Faced with a sluggish economy that puts pressure on profits and hinders early sales to buyers or public markets, private equity firms often have to keep companies in their portfolios longer than they would ordinarily prefer. But what should happen during these extended holding periods to increase the value of a company? How much assistance can a firm provide without undermining the company’s ultimate independence? And what can a firm do during a prolonged period of ownership to reassure a company’s key audiences — from management and rank-and-file employees to customers and investors — that their efforts continue to strengthen the portfolio company over time?

Taking a less hands-on approach may have been a less risky proposition when the economy was booming and portfolio holdings could be resold quickly and profitably. But these days, most companies are struggling to rebound from the recession, and if a PE fund is not responsive to the needs of a company
on a real-time basis, its future value will be negatively impacted.

At the other extreme, some private equity firms react to hard times by immediately replacing management, slashing costs and assuming complete control of the business. But that, too, brings risks, including damaging employee morale, lowering productivity and slowing the timetable for getting the company in shape to be sold. Rather than being able to exit within four to seven years, the private equity owner might have to stay invested considerably longer, waiting for the new managers to establish the kind of track record that could attract buyers willing to pay a premium price.

Often the approach is to split the difference, not only keeping most or all of current management but also bringing in temporary outside help that can speed the rehabilitation of the company. The idea isn’t to dictate changes but rather to aid in analyzing problems and developing solutions that the managers will embrace. If the ideal balance is struck, the company’s management team will emerge with a record for succeeding despite adverse conditions, and the private equity firm may be able to take its leave on profitable terms — and to build a reputation for turning around troubled businesses, which can help it attract the next round of investors.

Particular success can be achieved when the PE fund and its specialist teams are brought in to work with management to improve particular areas of a company, providing expertise on human resources, information technology, merger integration or underperforming departments.

For example, Wynnchurch Capital, a private equity fund in Rosemont, Ill., recently accomplished a textbook transition, improving a portfolio company by providing management with targeted specialized assistance and developing a framework to drive improvement across the entire organization. In 2007, Wynnchurch acquired two struggling automotive rubber seal manufacturers, GDX Automotive and Metzeler Automotive North America, with the plan to merge the two operations into a newly formed company, Henniges Automotive. The potential efficiencies were substantial, but so were the challenges of combining the two businesses. Wynnchurch had to establish a new management organization, install new management processes and frameworks, dramatically improve operating efficiencies and quality, and replace two incompatible information systems that affected a range of essential functions — from accounting and purchasing to sales and customer relations.

A major attraction of GDX was its strong customer base and product mix, but prior to the acquisition the company suffered from poor quality, inefficient manufacturing and significant operating losses. In some cases as much as 20% of the parts rolling off the production line were flawed and had to be scrapped, and the productivity of certain operations was half of industry averages. Management had to rebuild customer confidence in the business while also completing the integration of the two companies. Since the merger, Henniges has not missed a single launch date and has dramatically improved quality and efficiency. As a result the company has re-established itself as a preeminent global supplier.

Many of GDX’s quality control and efficiency problems, says Wynnchurch partner Terry Theodore, stemmed from old-fashioned organizational structures and work practices. Management had not engaged the workforce to help solve performance issues and instead relied upon an archaic system of management-labor relationships. Changing that system was a priority, and Wynnchurch used the acquisition of GDX and its merger with Metzeler to engage the workforce, including the unions, to solve performance issues. The employees on the plant floor knew what the problems were, and so management provided them with the information, training and authority to solve issues quickly. The labor unions provided a highly constructive conduit to engage the workforce in a dialogue regarding required changes. In exchange for agreeing not to cut wages or health care benefits, the company was able to establish flexible work rules that allowed Henniges to dramatically improve quality, delivery times and efficiencies. One example of these changes involved a union practice known as bumping. Whenever a job opened up, union rules dictated that the employee with the most seniority could take the position. This encouraged workers to shift jobs whenever they wanted a change of routine, which meant that most employees didn’t stay in one place long enough to develop the expertise to optimize performance.

Yet even with that essential compromise in place, countless additional details had to be taken care of in merging the two companies — from getting the new technology system up and running and training employees to use it, to changing plant signs and all communications to carry the new name of the combined company, Henniges Automotive. All the while, managers had to assure customers that changes were being made in an organized way that would not disrupt production.

The merged company’s CEO, who had worked with Wynnchurch on a prior investment, and the CFO, who had worked for Metzeler, oversaw the massive overhaul. But Wynnchurch also brought in its teams of specialist advisors to help create uniform systems for accounting, human resources information technology conversions and other functions. In most cases the advisors stayed for less than 12 months, working closely with Henniges’s management to develop sustainable systems that were built by and for the management team. With the two companies effectively integrated and poised to take part in the auto industry’s rebound, the company has performed exceptionally well and won several new programs with its major customers.

THE IMPORTANCE OF COMMUNICATIONS

Regardless of how the relationship between the PE firm and the portfolio company is structured, the mere arrival of a new owner always causes a stir. Therefore, establishing an effective communications strategy is crucial — though it’s often beyond the capabilities of a newly acquired company’s existing communications team. Handling announcements of layoffs and other cost-cutting measures clumsily, for example, may provoke job actions by unions and denunciations from local politicians and media. To limit a backlash, PE firms can lend support by helping the portfolio company conduct a thorough assessment of its many stakeholders, determining who they are and how they’re connected to the business. For example, this could include an evaluation of how town officials will likely react to a significant reduction in workforce. If the team knows what to expect, it may be able to address and/or mitigate concerns before a public announcement by stressing the potential long-term benefits of necessary cutbacks.

CONSIDER THE BROADER MESSAGE

More complications can arise if the new owner isn’t sensitive to the company’s long-term relationships or commitments. For example, a company may have a long history of supporting hospitals or other philanthropic causes. If a private equity firm, in its cost-cutting efforts, simply eliminates that support, it may be taken as a sign that the company’s new owners are not interested in the community’s welfare. Similarly, the decision to relocate a company’s headquarters can be a communications disaster without careful preparation. Proactive communications aimed at building relationships with these stakeholders from the onset can establish a baseline of understanding and support that can preempt negative outcomes.

All such communications tasks are difficult for a company’s management to handle at a time when the business is struggling to rebuild. But with the support of the private equity firm, management can handle all these delicate jobs to pave the way for a smoother transition and preempt unforeseen interferences — ultimately succeeding in the task of enhancing a company’s value.

When we buy a company, probably the most important way we add value is by making sure the senior management team shares our vision. Of course, whenever possible we make this appraisal before a deal closes. Changing management midstream is hugely disruptive and costly, and it usually extends the time it takes to prepare a company for sale. Whereas private equity firms overall wind up replacing senior management about half the time, we keep our rate ataround 20% by being very careful before we invest.

Then we try not to get involved in daily operations. We won’t hire or fire a plant supervisor, for example, because you can run into lots of problems trying to shadow-manage every company in your portfolio. Yet we do follow the progress of our companies very closely. The closer you can get to being on the same page as a company’s management team, the better your chance of working together to increase that company’s value.

We once owned a company called Nimbus, based in Virginia. The management was particularly good at communicating with and supporting employees. I remember going to a company picnic where the CEO, other managers, board members and I put corn and burgers on the plates of employees. Later we talked to them and answered their questions. You don’t always get that level of communication and trust between company managers and private equity investors, but when you do, it’s a beautiful thing.

The best private equity firms excel at picking merger targets that will enhance the value of companies in their portfolios. They will look for compelling opportunities to increase market share, extend product lines, expand manufacturing capabilities or push into new geographic regions. Sponsors have carefully modeled the cost savings and related operational synergies. So why do as many as four out of five mergers fail to fully realize their merger objectives?

Consider a merger of two companies with combined revenues of $500 million. A reasonable expectation of annualized savings in this case equates to 8% to 10% of revenue, or approximately $50 million. But often enough, two years after the deal has closed, the new corporation may have realized cost efficiencies of only $10 million — dealing investors $40 million in unachieved savings each year, inhibiting margins and profitability. If the merged companies are in an industry in which the average valuation is seven times EBITDA, the impact of an incomplete integration in this case may decrease the valuation by hundreds of millions of dollars.

All M&A transactions have their own intricacies, and it can be a challenge to consolidate manufacturing facilities, legal and regulatory departments, supplier agreements, customers and sales channels, information technology, supply chains and each of the other functional areas of the business. There are many ways for a flawed integration to erode the anticipated returns on private equity’s invested capital. But as we have seen from our intimate work in many of these transactions, overlooking any of these five common pitfalls guarantees that an investment will not realize the full value envisioned.

