But expectations and reality have a way of diverging. And debt capital
has a way of being involuntarily transformed into equity, or is lost. The key is to balance the mix of debt
and equity or be willing to understand the risks and to accept the potentially negative consequences.

<h3>Common Ingredients—Lack of Effective Control</h3>

There are additional common ingredients that many managements ignore that contribute to business
failures.

4. The losses are temporary. The most pressing problem a company has to address is unanticipated losses
that it cannot easily explain. Worse, the company assumes or rationalizes that the losses will be non-recurring.
The failure to immediately stem unanticipated losses and to identify the source is a slippery slope from which
companies may never recover. Many businesses do not understand their core components of revenues and
costs and therefore do not know why losses occur. Further, many businesses don't even attempt to undertake
this type of analysis, so they cannot differentiate between profitable and unprofitable revenues and other
activities, relying instead on the belief that all revenues are good revenues.

5. I want a compliant board of directors. Every company, public or private, needs a good board of
directors (an outside group of advisors may be appropriate for a private company) willing to engage and
challenge management. This is especially important in private companies where management and equity
are often the same, and boards serve merely as rubber stamps. The failure of a board to properly engage
its management is a key business failure. For public companies, the pendulum has clearly moved toward
more activist boards. For private companies, the failure of a board is only acknowledged in the hindsight
afforded by a chapter 11 filing or a similar disclosure of trouble.

6. I don't need to empower or communicate with my employees. This has many variations—from the
mushroom approach (keep them in the dark and occasionally throw dirt on them) to the lack of
acknowledgement regarding their individual and group contributions, to restricting their ability to make
decisions. All contribute to a reduced ability to retain talented employees.

7. I can ignore my lender's concerns. There should be no louder wake-up call. Companies with
asset-based lenders should be particularly mindful of suggestions made by their lenders. Often, this comes
via a communication from a lender that a new officer has been assigned to your account. Regardless of
whether the lender's views are correct, their ability to impact liquidity can dramatically impact a business.
Failing to act decisively is a key business failure.

8. I don't need outside help. In building a business, leverage off of good ideas, people and external
capabilities. Wanting sole control of all factors of production or decisions is not very effective. Authorship
and even control of these components is not as important as business success.

9. I will call my lawyer and see you in court. When trouble appears, seek the advice of legal, financial
and operational professionals. While a legal solution may be appropriate, it may be costly and
time-consuming. Worse, it may not solve anything on a timely basis. Many companies falter by focusing
on litigation and not on implementing interim or permanent measures that are designed to improve the
long-term prospects.

<h3>Anecdotal Ingredients—Sure Signs that a Company Is in Trouble</h3>

10. I need a new corporate headquarters. Building a new corporate headquarters disproportionate
in size and opulence to its needs is almost always a sure sign of future trouble. If nothing else, it is a
major distraction for the CEO who may not get as much occupancy as contemplated.

Several years ago, Fortune magazine ran an interesting story about the dominance of certain
companies from the 1950's to the 1970's and how they failed to maintain their prevailing competitive
position in the 1980's and beyond. Each company had several of the ingredients noted above as
contributing factors. Much goes into making duck soup, and to quote Groucho Marx, "One taste and
you'll want to duck soup forever."

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<h3>Footnotes</h3>

<a name="1">1</a> "Trout Fishing South of the 49th Parallel," ABI Journal, Vol. XIX, No. 6, July/August 2000. <a href="#1a">Return to article</a>

Journal Authors

Harvey L. Tepner

Journal Date

Wednesday, November 1, 2000 - 12:00