Distressed Company Management: The Crucible of Leadership
By Thomas M. Kim, CTP, r² advisors llc
”Okay,” said the Wiz. “If you’ve got assets with a market value of $2.2 billion and debts of $1.3 billion, then your net worth is $900 million, and you’re rich, right? That’s where we were in late 1989, 1990 and early 1991 even. Okay? But if you wake up one day and the market value of your assets has declined to $1.1 billion, and you still owe the $1.3 billion, then suddenly the paradigm has shifted and your net worth is minus $200 million, and it’s a serious issue. And that’s where we are today. All right? In the real estate business, market values can move up and down very fast. They’re agile, they’re flexible, they’re terpsichorean.” The Wiz made an awkward little flutter with his fingers to indicate terpsichorean. “But debt just sits there, like a rock formation, like a mountain. It doesn’t budge. We’re not in a cyclical downturn, Charlie, we’re in a… special situation.”
A Man In Full, Tom Wolfe (1998).
Distress. Turnarounds. Special situations. These euphemisms describe the very serious circumstances that confront companies whose business plans are not working out. But encountering a difficult situation should not be the end of an otherwise economically viable enterprise. But the key determinant for success is the company’s management team. An enterprise that is facing a serious crisis must be led by a team that understands the dynamics of companies in crisis.
Companies operate in all types of economic weather. Sometimes the prevailing economic conditions are favorable, and only the most incompetent fail. Sometimes, the prevailing economic conditions are not favorable, and all but those who are best-led and capitalized fail or teeter on the brink of failure.
Success in the turbulent waters of underperforming and distressed companies can be difficult to define. This is particularly true when comparing distressed situations to the non-distressed, general business world. This distinction is important because it highlights the challenge facing managers of distressed companies. Many of these concepts have been written about ably by others, including Jim Collins in his books Good to Great and How the Mighty Fall. This article focuses on leadership at distressed companies, particularly those in the middle market. On the sunny side, business success is typically defined in terms of profit and growth. Some might put a finer point on this and define success as profitable growth while building enterprise or shareholder value. Success on the sunny side is normally not defined in terms of simple survival or a sale in which senior debt is repaid, without any meaningful payment to junior creditors or equity.
The distressed world is much different. In a distressed situation, a successful outcome might be a par recovery by senior debt or an asset sale in which all debt receives less than par. But, that may be the best recovery available under the circumstances.
Those managers must have specific skills and knowledge, and the experience to define success in keeping with their circumstances. They must be adept at handling the unique challenges that exist in the troubled company environment. Although the skills used managing in a distressed situation – leadership, decisiveness, insightfulness and motivation, their use and application is much different than when managing on the sunny side.
Middle market companies present interesting issues. Due to their smaller scale, there are fewer management levels, and hence fewer buffers between the distress and the employees. Also, managers are maneuvering closer to the ground, so there is less margin for error; when the company runs low on cash, payroll could be threatened. Another important element may be that the shareholder’s entire net worth, and that of his family, may be tied to the company; a failure could have a real impact on the family’s lifestyle. These situations place leadership skills into sharp relief; distress is the crucible of leadership.
It’s simply a lot harder to lead well when cash flow is tight, and difficult decisions are made to prioritize payments. The whole act of juggling resources and relationships can create a raft of unintended consequences. What’s worse is when these difficult decisions are not made in these circumstances. So in the best case, management is making very difficult decisions. At worst, these difficult decisions are ignored and are made by default. The strain on the management staff grows and the potential for lawsuits and threats of lawsuits can distract those unfamiliar with the process. Employees feel an overriding sense of doom. The purchasing department is told that by a vendor that they are on credit hold and cannot order products. This information trickles out to the rest of the staff and the next thing senior management knows, rumors are flying that the banks are going to lock the doors and the company is preparing to file bankruptcy!
An inexperienced manager might simply deny the rumor or berate the brave employee who asks. This is not the time to deny reality; employees should not be treated as if they are not completely ignorant. While they don’t know for sure, usually there is at least a kernel of truth in every rumor. When the rumors regard the company’s financial health and stability, they usually are based on more or more common markers of distress – examples include credit holds, deferred maintenance, restrictions on travel and entertainment, uncoordinated and hasty layoffs, desperate sales promotions, stern faces on managers and many more closed door meetings. When a company is nearing or in distress, the better course of action is to engage employees in a reasonable dialogue about the company’s condition.
Senior leadership can fall into a malaise that is induced by distress. Different people react in different ways, but one common reaction to distress is to bury one’s head in the sand. Some will acknowledge distress but conclude that if they can only get more sales, the company will be fine. This is the corporate equivalent of race car drivers simply giving it more gas whenever they find themselves in a difficult situation. Sometimes this is an appropriate reaction, but at times it is not. In fact, sometimes it is exactly the wrong thing to do. Indiscriminate application of the throttle can lead to more trouble. The same is true in business. The most talented turnaround managers know how to detect and work through all of these management reactions.
Since shareholders will typically have a large role in middle market private companies, skilled turnaround leaders will be adept at addressing their concerns and the behaviors that are common when their equity is threatened. It is common for human beings to be motivated alternatively by fear and greed. But effective leaders are more balanced and are capable of being much more disciplined even in the most stressful situations. This balance can be achieved and is easier to achieve when the leadership has a deep understanding of the environment in which they work. For example, bankruptcy is an option that is very disruptive. One of the primary reasons is that most business executives have no real understanding of the process. Further, what they think they know might be inaccurate. So, an accurate understanding of the bankruptcy process is essential in order to effectively lead a company through a turnaround. Another situation that arises frequently in distressed companies is the urgency with which decisions must be made. Typically, a company operating under sunny skies will have time to contemplate and analyze major initiatives to a meaningful level of comfort. Almost by definition, distressed companies do not have that luxury. There will be a high degree of urgency for most important decisions; the company must quickly and deliberately deliver results. To do this, leadership must have a balanced sense of urgency. The leadership must know the right things to do, and not just focus on doing things right.