Cutting too little too late. Probably the toughest task facing merging companies is deciding how many employees, including senior and middle managers, to eliminate. Many companies wait too long to reduce duplicate head counts, assuming — or hoping — that revenue will expand quickly or that internal politics will cause delays.

Two merging automotive supply companies made this mistake, failing to anticipate an economic downturn that occurred a few months after their deal closed, drastically reducing sales. Despite deep personnel cuts that were then made across the company, it was unable to bring about cost reductions fast enough and ultimately had to file for bankruptcy, wiping out equity. In hindsight, it was clear that if the company had eliminated excess jobs starting the day after the transaction closed, the resulting savings would have provided the company a buffer sufficient to avoid violating key debt covenants despite shrinking revenue.

An alternative approach was taken by two publishing companies that merged. But instead of going only far enough to meet merger model synergy targets, management took a more aggressive approach of planning for additional economies. After 18 months, the combined company had exceeded its cost synergy targets by more than 80%. That overachievement of synergies allowed the company to keep its costs in line with unanticipated revenue losses and to survive in an economic climate that was particularly hard on media companies.

Not understanding true profitability. It might seem obvious, but if a company cannot accurately quantify the cost of producing individual products and supporting customers, it becomes nearly impossible to make informed decisions about how to eliminate duplicate costs, rationalize product or service lines, or understand where investment will generate the highest returns. Inefficient companies tend to analyze profitability in terms of gross margins for each operating unit rather than to look at the profitability more directly by individual product and/or customer, for example. By breaking down profitability by customers, products, service offerings and manufacturing plants before merging, two printing companies learned what was and was not working. They avoided folding unprofitable elements of the businesses into the merged company, instead electing to churn the bottom tier of the combined customer base, collapsing small business units into a more efficient infrastructure, exiting two major customer contracts and shutting down 20% of the manufacturing capacity.

In contrast, operating with inaccurate assumptions about line of business profitability could also stop a merger cold, as it did for a communications company that was embarking on acquiring a large competitor. During due diligence, it became apparent that the acquiring company was not nearly as profitable in key business segments as originally assumed. Without the necessary cash flow and valuation to raise funding for the acquisition — and finding itself out of strategic options in a consolidating industry — the would-be buyer was acquired by another company a few months later. Had the company dug deeper in analyzing its costs before embarking on an acquisition, it would have realized it had to fix its cost structure first and assert more control over its destiny.

Getting IT wrong. Merging databases and IT systems is often the most challenging — and most time-consuming — element of merger integration. Yet companies routinely minimize the difficulties. As a rule of thumb, merging the IT elements of two medium-size companies with combined revenues of $500 million to $1 billion will take 18 months to two years and cost a third to half of a normal year’s IT operating budget.

But until the systems are thoroughly consolidated, the merging companies could endure a heavy “swivel chair” burden, with employees forced to work with multiple computer applications and operate unrelated software systems to complete transactions.

Merging corporations also have to be concerned with database capability and accuracy — a step one telecommunications company ignored at its peril. In trying to rush the integration of its systems with those of a company it had acquired, the company was forced to “flash cut” the acquisition’s databases — essentially importing the data and going live with minimal testing. Almost a third of the combined company’s invoices ended up having incorrect addresses, and half contained errors six months after the integration of the two systems. Annoyed customers stopped paying their invoices, reduced their monthly services and/or turned to another provider, which ultimately forced the company to file for bankruptcy protection.

Contrast this experience with that of a transportation company that acquired a major competitor a few years ago. The acquiring company had exhausted accounts receivables of 28 days sales outstanding (DSO) while the target achieved 47 DSO. Before integrating the acquired company’s customer and billing data, the firm went through an intensive database cleanup to eliminate erroneous customer information, align the necessary fields, and confirm billing terms and mechanics. Once the database was modified, the acquiring company was able to smoothly integrate the customer and billing IT data into its own system and was easily able to perform root cause analysis on the high DSO customers. As a result, the acquired company’s DSO was reduced to 35 days, and $9 million in cash flow was accelerated.

Not sweating the small stuff. In advance of closing a deal, merging companies typically establish a program management office (PMO) to oversee transaction integration activities. This is the nerve center, a unit that coordinates thousands of tasks and tracks their progress against the integration plan to make sure the merger will close on the target date. It also identifies potential impediments throughout the pre- and post-close periods with enough lead time to permit them to be addressed. But too many PMOs passively tick off completed tasks, rather than proactively forcing adherence to schedules, confronting issues and pushing senior managers to make decisions.

There is an enormous amount of interdependency in an integration plan, with every area of a business affected by when and how well other business areas plan and execute their part of the integration — and it falls on the PMO to keep all the moving parts synchronized. At any given moment after the close, the PMO should know how much of the integration has been completed, how much it has cost and what else is needed to achieve the targeted benefits.

Another critical role of the PMO is to coordinate communication about the merger with employees from each company, managers not directly involved in the integration, suppliers, customers, and government and regulatory agencies. The PMO needs to manage expectations and to minimize the spread of rumors and speculation that can damage the new company.

Forcing the issue on corporate culture. Companies may democratically try to merge their ways of doing things, or the acquiring firm may attempt to force its culture on its target. Neither works. After a successful integration, a new corporate culture will emerge on its own, helped along by leadership from top managers. Involving middle and upper management from both organizations in setting a path for the merged company will help avoid the perception that there are winners and losers and, ideally, will promote people, processes and technology that are the “best of the best” from both companies.

Private equity sponsors, hedge funds, capital markets, bankers and companies all realize that M&A is about creating value through revenue and cost synergies. But finding and capitalizing on those synergies can seem paradoxical: It involves charting an integration path that is sufficiently comprehensive (without paralyzing the organization) and rapid enough that executives focus without promoting the “ready, shoot, aim” mentality. A carefully considered and managed integration that aligns with the transaction’s strategic objectives is most likely to deliver the returns that made the merger so compelling in the first place.

During the period leading up to the acquisition, the sponsor presumably has communicated its investment thesis clearly to management of the acquired company and had frank discussions on how it expects to achieve the goals that underpin its rationale for the investment. These should include realistic expectations about the level of involvement the sponsor expects to have, reporting requirements it expects to institute and the various metrics it expects to employ to monitor the company’s progress toward its investment goals. (Sponsoring companies commonly complain about the sometimes cloudy distinction between the roles and responsibilities of their CEO and those of the acquired company’s CEO.)

Once an acquisition takes place, it is important that the sponsor and company management finalize a concrete plan for achieving the investment objectives; and doing so within the first 100 days takes maximum advantage of the relationships and momentum that have been established during the negotiations. Management should be charged with preparing a bottom-up business plan that sets forth the tactics it proposes to achieve the agreed-upon near- and mid-term goals for the company, the metrics it recommends that the sponsor employ to measure progress, and a road map of middle management responsibilities, milestones and timelines that will be used to implement the plan. The plan should then be presented to the board (that is, the sponsors), for (first hand) input and approval. If the portfolio company operates in a sector that is not well known to the sponsor, or the sponsor believes that the company requires dramatic changes to either its business model or operations, the board might be well-advised to retain experts with executive level experience in that sector to provide additional guidance during this process. The agreed-upon business plan can then be used to establish annual incentive plan targets (potentially reflecting a mixture of financial and nonfinancial goals) and performance rewards that incentivize the actions deemed necessary to achieve the business plan’s goals.

A detailed one-year plan is particularly important, but we would recommend that the plan encompass at least a three-year horizon so that the management team and sponsor can agree on the nature of the medium-term direction that will be pursued to reach the goals that have been established, and the steps that they expect will be required to get there.

SIX KEY FOCAL POINTS FOR THE FIRST 100 DAYS

Each of the following issues is critical in positioning a new acquisition for success. While some may seem commonsensical, each requires thoughtful planning and execution.

Clearly communicate with all key constituents on day one and again during the first 30 days. A comprehensive communication plan should be developed to address the anticipated concerns of key constituents, including customers, suppliers, employees (including unions or workers’ councils) and financial stakeholders. If the acquired firm has various operating entities resident in different countries, it is possible that this will require tailored communications in terms of both content and local language. In many cases, this plan will be developed and implemented before the acquisition, but once the transaction is complete, these stakeholders will want to learn more about the sponsor, its goals and objectives in making the acquisition, its vision for achieving those goals and objectives, the thinking behind any announced management changes and a report on the financial stability of the company after the acquisition. Consideration should be given to having the sponsor and senior management meet individually with key customers, critical vendors and valuable employees to share their vision and enthusiasm, calm fears, solicit concerns and gather input. Directly or indirectly, these conversations should address the sponsor’s level of commitment to the company and the opportunities that are created for each constituency.

