A few recent headlines underscore the danger:

• The Carlyle Group lost $105 million after the Hong Kong Securities and Futures Commission suspended trading in China Forestry Holdings and brought criminal charges against its CEO.
• Shares of China Natural Gas plunged 59% after the company “restated earnings.
• Paulson & Co., one of the world’s largest hedge funds, lost more than $550 million after financial fraud was revealed at Sino-Forest.

Investors aren’t always cognizant of the role of audit firms. These firms primarily serve to verify documentation behind financial statements, not probe for evidence of fraud. Many investors also make the perilous assumption that an Asian company listed on the Hong Kong, New York or other established exchange meets the same standards of disclosure as Western companies listed there. Moreover, investors don’t usually have the resources needed to investigate a maze of jurisdictions and languages to verify a company’s claims.

But the next big corporate failure has already happened. It just hasn’t surfaced. When considering Asian opportunities — particularly in emerging markets such as mainland China, India, Indonesia, the Philippines and Thailand — investors need to conduct deeper and broader due diligence, beyond just reviewing audited financial statements. They need to scrutinize corporate governance and business structures, and examine in depth what lies behind the assets on the books.

What to Look For

Investors should dig deeply into these issues to vet opportunities and protect their interests.

Corporate Governance

Look carefully at corporate governance structures. An Asian company may not have the clean segregation of duties between board, CEO and management that is common in the West. Family relationships and personal networks play an enormous role in Asia. In many ways, these relationships hold the society together. Reciprocal obligations with extended family, or even someone who hails from the same village or town, can be a counterweight to the more objective business decisions expected in the West. Many publicly traded companies, for example, began as family-run enterprises. Family and friends may sit on boards or even audit committees. It is also not uncommon for the head of a family to be both CEO and chairman. Weak governance structures can allow for company investments to be based on family ties and needs vs. all shareholder interests.

Complex Business Structures

Unnecessarily complex business structures may be designed to conceal inappropriate activities. For example, Peace Mark (Holdings) Limited, a Hong Kong–based watch manufacturer, distributor and retailer, collapsed in the wake of financial irregularities. When FTI Consulting investigated, we discovered that the $900 million company had more than 300 corporate entities. The annual report disclosed 60. The complex group structure was being used to conceal various transactions and financial arrangements.

Assets and Holdings

It is crucial to verify the assets and holdings a company claims it has. Among the issues that led to suspension of trading for China Forestry: The company did not have the logging permits it claimed it did and the company also materially misstated its cash balances. China-Biotics, a provider of probiotics used as dietary supplements and food additives, reported that some 25% of its revenues came from 100-plus stores it owned and operated. Most did not exist.
Inventories and receivables are the asset types most often misstated by troubled companies trying to deceive stakeholders. There are countless stories of companies in China financing the same purchase multiple times and making sales to parties that don’t exist. Several companies may even pool inventories at audit time.

Reporting large levels of cash while increasing debt levels can be a warning sign. The company may be trying to conceal operating or other losses — or the cash may not have existed to begin with. Moulin Global Eyecare, a Hong Kong–listed company with operations primarily in China, shifted cash into a subsidiary from outside the group just before the financial year-end and then back out again immediately afterward. The purpose was to artificially inflate its consolidated cash balances.

Companies that regularly raise capital should also be scrutinized. Management may be trying to fund its way out of inherent operational weaknesses.

More than one acquisition every two or three years is a red flag as well. The company may be trying to mask underlying financial problems by increasing the size of the business.

It is not atypical for Asian companies in financial trouble to misrepresent their assets and transactions. Western investors can be caught by surprise if they do not look hard for troubles before they commit.

Then, European corporations sent their treasurers from bank to bank shopping for the best deal, and capital was there for the asking.” Today, however, there are new banking regulations, loan structures and products, and the bankers themselves have changed. “It might take 10 calls within a bank to find the right person for a CFO to speak with, and then she still might hear ‘No’ several times before she hears ‘Maybe,’” says O’Callaghan. That, he notes, is especially true in Europe, where “a mountain of corporate refinancing” is chasing a competitive, finite pool of capital. “C-suite executives who never viewed refinancing as a priority will be getting a rude awakening during the next 18 months,” he predicts.