Effective leadership is a function of the environment. A pure sunny day attitude usually does not work because the employee base knows something is amiss. By the same token, a down beat attitude also needs to be changed. An unnecessarily downbeat approach is likely to be just as ineffective as an overly sunny disposition.
How can a manager convince the ablest people to remain on board to turn a company around? Most of the time, the best employees have career options and will need to be convinced to remain at the troubled company. To provide guidance, the leader has to have experience with distressed situations in order to speak persuasively about the potential outcome and the chances for a successful turnaround. This is not to suggest that all employees will choose to remain at the company in order to participate in the turnaround. Many will choose to seek alternatives. Since the most talented people will have options, the leadership must be sensitive to team dynamics and should have some understanding of the disruption that will be caused by the departure of some or all of the essential team.
Of course, the turnaround advisor must be candid. Surely, the chances for a successful turnaround can neither be 100 percent, nor can they be zero. Irrespective of odds, the advisor must be able to communicate his or her sense of whether the company can be turned around. This discussion should include a statement, when appropriate, about the factors that would make turnaround more or less likely and the process through which the return to profitability would occur.
Leadership in distressed situations is different from sunny day situations. Most companies with viable products/services who end up in trouble likely got there through some management misstep. Typically, the best management teams avoid distress by adequately planning their strategies and by making decisions that minimize the chance of creating distress. Almost by definition, companies that do not employ adequate decision-making processes will be suffering some weakness in their personnel. Now, when the company is in distress, the challenge is to get better performance from people who underperformed when the company was doing well. Sometimes, it is not as easy to replace underperforming employees; they want to hold on to their jobs and recruits will be leery of joining a company with open issues.
So, imagine a hypothetical company:
A 45 year old manufacturing concern has $50 million in annual revenue. The company makes a variety of products, and the products are sold to a wide number of customers, but all products are tied to one industry. The company has 6 shareholders – father, mother, brother and three children; the father serves as the CEO, and his brother works in the research and development department. The CEO leverages the company to the point that the company’s total secured and unsecured debt exceeds its tangible book value; equity is essentially worthless. Operating margins are theoretically substantial, but have shrunk recently and the trend appears to be negative. The company is losing money on an accrual basis and is cash flow negative for the most recent quarter
Assume that the CEO comprehends that the company is in financial difficulty, but he believes that he is going to increase sales somehow, and power his way out of the situation. Assume that the CEO is seeking input on the decision whether to hire a turnaround advisor.
One of the basic truths is that if the CEO had the skills to manage this crisis, he probably would not have gotten to the point that the company is overleveraged, has shrinking operating margins and has no net equity value. So the first challenge is convincing the CEO that a consultant has the skills to help him out.
During the initial assessment, the turnaround consultant should begin the process by establishing that the company’s operating margins are sufficient – this will involve a disciplined review of the company’s historical financial statements, and by reviewing source data to determine that the company’s recent operating margin erosion can, in theory, be reversed. The source data can include vendor invoices and, if the company uses a standard cost system, a review of the internal process for maintaining the system. This initial assessment also should involve a review of the company’s overhead to establish that the operating margins are sufficient to sustain the company’s operations in their current form, or to determine whether there is a level at which operations can be sustained. The CEO must be confronted with a fresh, objective, and realistic assessment of the business to determine whether it is theoretically possible to remain in operation.
In many respects, the experienced turnaround advisor occupies a unique position; typically analytical and inquisitive, the turnaround advisor is able to provide conclusions about the business and to justify the conclusions with objective data. Experienced turnaround advisors have the skill and tact that allows them to communicate findings in a persuasive manner. This is not to say that managers experienced with divisional turnarounds do not possess these skills. However, the skill needed to lead a divisional turnaround is different than that needed when the division does not have the financial resources of a larger corporate parent. These situations tend to be income statement focused efforts. Turnaround managers are required to make income statement changes while also tending to the balance sheet. At the end of the day, the lack of adequate financial resources is the catalyst that turns a difficult situation into a distressed one. Large corporate managers contemplating a move into the turnaround world ought to audit their skill set and determine whether they should augment their repertoire by learning more about the stresses induced by a real sense of urgency.
Sometimes, for the sake of precision, the analysis must be segmented by product, customer, division, location or other differentiators. It is important to determine the true source of distress. It is more tragic when a distressed situation is worsened by a sloppy turnaround effort. If a company’s main product cannot be produced at a profitable operating margin, then attempting to produce and sell more of them will not result in positive results. Likewise, if a particular customer, division or location is unprofitable and a drag on cash flow, the solution must involve correcting the problem or the future will remain imperiled.
Thomas M. Kim, CTP, JD, MBA
Mr. Kim is the founder and Managing Director of r2 advisors llc, a Denver-based financial advisory and turnaround consulting firm. His advisory practice revolves around businesses that are facing financial or operational distress.
The author acknowledges Randy Lewis for his contribution to this article, and for his insights throughout the years.
For more on the TMA visit their website at: https://www.turnaround.org/