Establish control of cash from the first day, even if there is an abundance of it. Many acquisitions, particularly divisions carved out of larger businesses, are more focused on profit and loss than on the cash flows. First identify all of the ways obligations can be entered into cash (such as by field staff, individual store location, corporate, p-card and contract) and how cash disbursements can be made (such as check, wire transfer and petty cash). Armed with this inventory, evaluate and adjust authorization limits to levels the sponsor is comfortable with, then modify the related procedures accordingly. Tightening down the many ways cash can be committed to and disbursed will often save the company significant dollars in situations where controls were somewhat loose under prior ownership. In addition to maximizing cash flow in the short run, taking this step in the first 100 days fosters a culture of cash maximization that is often critical to achieving the long-term goals of the sponsor.

Implement corporate governance policies that provide the appropriate level of oversight by the sponsor and establish authority limits at different levels within the portfolio company. Companies permit varying degrees of authority to obligate the company and disburse funds. In more decentralized organizations, significant authority sometimes lies at relatively low levels. A sponsor needs to evaluate commitment and disbursement authority levels from senior management down to the most junior levels and adjust them as necessary. At the senior management level, authority limits establish the degree to which the sponsor desires to be involved in decision-making beyond approval of a business plan and monitoring of results.

The proper balance will depend on the unique facts and circumstances of each situation — the important point is to explicitly address the issue, and establish well- thought-through incentives and the necessary governance procedures, in the first 100 days. For example, negotiating an owner earn-out that focuses exclusively on revenue metrics might encourage management to enter into major post-acquisition customer contracts at margins that generate little net cash flow. On the other hand, management might respond to incentives to improve profits by seeking to implement price increases on large customers with other options who could respond by taking their business elsewhere. In another example, one would want to make sure management did not commit significant marketing dollars to repositioning its brand before having fully implemented the product changes that underpin the repositioning, or before quantitatively assessing the potential ROI of the marketing initiative. These lessons demonstrate the need for a sponsor to balance management’s latitude in running the business with necessary sponsor oversight. In thinking about how to incentivize desired behavior on the part of portfolio management, it is critical that the sponsor examine in a nuanced way how those incentives could backfire, and then establish corporate governance procedures accordingly.

Establish financial and operational metrics and tools to ingrain financial discipline and accountability in the business from the outset. This often involves adjusting the mind-set of the existing management team to reflect the sponsor’s core objectives of cost containment, profitable growth and efficiencies that will drive positive cash flows and generate the contemplated return on investment. Within the first 100 days after acquisition, the sponsor should work diligently with management to establish the specific process and reporting that will be implemented (e.g., “bottom up” budgets, cash flow forecasts, cash conversion plans, detailed cost containment initiatives and financial metrics). Once in place, these new procedures can be used to evaluate product development, portfolio and product offerings, and distribution and manufacturing alternatives. And in undertaking these changes, sponsors should not ignore other metrics such as customer satisfaction, win/loss rates, upsells, same-store sales, sales force productivity, shipping costs, on-time delivery, days to close the books or employee retention, all of which provide valuable insight into how well the business is being run. The key for sponsors is to agree with management about the most important metrics and seek weekly and monthly reporting and, in some businesses, such as restaurants and retail, daily reporting of certain key metrics.

Assessing human capital requirements should begin in the due diligence phase but continues to be crucial throughout the first 100 days. In the due diligence phase, the sponsor seeks to predict whether the existing senior and middle management teams have the experience and leadership to execute and to design compensation structures that reflect appropriate incentives to do so. Seeking to complete whatever management changes are necessary within the first 100 days — including identifying and retaining key individuals who can act as “change agents” by being visible proponents of the deal and the elements of the going-forward plan — will allow the dust to settle and reduce the inherent anxiety associated with uncertainty within the leadership ranks. Often companies are paralyzed if a pending management change is anticipated. Committing to a go-forward management team as early as possible, and certainly within the first 100 days, is important. In carve-out situations, sponsors will probably need to recruit a new senior management team, such as a CEO, a CFO, a controller and other key executives.

Ensuring the technology infrastructure is adequate to implement the necessary financial and operational discipline, as well as report on established metrics, is critical to instituting and measuring change and performance. The supporting systems go beyond the traditional accounting system and may extend to the point of sale, customer relationship management, work flow, enterprise risk management, forecasting tools, inventory management, scheduling and procurement, among other areas.

Information systems and infrastructure can play an invaluable role in leveraging an acquisition’s value and overall performance, particularly where target company operations are decentralized and IT assets are critical to tracking the progress of 100-day initiatives. Sponsors need to ensure that the technology platforms provide what is needed, and they must implement plans (upgrading or outsourcing) to ensure that IT does not hinder the company’s success.

With any acquisition, a fast-track approach to aligning the management team with the sponsor’s investment thesis is a vital step. During the first 100 days, the sponsor needs to address with management the six pillars discussed on the previous page, implementing policies, strategy and reporting with an overlay of risk management. In “cross border” acquisitions, particular attention also should be placed in defining and effectively communicating goals for what will be perceived as “remote” or “foreign” parts of the organization. Developing an agreed-upon plan to achieve the sponsor’s investment thesis through finalization and formal adoption of a three-year business plan in the first 100 days lays the foundation for a successful path forward.

As the global economy struggles to shake off the lingering effects of the recession, private equity firms, with approximately $500 billion in uncommitted funds, are facing mounting pressure to identify desirable targets that will deliver a solid return on investments. The resulting competition has driven up the purchase prices in many deals: To outbid more than a dozen firms for Virtual Radiologic Corp., Providence Equity Partners paid a 41% premium. While private equity firms have always been known for their exhaustive due diligence, the postrecession climate has made them more susceptible to the misstatements of companies desperate to be acquired. As many buyers are discovering, the frenzied rush to close a deal can obscure issues that later come back to haunt the buyer. It’s been said that “love may be blind, but marriage is a real eye-opener.” The hard work of post-acquisition integration is now more likely to uncover errors and misrepresentations that can have a significant impact on the purchase price. As a result, an increasing number of M&A deals are involving some litigation. Since 2% to 5% of the purchase price — often a substantial sum — can be kept in escrow until disputes are resolved, companies have added incentive to settle matters expeditiously.

By understanding the common trouble spots in typical acquisitions, private equity firms can put themselves in a better position to resolve potential disputes. If problems do arise, determining the appropriate channel for addressing them — from early dispute resolution and mediation to arbitration and litigation — can be critical.

TRADITIONAL SOURCES OF DISPUTES

The complexity of M&A deals has the potential to create a range of issues, but certain areas are more likely to result in post-acquisition disputes.

During the deal, the seller will make certain assurances and formally confirm facts and figures. Representations (an account or statement of facts, allegations or arguments) and warranties (allocating financial responsibility for the accuracy of those statements of fact) can range from verifying that interim financial statements have been prepared according to GAAP and/or disclosing pending lawsuits to stating the value of inventory and outstanding accounts receivable.

Indemnification provisions. These measures are intended to protect the buyer and seller from each other’s actions. Indemnification provisions can cover representations and warranties and covenants. During negotiations on the purchase price, each side will insert language to cap damages arising from specific areas. However, these caps can be negated in the case of intentional fraud or on public policy grounds, such as in disputes arising from gross negligence.

Working capital. Within a certain time period after the closing date, the seller must provide a closing balance sheet that includes its working capital. The working-capital “true-up” determines the amount of actual working capital at closing compared with what the seller estimated. Since the buyer will seek to deduct any shortfall (a potentially substantial sum) from the purchase price, calculating the true-up can be particularly contentious.

Earn-outs. An earn-out is a contingent element of the acquisition’s purchase price that is determined after the closing based on the target business’s performance against contractually defined criteria or benchmarks. Disputes can arise, for example, from business decisions that negatively affect the performance of the purchased entity, how that performance is measured or how amortization and depreciation is recorded for accounting purposes.

THE EFFECT OF THE RECESSION ON M&A

In the postrecession landscape, several trends have emerged that are affecting not only how deals are being structured but also the most effective channels for resolving disputes.