A Revitalized U.S. Loan Market In the United States, where acquiring capital through the high-yield bond market is a much more accepted and developed business practice than it is in Europe, most companies find that route open again after steep declines in 2009. The high-yield bond market had one of its best years on record in 2010 in terms of volume, with $259 billion of new issues. Merger and acquisition activity was also strong, with $43 billion in leveraged buyouts and $37 billion in dividend recapitalizations. By the fourth quarter of 2010, U.S. lending was up 100% from the previous year. “The increased inflows to the bond market and the leveraged market meant there was more capital available to lend,” says Kris Coghlan, senior managing director, Corporate Finance/Restructuring, in the Philadelphia office of FTI Consulting.

From the perspective of U.S. bankers, “the loan market is the healthiest it has been recently, certainly since the fall of Lehman Brothers and arguably since the summer of 2007,” says Joseph P. Powers, senior vice president and marketing manager for Bank of America Business Capital. “Once banks built fences to contain their problems and began to get their own capital ratios in order, they started seriously looking for opportunities to lend.” A dramatic improvement in corporate-bond default rates — from more than 10% of all bonds in 2008 to less than 2% recently — also reassured banks that companies again had become reasonable credit risks. “For quite some time, Bank of America and other institutions have had many billions of dollars of available credit that went unused because companies reacted rationally to the severe economic downturn and weren’t borrowing to build plants, invest in inventory or start hiring,” says Powers. This situation is beginning to change, though, as companies become increasingly bullish on the recovering economy. “Our outstanding loans are still down from where they were before the crisis, but we are prepared to lend aggressively, and that’s true for mostbanks,” says Powers.

Good Credit, Bad Credit

As lenders compete to get loans on their books, companies with high quality credit profiles are being offered interest rates 50 to 100 basis points lower than what they could have gotten a year earlier, along with more favorable covenant structures. Dividend recapitalizations are also being considered, Powers says. Large deals of more than $100 million might command rates of London Interbank Offered Rate plus 250 to 300 basis points, while interest rates may be even more competitive for middle-market companies seeking smaller loans. “There is less discipline for banks doing local lending on smaller deals than there is in the broader syndicated market,” says Powers. “Middle-market companies, even those with somewhat marginal credit, may be able to get great deals from local lenders, especially if there are a number of banks vying for that business.” Companies with a more challenging credit story face an evolving plateau. “Companies that have had some trouble can still get loans, but they are not priced anywhere near as favorably as they were before the crisis,” says Carlin Adrianopoli, senior managing director, Corporate Finance/Restructuring, in the Chicago office of FTI Consulting. “Nor are banks lending as much to these companies.” Each situation is unique, but in general, says Adrianopoli, a bank will lend a troubled company as much as 3½ times EBITDA , while, for those with good credit, it’s 4½ times EBITDA . “And whereas before the downturn, there could be a spread of 100 to 150 basis points between the two types of loans, now you’re looking at a spread of 200 to 300 basis points,” he says.

Even companies that haven’t had past credit problems may face skepticism about overly bullish business projections. “Banks these days are much less forgiving of a hockey-stick business plan for which a bridge to an acceptable EBITDA or an acceptable level of earnings is built into the forecast but hasn’t yet been achieved,” Adrianopoli says. “You will have a much tougher time commanding competitive pricing with a business plan that has an unproven level of growth than you will with one that demonstrates a track record of earnings.” Companies turned down by their banks have other options, including mezzanine lenders — hedge funds that will take a second lien or a junior position behind a bank on lending in exchange for a higher return on an investment. “Hedge fund lenders are out raising capital again and have resolved many of their portfolio-management issues,” says Coghlan. “They’re optimistic that they’ll get back into the lending market, which will create available funds for underperforming or distressed companies.” And while a traditional lender won’t lend these companies more than 3 to 3½ times EBITDA , a mezzanine provider may be willing to go as high as five to six times EBITDA , says Powers. Private equity investors are another option. “Companies without good credit that are looking for capital don’t have to restrict themselves to a traditional bank lender,” Powers notes.

