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.

Indeed, there are many reasons why companies end up in poor health: flawed business models, strategic gaffes, poor execution, emerging competitors and weak management, to name a few. When it comes to turning around an unhealthy company, however, there is a single formula that works. The field of turnaround management has attracted a wide range of practitioners and philosophies over the years. We believe that some approaches are not only ineffective, but actually serve to stifle recovery. This article will describe a proven framework for operational turnaround management that can help to ensure sustainable long-term profitability and market leadership.

The Balance Sheet is Not the Place to Start

Thousands of companies are in the midst of financial distress every day, even in the best of economic climates. But restructuring and operational turnarounds tend to attract the most attention during periods of economic contraction. Underlying problems in core business models are exacerbated during these periods, and bankruptcies surge, as recent experience has demonstrated. Moreover, projections of corporate debt maturities and defaults over the next few years (see Debt Maturity: The Next Wave on page 8) suggest that we may see a record number of restructurings before this cycle ends.

The effects of the recent global credit crisis notwithstanding, the majority of distressed companies historically have faced challenges well beyond the balance sheet. The problem is that so many management teams in turnaround mode focus primarily on access to capital. This finance-first approach is short-sighted at best, fatal at worst. Recapitalization is helpful for shoring up finances quickly, but it does little to guarantee long-term cash flows and operational sustainability.

We have seen the failure of this approach most notably in the retail sector, where there are repeated declarations of bankruptcy – known as ‘Chapter 22’ and ‘Chapter 33’ scenarios. Many retailers are prone to multiple bankruptcies because their turnarounds are often little more than feats of short-term financial re-engineering. From an operational standpoint, most distressed retailers overly focus on a ‘four wall’ cash flow analysis. The allure of such an analysis is its simplicity: keep stores that contribute positive cash to overhead and close cash-flow-negative stores. The result is often a slimmed-down operation and a smaller footprint that’s still riddled with shortcomings. Unless management addresses competitive advantages (or the lack thereof), the smaller chain continues to see declining operational performance. It’s akin to treating symptoms.

Sustainable Turnarounds Focus on the Income Statement

Most failing companies have a fundamental problem in their core business, which is why the only way to execute a successful operational turnaround is to focus on the core, not, as we call it, the clouds. The first instinct of many managers when commencing a turnaround strategy is to cut costs. Costs should and will be scrutinized and there will always be areas of inefficiency and waste. However, from a long-term perspective, a company cannot cut its way to an operational turnaround. While cost-cutting can help to achieve a cash-neutral or cash-positive position in the short term, it won’t solve deeper structural problems facing the core business.

A more dangerous instinct is for managers to try to supplement the core business by launching new products and/or entering new markets. The theory is that the revenue and cash flow from successful new businesses will help to fund the turnaround of the core. This is illogical. Growth on top of a flawed business simply produces a larger flaw. For a struggling ice cream chain, introducing a new flavor will never repair the underlying business problem. Instead, managers must identify and capitalize on the company’s distinct competitive advantage. This advantage, if one exists, will serve as a life raft to strengthen core operations over time.

The initial phase of a turnaround is day-to-day implementation toward defining the end-game. It involves a combination of short-term and long-term decision-making, which must be executed quickly and communicated clearly. We’ve found that maximum interaction with staff during this phase leads to maximum performance outcomes. Ride along on repair calls. Have lunch with the admin pool. Go on sales calls. Such interactions help the turnaround team to frame the discussion about the competitive advantages.

Like many turnaround advisors, I learned my most important lesson early on in my career: many companies cannot be turned around. Despite natural optimism and good intentions, management teams cannot will an operational turnaround to happen. The most brilliant turnaround team cannot turn a market laggard into a market leader. The company’s assets and advantages must be evaluated with brutal candor; only then can management determine with confidence whether a turnaround is feasible or if the company’s best course of action is liquidation. If there is no clear competitive advantage on which to build a realistic plan, then an operational turnaround is not feasible. And if a turnaround is not feasible, recognizing this fact quickly is the most important strategic decision for preventing further losses.

If a competitive advantage does exist, then it must quickly become management’s platform for future profitability. The most effective way to harness this advantage is to make it the core of the end-game, which is management’s vision of the company’s future state once it has achieved sustainable long-term health. The end-game must be driven by the market opportunity inherent in the company’s competitive advantage. An end-game must be as specific as possible and must be driven by markets, not finances. A return to profitability is not an end-game; it is a tool required to achieve the end-game.

Cultural Change is the Ultimate Factor in Turnaround Success

Achieving the end-game will often take years and will depend on the wisdom of hundreds of decisions along the way. After nearly three decades in this field, I’ve learned that one element in the turnaround process is more important than any other: employee behavior. In fact, we’ve developed a Golden Rule of operational turnarounds (see below).