Financial constraints slow deals. The overall decline of deals can be directly attributed to financing constraints. Private equity firms can no longer rely on banks to provide ready funding for highly leveraged buyouts. Because of this, not only have acquirers been pulling out of deals prematurely after failing to secure the necessary credit, but financial institutions have also backed out of acquisitions they deemed too risky. As a result, other arrangements such as club deals, where two or more firms form a consortium to acquire a company, have become more prevalent.

Increasing reliance on earn-outs. As buyers look for ways to finance deals that require less cash up front, purchase agreements are featuring earn-out provisions more frequently. Indeed, more than 30% of deals now include such provisions. The structure of earn-outs, however, lends itself to disputes over control, business decisions and accounting practices. The buyer can face allegations of acting in its own interests in ways that adversely affect the acquired company’s performance and, thus, the earn-out payment to which the seller is entitled. Attempts by the seller to exert its influence can be perceived by the buyer as maximizing the target’s performance at the buyer’s expense. Agreements will often include covenants by the buyer to operate the business consistent with past practice or in normal course, although that can still allow for substantial variance in interpretation. So if earn-outs are such magnets for disputes, why are they being included in more and more deals? The postrecession landscape and lack of available credit are two drivers. For the buyer, an earn-out not only reduces the cash necessary at closing but also acts as an incentive for the seller to perform up to expectations after the closing. Indeed, private equity firms want additional assurance that the companies they are buying will meet their high expectations. On the seller side, earn-outs offer potential for increasing total compensation, especially advantageous given the current climate. For these reasons, we expect to see more earn-outs over the next two to three years — and a corresponding rise in resulting post-acquisition litigation.

More MAC litigation. Purchase and sale agreements typically include a clause on material adverse change (MAC), defined as any event, development, circumstance, change or effect that would have a materially negative impact on the business, financial condition or results of the operations of the acquired company. MAC actions involve disputes that emerge from the failure on the part of the seller to disclose material contingencies and liabilities, a loss of a key customer, or other developments that represent a significant and lasting change in the business. Since the recession destroyed the value of many companies, litigation offers an opportunity for acquirers to recoup a portion of their losses. A MAC is very difficult to prove, however; in fact, the Court of Chancery of Delaware, the forum for 30% of all M&A litigation, has never issued a MAC ruling in favor of the buyer. Therefore, buyers should incorporate specific economic targets into the purchase agreement’s MAC clause. Clearly defining what is meant by the term “economic downturn” (in terms of duration and dollar amounts), what constitutes a material difference between projected and actual results, or a material loss of customers can more concretely define failed performance and can provide a more defensible basis for adjusting the purchase price. In addition, the recession has created a breed of professional bargain hunters that have honed their skills in using disputes as a strategic tool to wring more value out of deals. Suits based on the MAC clauses of purchase agreements have become a way for the buyer to get a second bite at the apple during the post-acquisition closing.

RESOLVING POST-ACQUISITION DISPUTES

Given the complexity and the compressed time frame of most acquisitions, it’s nearly impossible for private equity firms to foresee and preempt all potential issues. If disputes do emerge, buyers have several tools at their disposal that they should evaluate based on the type of dispute and the dollar amount under consideration.

Early dispute resolution. Corporations that are well versed in M&A often devote significant time and resources to resolving disputes as soon as they are identified. Some agreements call for senior executives of each company to meet and try to resolve the problem before it can proceed to arbitration. Given the recessionary climate, companies are increasingly turning to mediation as a means to avoid more costly litigation. In this nonbinding process, the companies agree on a judge, an attorney or an accountant to help them reach a settlement. The mediator then conducts “shuttle diplomacy” between the two parties until a settlement is reached. Mediation is especially effective when both parties are motivated to settle and when the legal issues underlying the dispute aren’t complicated. Similarly, if both parties have a lot to lose, mediation is a natural channel to pursue. Some companies, however, treat mediation merely as a tactic to demonstrate to the courts that they have exhausted every means at their disposal before pursuing litigation.

Neutral accounting arbiters. For claims that arise from accounting-related disputes, such as those involving working-capital true-ups, earn-outs and interpretation of GAAP, companies may opt to retain a neutral accounting arbiter to adjudicate the dispute. Purchase agreements will often require the use of a neutral arbiter and provide a list of accounting firms that the buyer and seller have deemed acceptable. The arbiter will engage in a multistep process, including interviews, a review of position statements, interrogatories and hearings. Once all of the facts have been presented, the arbiter renders a binding judgment. By highlighting the strengths and weaknesses of each party’s claims, the arbiter can facilitate an expeditious settlement. A neutral accounting arbiter offers several benefits: The process is a truncated version of arbitration, so it saves the buyer and seller time and money. Since the arbiters are drawn from accounting and consulting firms, they are very well versed in the intricacies of these disputes, ensuring an informed judgment. Last, a neutral arbiter can be empowered by the parties to settle disputes regarding access to information and people and the production of documents, serving to expedite the process.

Arbitration. Arbitration can be a useful path for disputes involving more substantial claims that relate to such issues as benefit of the bargain, fraud, and warranties and representations. The majority of sale or asset agreements include arbitration as the dispute resolution mechanism. While arbitration isn’t necessarily less costly than litigation, it can offer several important advantages that must be weighed against the other factors of the case. First, arbitration generally offers a speedier resolution than litigation: A final judgment can be reached in as little as six months, which allows each party to focus on business operations rather than on the disputes. Second, companies can select arbitrators who have expertise in accounting, specific industries or certain areas of law. Since complex cases can often be misunderstood by juries, arbitration can represent the best path to an informed ruling. Last, arbitration proceedings are private, allowing companies to keep the details of a case from being dissected in the marketplace. One potential disadvantage of arbitration is a perceived tendency for the arbitrator to “split the baby” — that is, to settle somewhere in the middle rather than granting one side or the other full redress. If a company has identified the potential for a large settlement or if it has built a strong case, litigation may be a more beneficial course to pursue. In addition, the right to appeal a decision is not part of arbitration proceedings, so a company must abide by the ruling. In some cases the buyer or seller might make a claim of fraud in an effort to bring the matter out of arbitration and into litigation. This strategy has been used by companies looking to avoid escrow limits, for example. If the dispute qualifies as a game changer, with a significant amount of damages at stake, litigation may end up being the best course. However, many companies are still favoring settlements rather than going to trial to avoid reputational damage, the disclosure of private information and drawn-out court proceedings.

Given the degree of complexity in M&A, companies that recognize the common sources of disputes during negotiations will be in a much better position to address them during the post-acquisition phase if they do occur. Since litigation often represents the most costly and least efficient channel for resolving disputes, private equity firms that understand the alternatives will be able to devote more of their energy to the core objective of any acquisition: creating value.

CONDUCT THOROUGH DUE DILIGENCE AT EVERY STAGE

Certain due diligence steps traditionally regarded as routine have taken on added importance. The seller’s interim balance sheet should receive particular scrutiny, since in uncertain economic times or cyclical businesses it often isn’t as precise as the quarterly or annual statements. In addition, buyers should augment the accounts prepared specifically for the acquisition process by reviewing the management accounts, which may be more detailed and provide a different picture.

Due diligence tends to be focused on a tightly controlled “data room” where the buyer sees only what the seller wants it to see. Therefore, the challenge for a buyer is to gain access to the people who know about the business, such as employees in key functions who might inadvertently share information. Acquirers should also obtain representations from the seller regarding key valuation assumptions and high-risk accounting areas, such as inventories, accounts receivable and the like.

ESTABLISH CLEAR LINES OF COMMUNICATION

Companies should agree on the accounting policies and methods that the deal is based on — for example, by explicitly discussing the target working capital and how it will be calculated prior to signing the merger agreement. Since issues can emerge once the acquirer transitions the seller’s information to its systems and uncovers discrepancies in how assets and liabilities have been recorded, reaching consensus on accounting standards beforehand can reduce the likelihood of such claims. Access to information can be a key advantage in the event of litigation, so the buyer should seek to “freeze the scene” — that is, retain a copy of all the accounting records that could be used to resolve a dispute. If possible, this information should extend to the e-mail accounts of directors and senior staff as well as file servers. The seller should also keep a full copy of the accounting records on its system; in fact, many companies have been unable to defend themselves adequately because they relinquished access to this information during the course of the deal. Both sides will want to negotiate to prepare the closing balance sheet in an effort to maintain control.