A More Stringent Europe

In Europe, however, to be considered for a loan, companies may have to measure up against a much longer list of criteria. Some banks will lend only to corporations with headquarters in their local jurisdiction, for example. Others routinely turn down loan requests from companies in certain industries, including construction and real estate, or they may court only those in sectors in which the banks have had successful deals in the past. “If you understand a bank’s sweet spot and can tailor your request, asking for financing becomes an easier conversation,” says Mark Dewar, senior managing director, Corporate Finance/Restructuring, in the London office of FTI Consulting. Banks can afford to be highly selective because there are far fewer traditional institutions willing to take a pure lending position on deals in Europe today. “In the past a number of banks would have been quite happy putting £30 million to £40 million to work at LIBOR plus 250,” says Dewar. “Now banks have to pay an internal capital charge against that money, and the economics don’t work out unless the bank can, for example, also underwrite a bond issuance for the company or generate additional income through ancillary business such as hedging or cash-management services.”

That’s not a concern for very large corporations or very small ones. “If you are on the top of the pile, you’ll always get your financing, no problem,” says O’Callaghan. “And there are political pressures on banks to keep lending to small companies so they’ll also get the financing they need. It’s the midmarket corporates wanting to borrow $50 million to $200 million that can end up in a difficult place because they’re not big enough to go to the debt capital markets — you need a minimum of $200 million to $300 million for that — and they don’t generate enough ancillary fees to support a large syndicate of banks. Many of these mid-market companies have loans that are maturing, and it’s unclear where they’ll get the money to pay off those obligations.”

One strategy for dealing with that uncertainty is to refinance existing loans now, even if a loan doesn’t mature for another year. “You may pay a premium over today’s rates to refinance early, but that may be a price you’re willing to pay to secure future financing,” says O’Callaghan. And that approach could be preferable to seeing your company’s valuation take a hit if investors get worried. “There’s a tangible link between securing refinancing and valuation of shares,” O’Callaghan says. “If there are concerns about your ability to refinance, then it clearly will affect investor sentiment.”

European executives also need to embrace the American model of asset-based lending and bonds as part of a company’s financial model, O’Callaghan adds. “As a result of regulatory requirements, traditional European credit lines and products now can carry some of the highest capital charges for the banks, whereas asset-based lending often carries the lowest charge, and bonds are even better for banks because they involve only a fee and not a hold position,” he says. “In America asset-based lending is highly sophisticated and accepted, but some European corporations wrongly see it as a last resort. And there is a much longer history of U.S. companies going to the bond market to finance debt than there is in Europe. It’s going to be a cultural adjustment for European companies.”

Lenders as Strategic Partners

On both continents, forging strong relationships with bankers, always important, has become an absolute necessity. “More than ever, CEOs and CFOs need to view their lenders as strategic partners,” Adrianopoli says. “The business environment can change quickly, so you need lenders who are willing to stand by you through business cycles and are ready to capitalize on opportunities. You don’t want to be the CEO who comes to his bank group only when something is wrong. Lenders hate surprises, and they hate it when you talk with them only when things are bad.”

Adrianopoli recommends that companies with a syndicated loan involving several lenders use the lenders for each aspect of their financing needs, such as for hedging and cash management. Developing multiple relationships within your banking group may cost you more in banking fees, “but your lenders will be more in tune with your financial needs than if you’re viewed as simply another loan,” he says. Often, flexibility is at least as important as pricing. “You want to make sure that your loan gives you an adequate line of credit for short-term liquidity needs, that it has a flexible capital structure so you can repay your debt early with limited penalties, and that the lenders will be receptive to a business acquisition opportunity or foreign expansion if that’s what you need,” says Adrianopoli. A lender that markets itself to your industry may be a good fit for your company, but only if the bank has a track record of staying with businesses through good times and bad, he notes. “A bank’s expertise in lending to particular sectors shouldn’t be the only deciding factor,” he cautions.

Also new is the need for the CEO and the CFO to get involved in choosing lenders and “proactively engaging in the lending process,” says Dewar. That’s a departure from the passive slamdunk refinancing that a corporation’s treasurer would have handled in years past. Talking with bankers today requires the same careful crafting of mission and message that corporations rely on to prepare for a stock offering or an M&A deal. “You have to be ready to articulate your credit story in a concise and compelling way and realize that bankers are carefully listening to what your customers, your creditors and the analysts are saying about you,” says Dewar. “Demonstrating that you have complete control over your company’s finances is key. You can’t have overdue receivables, your inventory turns must be in line with industry norms, and you need a clear view of your cash flow requirements for the next 18 months.”