Culture is all-powerful in turnaround situations, and what fuels culture are the incentives for staff to behave in a certain way. What’s more, culture has little to do with the balance sheet, but has everything to do with the income statement. The key is to focus employee behavior – through proper incentives – on the activities that will most rapidly enhance the income statement, which of course will depend on the nature of your business problem. If done properly, these new behaviors can reduce or eliminate negative cash flow, which is a necessary precursor to long-term health.

Every unhealthy company struggles with counter-productive internal behaviors, even if these same behaviors at one time enabled the company’s growth. As shown in Figure 1, negative behaviors do not appear overnight. They typically become entrenched in the culture of the organization over many years. And when they are exacerbating the core business problem, the first job of the turnaround specialist is to identify them.

A real-world example will help to illustrate our recommended approach to operational turnarounds. In 2000, I was CEO of a leading company in the time-share market, with 89 resort properties in eight countries and $500 million in annual revenue. A key growth driver for the company was its mortgage origination business, which loaned customers 90% of the $10,000 unit purchase price. A majority of these subprime mortgages were securitized and sold to Wall Street, thus removing significant risk from the balance sheet. However, some of the mortgages remained on its books. When defaults on the mortgages held by the company accelerated, its ability to tap the secondary market dried up and this sudden lack of liquidity forced it into bankruptcy. When I became CEO of the company, I worked with management through four key stages of the turnaround process, forcing honest reflections and tough decisions. This process generally doesn’t make a lot of friends, but sticking to these phases will invariably optimize any company’s outcome.

Assess Existing Behaviors

Nobody likes working for a weakened company. But it’s the entrenched behaviors of these same employees, often starting with the CEO, which usually have weakened the company in the first place. And they usually know it. That’s why employees often open up to the turnaround team, offering their own diagnoses and sometimes already knowing the solution. As implied in Figure 1, the turnaround team’s first priority is to understand the existing behaviors and their impact on performance decline. Then they must take a step back and evaluate the incentives that are in place to motivate and reward these behaviors. Is the culture driven too much by the sales function? Too little? Are employees rewarded for retaining or expanding customer relationships? Are they given the tools to do so? How are collaboration and cross-selling rewarded? How are acquisitions integrated culturally? Has management communicated a vision and strategy for the future? How does the company reward employees for helping to achieve that strategy?

At the time-share company, the corporate culture was driven entirely by sales. Built by acquisitions, these acquisitions were poorly integrated. Customer experience and retention were not a priority. An exclusive behavioral focus was on revenue growth. Sales representatives, who were paid entirely on commission, earned 20% of each $10,000 sale. At the same time, the time-share company provided most customers with mortgages for 90% of the purchase price, or $9,000. With no credit standards in place, these subprime mortgages came home to roost as high defaults (in the same way as we have seen over the past two years in the U.S. housing market). Without the ability to securitize the loan, even before taking into account overhead and marketing expenses, every sale immediately ate into the company’s cash flow, setting it up for a death spiral toward liquidation.

Define the Competitive Advantage

A turnaround lives or dies on the basis of a company’s ability to define its competitive advantage, which necessarily forms the core of the turnaround strategy. So, what is a competitive advantage exactly? Above all else, this stage is an exercise in market assessment. What distinct advantage or niche does the company own in the market? Why do customers choose the company over its peers? Most importantly, the results of the competitive advantage must be clearly reflected on the income statement; if historical sales patterns and/or cash flows can’t demonstrate that the advantage is real, then it isn’t.

Examples of competitive advantage may include:
• A presence in more lucrative geographies than any competitor
• A reputation for customer service and support unmatched in the industry
• Exclusive licensing deals with important partners or distributors
• An unrivaled R&D capability and reputation for innovation
• A respected brand that generates greater customer loyalty than that of competitors

Once the competitive advantage is defined, it will become the foundation of the company’s turnaround strategy. The competitive advantage will quickly come to define the company’s success, both today and in the future. This means that management’s end-game must be defined in competitive terms and then communicated aggressively both internally and externally.

Every decision throughout the turnaround process will be measured against its effect on the end-game, which is why it must be as specific and realistic as possible. Years ago, I asked a client to describe his end-game, to which he replied, ‘To get bigger.’ Such a response is not entirely uncommon. Unfortunately, such a vague notion is not only reckless, but can be extremely damaging to the turnaround process. On the contrary, end-games must be market-driven and specific, such as to become the number one or number two player in market A, or to be the largest provider to vertical market B, or to have physical presence in our 10 most important geographical markets. Such objectives are not only realistic and measurable, they are infinitely more inspiring to employees who know the company’s competitive position better than anyone.