PREEMPT COMMON EARN-OUT DISPUTES

The buyer should clearly define the accounting methods to be used during the earn-out period in order to develop sufficient reserves for balance sheet items such as inventory obsolescence, collectibility of receivables, warranties, returns and other contingencies. Companies should also keep earn-out criteria simple, easily measurable and unambiguous — for instance, by addressing whether or not overhead expenses will be included in earn-out calculations. Last, an earn-out should avoid cliff-vesting earn-out amounts — for example, when revenue hits $20 million, the seller receives $5 million. By making targets and related payments more gradual, sellers can significantly reduce the risk of intentional manipulation.

He is equally well versed in global markets, economics and investing. After an earlier career in consulting, he was the Vice Chairman of Soros Fund Management until he entered the British government. Throughout his career he has had frequent interactions with finance ministers, principal economists and
high-profile business leaders. Moreover, his heavy involvement in the G-20 summits, his tenure at the World Bank and his private sector experience providing financial services and investment strategies for various funds, as well as his early years as a journalist for The Economist, afford Malloch-Brown a unique and nuanced perspective on a wide array of global economic, political and social issues, including private equity and capital flows.

For this issue of FTI Journal, the editorial staff sat down with Malloch-Brown to discuss private equity in emerging markets — especially those beyond the BRIC countries — and to outline some of the opportunities and challenges facing private equity firms seeking to invest overseas.

From your vantage point, what is the current investment climate in emerging markets, and how should private equity investors consider it?

MALLOCH-BROWN: Right now developed markets are experiencing an economic hangover. There are limited growth prospects for companies providing goods and services in these markets, which have matured and continue to face structural deficiencies that impede demand. The prevailing wisdom is to invest in markets showing prospects for rapid growth — whether it’s private equity seeking investments or multinationals doing M&A — and these areas are increasingly not only in the BRIC countries but also beyond them in a second circle of growth, which includes Indonesia, Malaysia, Thailand, Singapore, South Africa, Nigeria, Colombia, Chile and Mexico.

In the BRIC countries, asset values are already high, and it’s hard, although not impossible, to find attractive deals. In contrast, a number of attractive opportunities clearly exist in the second circle. On the other hand, deal sizes can be smaller and exits can be a challenge. As a result, successful investing in these areas requires a very careful balance between deal size, due diligence, knowledge of local environment and an ability to get involved in the operations.

What would you say are the most attractive geographic targets?

MB: Attractive geographic markets that lie outside of the BRIC states include countries in Asia, Africa, Latin America and the Middle East, but the pros and cons of each of these regions must be weighed carefully.

Asia as a long-term option is one of the more important investment alternatives, largely because of its sheer size. Asia already accounts for more than half the world’s population; in contrast, by 2050 the U.S. and Europe will account for less than 15%. The size of the Asian market of consumers and industries means that investors can’t ignore it.

But Asian assets can be expensive, and depending on what you characterize as Asia — India, Pakistan, North Korea, Thailand, Myanmar — it is a region of the world where there is considerable territorial and sectarian conflict, and the effects of very rapid economic growth on economic inequality are also risks. Finally, while the sheer size of Asia makes it attractive, the rapid population growth and rate of urbanization have led to major environmental challenges. So this idea of Asia as El Dorado is not accurate, as attractive as the macroeconomic picture may be.

By contrast, Africa is just now finding its feet in terms of being a target for private equity investors. It is a very small market — unless you have an Africa-wide roll-up strategy — but especially for the long-term players, there are pockets of opportunity across the continent. Corruption remains a challenge in some countries, as well the fact that outside of such countries as South Africa and certain North African ones, investments in roads, infrastructure, health and education are only being made in fits and starts.

Would you say these areas are pro private equity? Are they accepting of Western private equity investment?

MB: Across much of Asia there is a continued desire to attract overseas investment. Hong Kong and Singapore are already highly sophisticated financial centers with homegrown private capital and public markets. But Vietnam and its neighbors — Cambodia and Laos — are now increasingly opening up to overseas private equity, as are South Asian countries such as Bangladesh. Asian countries are divided into the “fashionable” markets, if you will, which are more expensive but easier to enter, and the “less fashionable” markets, which are cheaper but in which success is perhaps harder to achieve.

In Africa, South Africa has a well-managed and sophisticated financial sector. Nigeria is a huge market that is rapidly developing, but it lacks the rule of law and transparency that Western investors generally seek.

Chile, Colombia and Mexico are also well-run countries with investor protections, solid infrastructure and a pro-investor mind-set.

How would you describe changes in the landscape for global private equity investment over the past 20 years? Have the strategies shifted for investors?

MB: Twenty years ago it was clearly more of a buyer’s market. Countries as geographically disparate as Hungary, China and Mexico were desperately competing for the same foreign investment. Now it is more of a seller’s market, by which I mean a country has the opportunity to choose between investors, and private equity investors are therefore going to have to prove that they can be long-term partners prepared to contribute to local society and the growth of the country. They are going to have to be focused on job creation, demonstrate commitment to corporate social responsibility and contribute to tax revenues. In other words, investors seen as friends and partners of the region, as opposed to just foreign money, will have a definite advantage. To achieve this, they will have to strike the right balance.

In Asia, for example, there’s a history of “financial nationalism” that was born in 1997 with its financial crisis and then was reinforced by the 2008–09 crisis. As a result, private equity investors now need to have more sensitivity toward local markets, businesses and leaders. It’s the same in South Africa, where there are a lot of services available locally and resistance to importing services.

In many ways, it is no longer about simply buying and maximizing the value of the components of businesses, but about buying “sleeping national monopolies” that need capital, infrastructure and technology. They have to be shaken up to make them stronger regional performers in a competitive global economy. They need to be capable of becoming acquirers themselves.

This is not to say there is an absence of good management in the emerging markets, because it is typically the younger, more highly trained generations running these businesses. But there is an absence of aspiration in terms of where businesses need to go. And the reporting and transparency and so on must be fit for a private equity market exit strategy down the road.

What do exit strategies look like in these emerging markets?

MB: In all these regions, without doubt, exit strategies at the end of a seven-year investment cycle, for example, are not as straightforward as they are in the developed world — there is not always a liquid local stock exchange on which to list the business. In many cases the journey between acquisition and exit will be longer than seven years because investors are buying family-owned companies without a listing, with limited disclosure and with significant restructuring to do. In other cases these companies are operating in single national markets, but the likely private equity strategy will be to make them players across an entire subregion. For example, the plan may be to acquire a company in Bangladesh and take it to market in India, where the market is much more active. Whatever the plan, it will almost always require a bigger corporate 3transformation than a private equity investment in Europe or North America. It will require more human capital as well as monetary capital, and therefore it will be a hands-on investment.

In terms of global regulation, are there any reforms or trends on the horizon that will impact private equity in emerging markets?

MB: I think a significant inflection point will be the November G-20 Summit in Seoul, South Korea. While the principal focus will be reform of the banking sector, France and Germany have insisted that private equity remain on the table for reform discussions. Since the April 2008 G-20 Summit in London, which I helped organize, a lot of the energy for reform has dissipated. This is because we’re now viewed as being on the other side of the crisis, and looking back, many are saying it was a subprime crisis or a crisis created by overleveraging and that private equity was peripheral to the meltdown. But others see private equity as a potential source of future crises, so there is not exactly consensus. And, of course, were there to be further economic setbacks and anything approaching a double-dip recession, the Seoul meeting would acquire the same political crisis stages that the London meeting had in 2008, in which case all bets would be off as to what leaders might choose to do.

As economic historians debate whether or not Lehman Brothers could have been saved, it’s clear that the global financial markets crisis of 2008 was entirely a self-inflicted wound, which had been years in the making. There were no external factors or shocks to blame. Quite simply, investors collectively lost confidence in the decision-making and risk-taking practices of large financial institutions, private investment capital and large swathes of Corporate America – arguably with good reason.

In the corporate sector, credit quality had never been so poor going into a recession. As we entered the maelstrom a little over a year ago, some 62% of rated U.S. non-financial corporate issuers were considered speculative-grade by Standard & Poor’s (S&P), of which over two-thirds were considered “deeper junk” (B+ or worse) – a significant deterioration in the distribution of credit ratings compared to a decade earlier. The leveraged buyout (LBO) craze of mid-decade contributed greatly to this phenomenon, with some $400 billion of LBO-related loans made in the U.S. between 2005 and 2007, according to Reuters LPC. European borrowers got in on the act too, with the equivalent of some $580 billion of leveraged M&A loans made during this same period, over half of them earmarked for LBO transactions. Already that fallout has begun; S&P recently noted that 42 of 46 European debt defaults of credit-rated or credit-estimated issuers that occurred in the first half of 2009 were LBO deals gone sour.