Proceed With Caution

Though most bankers now appear eager to lend to highly creditworthy companies, any number of economic problems could cause credit markets to seize up again. “Several troubling macro indicators — sovereign foreign debt; U.S. federal, state and local municipality debt; underfunded public pensions and other medical benefits; and long-term unemployment — are present despite a growing bullishness about the economy,” says Adrianopoli. “Until we have true fixes to these problems, be prepared for lending choppiness to come back.” Banks seeking new business may later pull back on their lending criteria and pricing. That’s why it’s crucial to develop a strong relationship with a lending group, says Adrianopoli. “You need to cultivate the relationship so your bank group won’t just walk away from you if the lending and business markets become harder. If you have a flexible lending line and strong relationships, you’ll have access to capital when you need it, you’ll have competitive pricing, and you’ll be able to prosper and grow your business in any lending environment.”

A trillion dollars is hard to miss, and with almost that much cash on the books, U.S. corporations have attracted the attention of hedge funds and other activist shareholders who want to know just how companies plan to put the money to work. According to Moody’s, U.S. nonfinancial companies had $943 billion in cash on their balance sheets at mid-year 2010, up from $775 billion at the end of 2008, and with interest rates at historic lows, that stockpile of dollars isn’t adding much value to the companies that hold it. Activist shareholders are pressing corporate management and boards to buy back shares, increase dividends, make acquisitions or otherwise deploy the cash in ways that explicitly benefit shareholders. But that pressure puts directors in an uncomfortable position.

Board members well remember the depths of the recent recession, when credit markets froze and liquidity was precious. They understand the need to invest in the business but want to be prudent and responsible, as global competition is fierce and the economy is susceptible to another decline. At the same time, trends in regulation and corporate governance, such as “say on pay” and proxy access, are giving shareholders more input into strategic and other corporate matters. If boards fail to heed the complaints of shareholders, activists could launch proxy fights or propose slates of directors who might disrupt corporate functions or result in the ouster of company officers. So as global economies improve and visibility into the future increases, how should boards respond to the tradeoff between preserving liquidity and pursuing investment during 2011? And beyond that, what should a board’s role be in setting strategy, working with management and monitoring performance? For insights, FTI Journal convened a roundtable of veteran board members.

Meeting in FTI Consulting’s Manhattan office, the panel included Robert Dinerstein, chairman of Crossbow Ventures and a former vicechairman of UBS Investment Bank; Rita Foley, director of Dresser-Rand and PetSmart; Stuart R. Levine, director of Broadridge Financial Solutions; and David Meachin, chairman and CEO of Cross Border Enterprises. Unable to attend but weighing in during separate interviews were Edward A. Kangas, chairman of the board of Tenet Healthcare; Philip R. Lochner, who serves on the boards of Clarcor, CMS Energy, Crane Co. and Gentiva Health Services; and Blythe McGarvie, CEO of consulting firm LIF Group and a board member for Accenture, The Travelers, Viacom and Wawa.

FTI Journal (FTIJ): In a recent survey of activist shareholders and corporate executives, the law firm Schulte Roth & Zabel found that both groups expect shareholder activism to increase during 2011, though they disagreed about what issues will provoke that activism. Activists said excessive cash holdings will be the primary catalyst, whereas executives thought financial performance would be the main catalyst. What is the sentiment of your boards? Are you concerned that activists will force you to change strategy and/or make premature decisions to commit capital?

David Meachin: If you sit on a big cash position for several years, you could have a huge political problem. But this is not a time to throw around a lot of cash just because activists tell you to spend. The economy still is deeply troubled, and it will be a long, slow process before the markets fully recover. And with the global marketplace becoming increasingly competitive, companies need to have a big cash war chest. There are any number of Western-educated Asian executives who now are running companies back home. They are very dedicated, and they have employees who will work hard for comparatively low pay. To meet that competition, many U.S. companies may have to spend money acquiring smaller businesses. Say you are a big pharmaceutical company. You could spend $1.8 billion developing a drug that may not succeed — or you could buy a small company that has strong research and development and a solid pipeline of new drugs.