In the case of the time-share company, rudimentary market analysis revealed that the company’s international footprint of properties was its key differentiator and unique advantage in the marketplace; not a single U.S.-based competitor offered customers such a breadth of international options. Moreover, the European operation was the only profitable part of the business at the time. Yet these were the assets that management was planning to sell to raise cash to continue funding the non-profitable part of the business. Such a transaction, which was ultimately canceled, would have all but guaranteed the infeasibility of a turnaround and the liquidation of all of the company’s remaining assets.

Define the Required Behaviors

The next stage can cause a turnaround specialist to become extremely unpopular, as it’s during this period that changes are made and sacrifices are required. Compliant with our Golden Rule mentioned earlier, new standards and incentives are introduced to change human behavior – a daunting exercise even in the best of circumstances. The first priority is to fix the cash-negative problem through short-term strategies, which may include:

• Centralizing operations to maximize cost efficiencies
• Decentralizing operations to promote greater revenue growth
• Closing certain business segments that are beyond repair
• Securing new contract terms with customers and vendors
• Introducing new metrics for staff productivity and performance

Since these short-term fixes will change incentives and require new behaviors, there is likely to be an onset of employee fallout. Embrace these departures! They are a sign that the message and end-game are clear. Headcount reduction is usually inevitable during a restructuring process and the most successful form is natural attrition. As behavioral standards suddenly change, certain staff will come to realize that they will no longer thrive in the new environment. And this is good.

From our experience, sales talent falls into one of two orientations – and skill sets – within an organization. We call these hunters and herders. As shown in Figure 2, hunters are oriented toward customer acquisition and see their mission as helping the company maximize revenue growth, while herders are oriented toward customer retention and see their mission as helping the company maximize efficiency and profitability.

These categories apply not only to the sales team. Typically, one orientation is more likely to leave the company based on the end goal. It is management’s job to change the incentives in a way that ensures the wrong type of talent is departing and that the talent required is staying.

In the time-share company’s situation, its short-term survival required a dramatic shift in behavior from revenue-at-any-cost to profitability-at-any-cost. The first step was to centralize control of the sales and mortgage origination processes, control for which previously was scattered across a variety of managers and locations. All contracts would require central approval. Credit standards would be dramatically tightened. The historical 10% down payment requirement was scrapped and we reset the goal of down payments to an average of 30%. These new standards proved highly disruptive to the company’s sales-driven culture, but were essential to guarantee at least a cash-neutral position in the immediate future. Using our formula, we changed sales compensation from being based on total contract value, to being based on total amount of the down payment. We achieved our target of 30% down payments and were cash neutral in just over a month.

Implementation

Consistent communication is critical throughout the turnaround. Management must make sure all decisions – even the ugly ones – are designed to leverage the company’s competitive advantage and achieve the end-game. A world-class communication infrastructure is essential here. The management team, particularly the CEO, should always be accessible for questions. (See sidebar on page 23.) Employees don’t have to like management’s decisions, but they need to understand them. During turnarounds, lack of information is always worse than having negative information. This is why management must be quick in disclosing bad news as well as good news. And if management doesn’t have the answer to a question, it shouldn’t be afraid to say so.

So when is the turnaround complete? There’s no magic formula for deciding when the company is on a path to long-term growth, but in our experience, the board and management team will know it when they see it. The results of improved performance will be evident on the income statement. Staff turnover will have subsided. New behaviors will have been institutionalized. And sustainability and growth will be the new words of the day.

At the time-share company, management made the long-term decision to kill bad revenue; in other words, it needed to reduce sales volume and revenue in favor of sustainable profitability. And that’s exactly what happened. Within two years, revenue fell from $500 million to $280 million, but the company was profitable again. Overhead expenses were shaved, but many costs – sales and marketing, for example – were appropriately right-sized for a leaner, smaller organization. In 2007, seven years after its brush with total liquidation, the time-share company was sold to its new owners for $700 million, a 35% premium to its stock price. In announcing the deal, the new owner cited the time-share company’s international properties as a strategic complement to its own U.S.-focused portfolio. 

Conclusion

Successful turnarounds have many elements. Financial engineering is often hailed as a cure-all, but in our experience, even the best-capitalized company will ultimately fail if its core business model is flawed and its internal culture and behaviors continue to support that model. The four phases of turnaround management described here represent a proven framework for any management team struggling to repair fundamental problems in its core business. Turning around any company is often difficult, disruptive and sometimes unpleasant. However, through proper strategic planning and consistent decision-making, even the sickest of companies can hope for a recovery and a long, prosperous life.

Greg Rayburn is Senior Managing Director at FTI Consulting in the Corporate Finance/Restructuring Segment and Head of FTI Palladium Partners, the firm’s interim management practice. He has 25 years of experience in operational turnaround management, serving as interim Chief Executive Officer at companies across a wide variety of sectors.