Today, even after cleansing the pool of rated issuers of hundreds of defaults that have occurred since early 2008, corporate credit quality remains exceptionally weak. Operating and financial challenges for high-risk borrowers still abound. The damage inflicted on a fragile global financial system from the combination of excessive risk-taking, high leverage and sharp economic contraction cannot be repaired in haste, notwithstanding the impressive rally in global credit markets since March 2009. This article will explore how risky borrowers have responded to largely inaccessible credit markets since late 2008 and the challenges that remain firmly in place even as the global economy seems poised for recovery in 2010. 

How are Financial Markets Faring?

Following the near-death experience in capital markets last fall and the precipitous price declines that continued into early 2009, the recovery in global financial markets has been striking. Conversations have moved on from open-ended bailouts, the nationalization of troubled industries and other dire rescue plans to, ultimately, the realization that the collective commitments and bold actions of policymakers in the developed world appear to have prevented the Depression-like scenario that seemed plausible last December. Yet this is no guarantee of smooth sailing in the months and years ahead, and it is certainly not a harbinger of borrower-friendly credit markets. Capital markets have opened up again to investment-grade and near investment-grade corporate issuers, but global fixed-income investors remain highly selective (and demanding) for riskier issuers.

One striking feature of the environment today is the growing divide that has opened up between investment banks and their corporate and retail counterparts. Investment banks – particularly in more traditional business areas such as foreign exchange – are delivering exceptionally good results. This is because a lot of capacity and capital has been withdrawn from the wholesale markets. By contrast, retail and corporate banking continues to struggle with asset quality and a lack of attractive new business.

As might have been expected, the first beneficiaries of government intervention programs have been financial markets. Equities, in particular, have rallied globally, while corporate credit markets have returned to pre-Lehman levels.

What’s Happening on Main Street?

The recession, which officially began in December 2007, is both a by-product of credit tightening and a contributor to its perpetuation; and this recession has been particularly brutal in terms of its impact on U.S. employment and economic activity and the destruction of personal wealth. Real U.S. gross domestic product (GDP) contracted by nearly 6% in the six-month period ended March 2009: its worst two-quarter slump since 1958. Real median household income declined 3.6% in 2008 – erasing gains of the past three years; and household net worth has fallen by 22% from its peak in mid-2007. Consequently, consumers and businesses alike have become exceedingly cautious in their spending and finance decisions of late – largely by choice, but also driven by market-imposed discipline.

Consumer spending, the main driver of U.S. economic activity, remains in deep doldrums. This is hardly surprising, given that three pillars of consumer confidence have crumbled: house prices (down nationally by nearly one-third), the unemployment rate (more than doubling to 9.8% – its highest level in 26 years) and the value of financial assets such as savings accounts and 401(k)s (down by more than 20% since the peak).

There are clear signs that many consumers have downshifted to survival mode. Monthly discretionary spending totals by U.S. consumers have been consistently lower by near double-digit rates or worse (year-on-year) in most product categories outside of consumables.
Despite talk of early recovery, there is virtually no evidence that consumers are willing to open their wallets without steep incentives, such as the ‘Cash for Clunkers’ program. Survey data consistently shows that about three-quarters of all Americans have cut back on personal spending. Credit-card debt outstanding has contracted at a record rate so far in 2009, while the personal savings rate has moved from nearly zero to its highest level in more than two decades – distinct signs that behavioral changes afoot may be more than just temporary adjustments. 

This state of high anxiety within the private sector is not just an American storyline. Consumer-driven demand in much of Continental Europe remains in contraction and massive government intervention has been required to prop up economies in most Western European nations. Despite recent indications that the recession may have ended in Germany and France, the outlook for private consumption in Europe remains poor in 2010.

Clouds are mostly gray in the corporate sector. Operating earnings for the S&P 500 Index have declined 53% from their peak in 2007, considerably worse than the 32% peak-to-trough decline in the 2001 recession and the 25% decline in the 1990-91 recession. Most companies that are meeting or exceeding earnings estimates in 2009 are doing so as a result of aggressive cost-cutting rather than generating top-line growth.

These tough measures are driving employers to shed staff in record numbers, blunting consumer confidence and reinforcing their reluctance to spend. Until there is discernible improvement in consumer sentiment, it is difficult to foresee any meaningful growth in their current timid spending patterns. Yes, a Depression-like scenario may have been avoided, but a period of prolonged economic weakness or anemic growth remains a distinct possibility.

We should remember that while equities are in recovery mode, the default and employment cycles are lagging indicators, which will continue to generate bad news for many months to come.

What are the Prospects for Corporate Borrowers?

Over the past two years, we have also seen a dramatic change in the composition of the lender landscape. There

are now fewer financial institutions, and those that remain are significantly more risk-averse. New paper issuance by collateralized loan obligations (CLOs), structured finance vehicles which provided so much cheap capital during the peak years, has largely dried up. Other non-bank lenders, such as hedge funds and pension funds, which also fed the leveraged loan market, have pulled back in a big way.

Traditional banks, many of which are either capital-challenged or propped up with federal assistance, are significantly more cautious lenders than previously. All told, new leveraged loan activity remains several hundred billion dollars below peak levels (see Chart A), and this decline dwarfs any buoyancy of new issuance activity in high-yield bond markets so far in 2009.

This much is clear. Big changes in the regulation of banks are coming. The effect of events over the past two years has prompted regulators in major countries to revisit rules and consider sweeping changes. The area of change most likely to affect corporate borrowers is that of capital requirements for banks.

Regulators are almost certain to introduce new rules to limit both the risks that many banks retain and the size of their asset base for any given level of capital. The message here is that banks will need to raise fresh capital just to stay where they are in terms of size. Meanwhile, loan underwriting standards are being raised, too. At best, all of this will make refinancing more challenging and expensive; at worst, over-zealous rule-making could lead to severe deleveraging and credit contraction.

Throw in the unfolding collapse of real asset values, and you have a heady cocktail likely to cause a lingering hangover. Declining residential property values, negative home equity and rising foreclosures have dominated business headlines for a while, but there is widespread belief that commercial real estate defaults are the next headline-makers.

Collateral values underlying commercial real estate debt are widely expected to drop by 35%-40% from peak 2007 levels during this down cycle. Transaction activity has plummeted and Commercial Mortgage-Backed Securities (CMBS) markets, previously a major source of real-estate finance, remain dormant, making the prospect of refinancing maturing debt without additional equity incredibly difficult.

A recent article in The New York Times (citing a widely read Deutsche Bank report) noted that “as many as 65% of commercial mortgages maturing over the next few years are unlikely to qualify for refinancing because of the drop in property values and new stricter underwriting standards.” Deutsche Bank Securities expects loss rates from defaulting real estate loans to exceed 10% of outstanding CMBS loan balances, a loss rate that would exceed the real estate crash of the early 1990s.

Until there is some persuasive evidence that the economic recovery has traction and that businesses are finally starting to expand again, markets for commercial real estate are unlikely to improve. Generally speaking, commercial real-estate markets tend to lag behind the economic cycle by at least one year.

A dearth of deal activity and depressed values in the M&A market are also impeding corporate turnarounds. There is little appetite to do deals at what might have once been considered ‘fair value,’ limiting the options of distressed corporates looking to dispose of assets to provide liquidity or refinance debt. Companies that can afford to do so are biding their time until the deal-making environment improves.

It is against this backdrop that hundreds of billions of dollars worth of leveraged corporate debt and commercial property loans will be maturing over the next five years. The ability of borrowers to meet or otherwise satisfy these upcoming obligations will depend on market-place conditions and economic circumstances outside their control, thus prolonging uncertainty in credit markets and corporate turnaround prospects.

Quantifying the Potential Size of the Refinancing Problem

An S&P study published in May showcases the scope of the future debt threat. The study analyzed nearly $4.4 trillion of U.S.-issued rated non-financial corporate debt, which included loans, notes and bonds. About $2 trillion (or 45%) was rated as speculative-grade debt, and $1.3 trillion of this total – or nearly two-thirds – was rated single-B or lower, a common threshold of ‘deep junk.’ Moreover, of the $1.4 trillion of speculative-grade debt scheduled to mature within the next five years, nearly $900 billion is rated single-B or worse. This is especially worrisome, given the ongoing difficulties of low-rated issuers in accessing credit markets despite the 2009 rally, and the materially higher default rates for issuers rated single-B or worse. The current skew of S&P’s ratings distribution of speculative-grade debt towards deep junk is one big reason why the rating agency is projecting an all-time high spec-grade default rate of 14% during this cycle, and a solidly double-digit default rate one year from now. Charts B and C show breakdowns of maturing debt by current rating and by debt type over the next five years.