Stuart R. Levine: Shareholders should give us advice, and we should listen. But at the end of the day, it is the responsibility of the chief executive and the board to make strategic decisions. Boards should develop long-term strategies that ensure shareholder value through R&D, M&A and organic growth.

FTIJ: In the wake of the financial crisis, how should boards look at the issue of holding cash vs. putting it to work?

Blythe McGarvie: Since the crisis began in 2008, corporate boards and managers have needed to answer three questions: Has the company restructured its debt to take advantage of some of the lowest interest rates in years? Have we reconsidered our discount rate when computing net present value analysis for potential investments? And what is a reasonable threshold, or “investment rate hurdle,” to use when comparing various potential investments? With interest rates so low, most companies can invest in their operations or in acquisitions for much higher returns than can be made in money markets. With returns on cash low, this is exactly the right time to invest in developing markets and in products to remain competitive and to capture market share. The rest of the world, particularly China, is not waiting to expand its reach into new markets. One of the best uses of cash now is to travel around the world looking for innovative products, services and processes that you can use in your own business.

Edward A. Kangas: If a company is generating strong cash flow and has more than adequate cash on hand, shareholders are going to want to know its plans for using that capital. One way to articulate that is to use return on invested capital to compare internal and external uses of cash. But if the ROIC on a stock buyback or dividend is much higher than you get from acquisitions or R&D, investors will question your priorities, and it will hurt the valuation of the company and its stock price. And though some companies want to keep “dry powder” for game-changing acquisitions, it’s generally better to arrange a large line of credit for that purpose rather than to keep a lot of cash.

FTIJ: By the time activist shareholders knock at your door, it may be too late to head off a confrontation. How can companies avoid becoming targets?

Rita Foley: By maintaining open communication with shareholders, who are less likely to side with activists if they understand your strategy. Some of that will come through individual meetings with investors, but companies also should hold strategy days that are open to all analysts. At these meetings, management can lay out a company’s five-year strategy and explain why it makes sense.

Levine: Some companies have effectively reviewed strategy through retreats. The sessions are designed to explore the future and are grounded in the reality of available capital and results. Reflecting on investor concerns helps enrich the discussion. This process helps the CEO continue to respond to these issues appropriately.

Kangas: It’s also important not to generalize about activist investors. They worry boards, which don’t appreciate the scrutiny. But some activists can add real value. And while they’re often seen as just wanting share buybacks, the really good activists can help companies improve their approaches to capital allocation.

FTIJ: Are there other effective forums for communicating with shareholders? And is it possible to communicate too much?

Levine: It’s important to talk with the general counsel about the best way to communicate so you don’t run into problems with fair disclosure regulations. I was a lead director at a company when a hedge fund took a substantial position in the stock. When a manager of the fund reached out to me, I listened for a reasonable amount of time while the investor shared his ideas about strategies on mergers and acquisitions. I thanked him for his ideas and assured him that I had heard his suggestions but explained that it would be inappropriate for me to get into a lengthy conversation. When people ask to talk with an independent board member at Broadridge, we refer the request to the CEO and determine which director would be the most appropriate person to respond, e.g., chairman of compensation, governance or audit.

Robert Dinerstein: There might not be much we can do to change the views of activist shareholders. But we need to find ways to reach retail investors. They have lost confidence in the market, and they are turning to brokers for advice. We need to provide focused communications for the brokers. It no longer is enough just to send out a press release.

Foley: You also can’t ignore Facebook, LinkedIn and Twitter. Someone has to be actively monitoring what is being said about a company in the new social media and respond accordingly.

FTIJ: One of the hottest topics for the next proxy season involves the “say on pay” provisions of the U.S. financial reform legislation passed last year. Under the rules, companies must give shareholders the right to provide advice on executive compensation. Some people see this as an intrusion on the rights of boards. But there has been an arms race to pay CEO s — if one CEO makes a certain amount, competitors feel they must match the figure. Could the new rule make boards more thoughtful about compensation policies?