For many leveraged loans, most maturities in the 2010-2014 time frame represent incredibly borrower-friendly deals originating from 2005-2007. Renewals at previous levels, terms and rates are most unlikely even for compliant, well-performing borrowers. Furthermore, a sizeable slug of these maturing loans represents LBO financings for deals that were aggressively structured and favorably priced.

In many cases, the new math simply won’t work come maturity time. Reuters LPC data indicates that some $230 billion of U.S. LBO-related term loans will mature within five years. This phenomenon is by no means endemic to the U.S.; Western European nations were also caught up in the leveraged buyout craze and the equivalent of $140 billion of LBO-related term loans will likewise be maturing by the end of 2014. 

Access to revolving credit continues to be reined in as traditional lenders seek to cut the size of new facilities, increase pricing spreads, shorten maturities and enhance collateral packages – in short, reduce their exposure to high-risk corporate borrowers. In May, Sears Holdings agreed to a bifurcated extension of its existing $4 billion asset-based revolver that was scheduled to mature in March 2010. Sears could only manage to get its lending syndicate to extend $2.4 billion of the original first lien facility by two years, despite a generous pricing margin increase of over 300 bps, a LIBOR floor, upfront fees and a BB+ rating. Now that’s risk aversion! It’s hard to believe the original ABL revolver was priced at only 88 bps over LIBOR in 2005.

The withdrawal or restriction of a line of credit can drive trade creditors and other critical suppliers to reduce their own exposures, by changing credit terms or placing riskier accounts on limit. This can intensify the pressure on a struggling company’s working capital when they are most likely to need it. In today’s new credit environment, the negotiating advantage has undoubtedly shifted back in favor of lenders, following several years when it was the borrowers that tended to call the shots. While large global companies often have access to alternative financing options or the ability to generate working capital spontaneously, those inhabiting the most precarious end of the borrowing spectrum typically have little choice but to accept more onerous terms and conditions offered by lenders.

Conservative lending practices and capital rationing by banks will disproportionately hurt small and middle-market companies, since the new emphasis on relationship banking and key accounts naturally favors the largest and most diverse clients that generate business volume and can be cross-sold an array of banking services. Middle-market borrowers are already feeling the neglect.

Patching Up the Wounded

Despite the daunting parade of upcoming corporate-debt maturities, there are no outward signs of panic just yet. Scheduled maturities for 2010 are relatively light (Chart B) and most likely to be manageable under current market conditions. However, the refinancing burden will intensify in 2011 and beyond. Concerned senior executives of underperforming businesses may be working hard to create a meaningful earnings recovery by then, but few are banking on it to save the day, judging by their actions of late.

Compelling evidence of highly cautious attitudes about the corporate credit environment can be found by examining the flurry of amends and extends (A&Es) carried out in 2009, often pre-emptive and usually on very costly terms, for debt maturities that were one or two years away. A&Es are essentially short-term deals that allow a company to extend loan maturities.

For borrowers, A&Es can push out maturities that cannot be refinanced outright, or they can grant financial covenant relief or added headroom until operating results improve. Lenders typically get to re-price these loans closer to market spreads, insert tougher loan covenants and extract lucrative fees as well. A&Es account for much of the recent leveraged lending activity, with S&P reporting over 200 rated borrower requests for loan amendments in the first half of 2009.

The problem with the A&E solution, known as ‘forward-start agreements’ in Europe, is that often it just delays the inevitable day of reckoning. It is a leap of faith by borrowers and lenders that the lending environment and operating conditions will be substantially better in the not-too-distant future. It does nothing to remedy the fundamental problem: too much debt. And given the mountains of debt due for refinancing before 2014, there is no assurance that credit markets won’t be just as tight or selective as these revised maturity dates approach.

Similarly, on the bond side, debt-exchange offers – whereby companies offer bondholders the opportunity to exchange maturing bonds for new bonds with a later maturity date and/or equity positions – have figured prominently in restructuring activity this year. Through August, S&P tabulated 74 distressed debt exchanges of rated securities in 2009 – easily more than twice as many as in the whole of 2008. Like A&Es, these transactions are often viewed as short-term fixes that allow distressed borrowers to buy some time to repair their businesses while achieving some degree of near-term financial relief.

This option is only possible because junior creditors often recognize that they are unlikely to see any meaningful recovery under a bankruptcy scenario, given the present economic environment and marketplace conditions. Ironically, it is the distressed borrower that often has the upper hand in these colorful, if not contentious, negotiations with bondholders, by using the prospect of a Chapter 11 filing as a cudgel to get creditors on board with an exchange proposal. Despite these fervent efforts to stave off payment defaults and bankruptcy, history tells us that many companies orchestrating distressed debt exchanges today will eventually file for Chapter 11 relief.

Both A&Es and distressed debt exchanges are practical responses to the scarcity of fresh capital for perceived high-risk borrowers in today’s new lending regime. But what other options are available, and what should companies facing significant maturities in 2011 and 2012 be doing now to prepare for the refinancing that’s just ahead?

The Potential Fallout

For the legions of companies that financed their growth with piles of cheap debt, the double-whammy of a recession and a stringent credit environment is likely to hasten a showdown with lenders or creditors. While A&Es and distressed debt exchanges might paper over the cracks in the short term, by allowing struggling companies to limp along in an uncompetitive fashion, the pain is merely prolonged, and recoveries for creditors may ultimately worsen.

This backdrop is likely to mean heightened levels of bankruptcies well beyond the end of this recession. Once upon a time, a failing business might still have had new money thrown at it. Nowadays investors or lenders are more likely to be throwing in the towel, or at least be looking at other ways to extract value and maximize recoveries – without necessarily saving the enterprise. Turnaround professionals and interim managers will be utilized more extensively as key players lose patience with incumbent executives in floundering organizations.

While deal-making continues to be difficult, there has been a huge upturn in distressed M&A activity. The Deal recently reported that Section 363 sales – the equivalent of auctioning off a failed entity’s business or assets – have almost doubled in 2009. These days especially, it may take a while to get to a Chapter 11 filing, but once there, the timetable really accelerates for some debtors.

Vulnerable sectors going forward will include a raft of consumer-dependent businesses that are asset-intensive, and burdened with debt or other onerous financial obligations. This extends well beyond the retail sector itself and includes airlines, travel and lodging, gaming, consumer finance, media and entertainment and consumer product makers, among others. In the healthcare sector, retirement homes and assisted-living communities are also looking vulnerable as the falling value of residential real estate and retirement accounts is frustrating the ability of potential new customers to take on units in these communities.

Lastly, consider the state of the banking sector. While some Wall Street banks were considered too big to fail, smaller regional banks will end up being too small to rescue. The irony is that many regional banks were conventional lenders that mostly avoided material exposure to toxic paper, risky financial derivatives and other structured investments that embroiled Wall Street. However, sliding values for commercial real estate, a business mainstay of regional banks, will inevitably impair their collateral and erode capital levels. Many believe the knock-on effect on balance sheets could prompt smaller regionals to fall by the wayside. No doubt the best assets of these failed institutions will be snapped up at bargain prices by national money centers and large investment banks – some of which qualified for previous bailout assistance. 

In all of this, antitrust authorities will likely seek to play a more active role, but their voices may ultimately favor measures that restore corporate profitability and the preservation of jobs. It follows that strong companies should have a good opportunity to pursue in-market acquisitions successfully over the next year or two, particularly if the target would otherwise struggle financially, or go bankrupt.

There Are No Magic Bullets

So what can be done? Most important is for companies to address the appropriateness of their capital structure and debt layering long in advance of refinancing dates, bearing in mind both the new tolerances and valuation parameters of capital markets and the expected persistence of weaker operating earnings in light of the recession.

As previously mentioned, a distressed debt exchange, especially one involving a substantial debt-for-equity swap, is a means by which a troubled borrower can reconfigure an unsustainable balance sheet in the absence of new money, and possibly without the need for filing for bankruptcy. But it requires Herculean negotiating efforts with recalcitrant creditor groups which may end up on the courthouse stairs in any event.

Secondly, companies must focus ruthlessly on driving business efficiency. Many have done so admirably during this downturn, with the retail sector coming to mind first. Large U.S. retailers generally surpassed Wall Street’s low earnings expectations in the second quarter, despite slumping sales and gross margin compression. Such results can be achieved through a combination of cost-cutting, vendor and landlord negotiations, reduced capital investment and better inventory management. Senior executives should keep an eagle eye on subtle changes in critical trends that impact their business, and should understand how key performance indicators can be utilized.