Foley: Surveys of board members suggest that “say on pay” won’t have a great impact. Similar rules have existed in the United Kingdom for a long time, and there hasn’t been much fallout. Many boards already listen to shareholders and are transparent about compensation, so they will have little resistance to change. There will be more pressure to show how you measure executives relative to the business results. Activist shareholders often complain that companies spend too much to hire senior executives from outside, in part because you typically have to compensate people for stock options or other payments they give up when they leave their old jobs. Now there could be even more focus on such payouts, and to avoid controversies, companies may put a renewed emphasis on promoting from within. But that will require boards and management to spend more time grooming executives and having a robust succession plan. That could be a positive development.

Meachin: Whether or not say on pay has an impact, globalization could put pressure on salaries in the United States, which tend to be higher than those at competitors abroad. To compete internationally during the next 20 years, you’ll have to cut costs to the bone and adjust compensation.

FTIJ: What role should a board play in developing strategy — what businesses and markets to be in, how cash is used, how executives are compensated and other important issues? Should the board actually formulate plans or simply oversee management as it develops ideas?

Meachin: It used to be that management would give a six-hour PowerPoint presentation to the board, which then would essentially give management the go-ahead to proceed with its plans. These days, the CEO and management are still responsible for making strategy, but to compete on a global stage, management has to harness the brainpower of everyone on the board, which needs to be involved in critiquing ideas and ensuring that plans make sense. Also, many board members serve for 10 years or more, while CEO s often are there for a much shorter time. So the board must take more responsibility for determining and implementing longterm strategy in case it needs to bridge a management transition.

FTIJ: We’ve talked about the important impact that globalization is having on business. Are boards doing enough to make sure that strategies are aligned with the demands of operating in a global environment?

Foley: Many people on the boards of U.S. companies have management experience only in the United States, and that really limits their ability to take a truly global perspective. It’s important to have people who have lived in different countries and have immersed themselves in those cultures. Some boards of multinationals are discussing where a company’s headquarters should be. Just because the company has always been run from the United States doesn’t mean it should stay there. If you have big operations overseas, it could make sense from a client standpoint to locate somewhere else. And you may be able to save on taxes.

Levine: If you are traveling and working abroad, it changes how you look at things. You look in the faces of people, and you can see how your product may not be suitable for particular markets.

FTIJ: The credit crisis and recession exposed the ignorance of many directors and boards about the companies they oversee. How can directors come to understand a business at a fundamental level? Do they need to go into the field and get their hands dirty?

Meachin Board members should visit plants and operations, and if plants and operations are overseas, that’s where board meetings should be. Procter & Gamble divides its board into groups and sends three board members to one country and three to another. You don’t have to travel 300 days year, but board members have to recognize that part of their job today is to travel to wherever major business is done. The point is to get a good understanding of the products and the customers.

Foley: Board members also need robust training. I serve on a board that includes several CEO s with experience in the industry. But everybody had to go through training, which consisted of getting tutorials and visiting clients as well as company facilities. It was helpful because some of those CEO s had come up through the financial ranks and were less familiar with the field and with manufacturing.

Levine: I have served on the board of a nonprofit hospital group for 25 years, and I find that field trips are always helpful. We recently toured a hospital and visited an emergency room and operating theaters. We talked with doctors and nurses. That provided important perspective about the reality of the organization and its operations.

FTIJ: Should board members seek to develop information sources that are independent of the CEO?

Philip R. Lochner: As long as a board has confidence in management’s willingness to report both good and bad news accurately and impartially, it’s entirely appropriate for boards to rely on management reporting. The CEO has access to performance measures and details the board couldn’t get from other sources. But intelligent boards supplement that information with industry analysts’ reports, SEC filings, trade publications and trade shows, other media coverage and so on. Boards need to have independent sources of information against which to test management assertions — not because anagements are dishonest but because, like all of us, they may have blind spots or get carried away with their own enthusiasm for the direction they’ve decided to take.

Foley: An outside perspective is important, and our board asks to see all of the analyst reports on the company. We also ask for an analysis of the competitive environment. That may come from someone in management, but it is helpful to look at reports from other sources as well.

Levine: Having access to independent analysts who follow your company is important. I was on a board that brought in one of our analysts. That direct conversation enhanced our board’s understanding of more indepth market realities that were contained in her report. Doing that, you find subtleties that aren’t in writing. In cases where I’ve been concerned about a particular issue, we have retained an independent counsel that reports to the board.

Another way to learn about a business is to get involved in succession planning. Board members should take the time to have a cup of coffee with candidates for CEO . That doesn’t mean just meeting with the top five candidates. You should consider talking with people in the top three tiers of management. By meeting with people at a variety of levels, you can learn a lot about the nuts and bolts of how the business works. Understanding how a consumer utilizes your product or service is huge. Understanding strategy requires you to view the service through the eyes of the end consumer of your product, with a global view of the future.

By sitting on mountains of cash until the recession has safely passed, companies may think they are acting prudently. On the contrary, they could be setting themselves up to be overtaken by competitors that have been strategically using their financial resources to make acquisitions, launch new products and create more efficient ways of doing business. Over the course of the 2007–09 recession, as credit markets froze and revenue plunged, companies jettisoned millions of workers and took the scalpel to their budgets, especially in Europe and the United States. Of course, those moves boosted corporate earnings, and companies’ coffers swelled. In Europe, for instance, cash makes up 12% of total assets on corporate balance sheets and is almost a third higher than at any point in the last economic cycle, according to UBS.

Globally, nonfinancial corporations are sitting on $4 trillion in cash today, a full trillion dollars more than they had on their books in 2007, according to Citigroup’s Corporate Finance Advisory Group. Yet, while the National Bureau of Economic Research in the United States reports that the recession officially ended in June 2009, many companies have maintained a viselike grip on liquid capital. Whether they worry about a double-dip recession, a lack of investment opportunities or the need to rearm against Asian competitors, their financial prudence risks becoming a liability. The reason: Competitors are already investing strategically and are gaining substantial ground. In industry after industry, companies like Netflix, W.R. Grace, Banner Health and Maersk have used the recession to invest aggressively in new products, markets and operations. As the global economy recovers, these companies will have first-mover advantages that will be hard for others to overtake.

Firms that keep hoarding cash face a big risk of being left behind competitively and frustrating multiple constituencies that want them to deploy their capital. Because returns on cash are at historic lows, investors are taking a dim view of many companies’ cash positions. A survey by the law firm Schulte Roth & Zabel in late 2010 showed that excessive cash positions would be the primary catalyst of investor activism over the next 12 months. Political pressure is being brought to bear as well. In February 2011, in an address to the U.S. Chamber of Commerce, President Obama implored CEOs to start investing and hiring, pointing out that “American companies have nearly $2 trillion [in liquid assets] sitting on their balance sheets.”

Yet the most important reason for getting off the sidelines and deploying that cash is neither shareholder pressure nor political cajoling. It is that companies will lose competitive advantage. According to numerous studies, companies that emerged in the best shape from past recessions had invested more and saved less than their competitors. As a 2002 McKinsey & Co. study found, the companies that came out of the 1990–91 recession the strongest had outspent peers in R&D (by more than double) and acquisitions while maintaining cash balances 40% lower than their competitors’. By spending their cash on pursuing market share, developing new products and opening new markets, they had significantly strengthened their competitive positions. It isn’t too late for companies that have been conservative with their cash to catch up. But the window of opportunity is closing.

Spending cash in all the Right Places

A number of companies have used the recession of 2007–09 to enhance their prospects. Even though the days of economic turmoil are not far behind them, they are already reaping the benefits of their contrarian investing ways. How they invested in the downturn while most of their competitors pulled back is instructive ways. How they invested in the downturn while most of their competitors pulled back is instructive. Consider the case of W.R. Grace. As the recession took hold in 2008, the $2.6 billion (revenue) global specialty chemicals company moved quickly to slash working capital and operating costs. By reducing net working capital days by half (from 106 to 53), Grace freed up $350 million in cash, an amount that was triple its 2007 operating earnings. As the credit markets tightened, that cash became pivotal to Grace’s overseas expansion. The U.S.-based company bought and acquired manufacturing capacity in growing markets from China to Saudi Arabia to Brazil.

Those investments are already paying off. In 2010, Grace’s sales from overseas markets increased 13% over 2009 — more than four times the firm’s overall growth (3%). More important, the company, whose products include catalysts for oil refineries and plastics manufacturers, expects emerging markets to be virtually the only source of growth in those two industries over the next three to five years. Grace’s new factories are critical to its participation in that growth. Grace’s lesson: Reinvesting cash strategically is as important as reducing costs and working capital to free up that cash. “There is a direct correlation between the reductions we made in working capital and the cash we had available to make investments in emerging markets,” says the firm’s chief financial officer, Hudson La Force. These lessons apply to companies that are as different from process manufacturers like Grace as baseball is from cricket. Take Banner Health, a $4.7 billion (revenue) U.S. healthcare provider that owns 22 hospitals.