Companies with marketable assets might consider selling some of the family silver to pay down debt. While M&A markets are slow, the deal environment is gradually improving. Sometimes such measures are painful, but necessary. Struggling retailer The Talbots sold the J Jill Group – a business segment it could no longer support, given the distress at its namesake chain – in June to a private equity shop for $75 million. Talbot’s purchased the J Jill chain some three years earlier for $500 million in cash. Even if a sale is not possible straight away, companies can start positioning some dispensable businesses or assets for sale as soon as markets improve.

Which Way Now?

We know that refinancing the dozens of billions of high-risk debt slated to mature over the next few years will be a challenge for most, and impossible for many. While there is a good chance that economic conditions may be showing signs of improvement as we move into a new decade, the consensus points to a slow, below average recovery. It is likely to take several years for corporate earnings to return to 2007 levels, for job prospects and personal wealth to recover enough to kick-start consumer spending and for lenders to shake themselves free of the noxious overhang of bad assets and bad practices that they acquired during the halcyon days of the credit boom.
However, some just can’t hold out that long; others will be unable to earn their way out of their financial predicaments. The term ‘jobless recovery’ is already being bandied around with a casualness that belies the grim reality of the expression for many millions of Americans. To make matters worse, federal budget deficits and borrowing needs will remain exorbitant. It’s not exactly a recipe for optimism.

2010 is certain to be a pivotal year for the U.S. and global economies – a ‘show me’ year in the minds of both equity and credit investors who now fully expect to see fresh, indisputable evidence of positive economic growth and solid earnings recovery, and who have already priced such expectations into capital markets. Many economists, though, are less sanguine about any rosy growth scenario as long as stricken consumers stay planted on the sidelines. The interplay between corporate operating performance and credit market conditions will likely be reinforcing: better than expected earnings may further embolden credit investors and ease access to capital, which will in turn bolster corporate results. But it could work the other way too, with vast pockets of economic weakness that persist into 2010 finally causing financial markets to doubt the adequacy or sustainability of a recovery. How the economy unfolds in 2010 may very well determine whether the debt maturity challenge eventually rises to the level of a crisis. We’ll be watching closely.

Dominic DiNapoli is Executive Vice President and Chief Operating Officer of FTI Consulting, responsible for the day-to-day operations of the company’s five business segments.

Anyone who predicted in the beginning of 2008 that some of the world’s leading financial institutions would be wiped out, that others would require rescuing via massive government bailouts or that the global economy would teeter on the brink of a new Great Depression would have been laughed at.

The size and speed of the financial tsunami last fall illustrated how ill-prepared the corporate world was for such a meltdown. 

While there are now some early encouraging signs that the worst may be over, uncertainties still abound. This is precisely when organizations should assess their ability to handle the unforeseen and to make wise decisions in crisis environments. 

From a corporate perspective, the most common crises are generally found in three key areas:

• Natural disasters – including floods, fires, typhoons and earthquakes;
• Environmental and health-related problems – including epidemics, accidental spills, hazardous material issues, nuclear or chemical scares, sudden reversal of government policy or the intervention of NGO environmental groups;
• Man-made events – including arson, sabotage, terrorism, aggravated labor issues and the public exposure of substantial corporate fraud or corruption, resulting in threats to the enterprise.

In Asia, we are routinely exposed to all of these risks. Natural disasters have occurred and continue to occur in South Asia and elsewhere in the region, and there is always a threat that Tokyo or Osaka will experience a major earthquake.

China is particularly vulnerable to health-related problems, given its explosive growth and attendant environmental problems. Over the past year, China has experienced widespread chemical-related problems and issues involving tainted milk and other food products. These incidents have had a global impact since China is increasingly the workshop of the world. Within China, it was recognized that these issues could potentially pose a threat to the legitimacy of the ruling party, and possibly impact internal stability.

From a corporate point of view, these crises issues require careful planning, execution and sensitivity.

In Asia, one of the most common ‘man-made’ crises is in the area of significant and sudden corporate fraud. In the coming months, we are likely to see further disclosures and significant failures, particularly related to corporate malfeasance. Companies need to be able to react swiftly and effectively in order to preserve their brand, reputation or market valuation.

Many companies have developed plans to deal with business interruption and continuity plans, perhaps following the occurrence of a ‘set piece’ event (e.g. a natural disaster or environmental crisis). Unfortunately, most organizations are ill-prepared to deal with the practical implications of substantial corporate fraud, terrorism or other man-made crises. Our experience is that the larger the company, the less likely it will be able to respond effectively and in a timely fashion to avert the fallout of a major crisis.

Larger companies frequently seek to identify risks and combat them by utilizing risk registers and other mechanical measures. These are helpful but not sufficient. The key after having conducted this process/exercise is to develop practical and realistic plans to actually deal with the problem in a hands-on manner.

How Prepared is Your Company to Handle a Crisis?

Company directors should be asking a number of questions:
• Do we have systems and protocols in place now?
• Have they been tested?
• Can we respond quickly and efficiently to a crisis?
• Do we have an effective infrastructure in place?
• Can we find the designated people who are part of our crisis containment team?

Directors need to know that in times like these, the company has sufficient resources, both internal and external, to respond to any major corporate emergency or challenge.

In the experience of FTI-International Risk, the first 48 hours from the onset of any crisis or emergency is the most critical period. The key to success is to support senior management in mobilizing resources, focusing them on resolving the core issue while also minimizing the impact to personnel or disruption to day-to-day operations. It is important, therefore, that the crisis containment team is activated at the earliest possible opportunity.

Where it is evident that management does not have the necessary knowledge or experience ‘in-house,’ organizations should seek the support of an independent risk mitigation consultant. For the first few days of the crisis, there is a need for someone, often an external firm, to act as the ‘aggregate’ to hold together the various disparate elements involved in the corporate response to a crisis situation. Organisations with matrix management structures are often ill-suited to deal with sudden and unpredictable events, which to be correctly addressed require a defined leader, and a clear chain of command with no room for equivocation, internal politics or finger-pointing.

While the size and composition of crisis containment teams in corporations varies according to their size and geographic disposition, they are usually comprised of elements of senior management, finance, operations and legal. Externally, specialist consultants in both crisis containment and crisis communications are often retained. Many public relations firms are not specialists in crisis communications, and it is important to make this distinction.

The collective goal of the team should be to facilitate well-informed decisions that are implemented in a consistent and timely fashion. While crises come in all shapes and sizes, the response tends to follow a classic pattern: the initial step is to comprehensively assess ‘Ground Zero’ and to realistically estimate the damage or likely future or continuing damage to the entity. For example, in the event of a catastrophic fraud or corruption issue, this is often determined via the swift examination of relevant documents, including phone records, emails and other computer files, meeting schedules, travel patterns, and so forth.

Ninety-five percent of the world’s business records are estimated to be in some form of electronic medium. Therefore, electronic evidence recovery and e-discovery protocols are vital in the support of almost any corporate crisis.

Once the team has a better understanding of the situation, efforts can be made to identify possible options, and the relative merits and disadvantages of various courses of action can be discussed.

CEOs are unlikely to be able to manage a significant corporate crisis as well as normal business operations for more than five consecutive days, without failing at both. Therefore, it is imperative that senior management be presented with sufficient information and recommendations to make the best strategic decisions. It is equally important that they be kept sufficiently above the fray so as not to be over-involved in the minutiae to the detriment of the ultimate objective of ‘seeing through the crisis and visualizing its resolution.’

Crisis Containment and Resolution

Throughout the handling of any significant crisis, the designated crisis containment team should be regularly addressing and readdressing the following issues:

• Is this an enterprise-threatening issue?
• Do we have sufficient resources in-house to deal with it?
• What is the likely long-term financial impact on the bottom line?
• Have we plugged all immediate and identifiable gaps to prevent further losses?
• Can the losses be recovered, or are they covered by insurance – fidelity policies, bankers’ blanket bonds or a directors’ and officers’ policy?
• Which controls failed and are we still exposed?
• Who was involved / what damage has been done / what are we doing about it?
• Should an immediate report be made to the police or to other local authorities?
• Is there a requirement to report to regulators?
• Crisis communications – are we prepared to deal with the media even if we have not yet had time to plan?

Crises are, by their very nature, unpredictable, but with a well-designed and tested structure in place, companies can mitigate the damage to their reputations and their share value, while also preserving the loyalty of their customers and staff.