In the recession, the company not only had to contend with flat or declining patient volumes, but it also had to prepare for the healthcare industry’s looming day of reckoning: healthcare reform legislation. Hospital systems like Banner face a future of declining public and private reimbursements for treatments and hospital stays. And because future reimbursements will be tied to the quality of care, Banner’s senior management knew the company had to upgrade facilities and medical equipment. Indeed, it has — to the tune of more than $1 billion in construction projects for new and existing hospitals. W.R. Grace and Banner Health could have conserved their cash until the financial storm had long passed. The stockpiles of cash that companies around the world are sitting on today suggest that many firms have done just that. Yet both companies decided to invest and strengthen their competitive positions. They and other companies that exit the recession having laid the building blocks for growth are likely to outrun competitors that continue to hoard their cash.

Deciding where to Invest: The stories of Netflix, Polo Ralph Lauren and Maersk

So if companies decide it’s better to spend strategically today than continue to save, where should companies invest? To be sure, the answer will be different for every firm. The right opportunities depend upon a firm’s unique circumstances: the markets in which it sees the greatest potential, its core capabilities and competitive position, the unfilled needs of its customers and more. The stories of companies that have aggressively deployed their cash during the recession provide useful insights on where to look. I’ll organize these stories into three categories: new products, new markets, and redistributing work around the world.

New Products Netflix is the world’s largest movie subscription service. The firm has gone from launch in 1997 to $2 billion in annual revenue today and has 12 million subscribers. It is led by Reed Hastings, its CEO and co-founder. Hastings has long believed that, although DVD rental by mail will be a source of growth for Netflix for many years, subscribers will increasingly want the immediate response of movies streamed over the Internet to their television screens. In 2007, Netflix began investing in software that would enable streaming on other companies’ devices, such as Blu-ray players, set-top boxes, game consoles and TiVo DVRs. Netflix was faced with a big investment, one that could have appeared untenable as the economy began backsliding into recession. But the company didn’t flinch, making streaming a focus of its research and development efforts. Between 2007 and 2009, Netflix doubled R&D spending from $70 million to $140 million. Meanwhile, it ran down its cash balance by two-thirds, from $400 million at the close of 2006 to $134 million at the end of 2009. Today, Netflix’s investments during the bleak years look prescient. In the third quarter of 2010, two-thirds of its subscribers were streaming movies online, nearly double the number in mid-2009. The company’s revenue last year was 80% higher than 2007’s, and profits have soared 140%. At the end of 2010, Netflix’s cash position was on the mend, rising to $194 million. These numbers have clearly dazzled investors. Netflix’s stock more than tripled in value in 2010 alone. Since 2007, the share price has risen tenfold.

New Markets History shows that recessions spread pain unevenly around the globe. While demand can be moribund in a company’s home market, emerging economies can offer lucrative opportunities. The combined gross domestic product of the BRIC countries (Brazil, Russia, India and China), for instance, is now almost 70% of Europe’s aggregate GDP. But what’s more remarkable about the $11 trillion BRIC GDP is its impressive growth. Between 2000 and 2008, the BRIC countries contributed almost 30% to global growth, compared with 16% in the previous decade. Since the start of the crisis in 2007, the BRIC countries’ contribution has risen to 45%, according to analysis by Goldman Sachs. Companies like Grace believe that rapid growth requires participation in emerging markets. “If you are a global company, as we are, and you are not investing in these markets today, you really run the risk of falling behind,” says CFO La Force. Polo Ralph Lauren is another global company that took this to heart three years ago and ramped up its investments in Asia-Pacific. The $5 billion (revenue) apparel and fragrances company began buying its Asian licensees in 2008, believing the product range they offered was too narrow and their inventories too low. With sales of luxury consumer goods exploding in Asia, the company needed to capture a bigger share of the pie. At the beginning of this year, it acquired its South Korean distributor, the seventh successive purchase of a Polo Ralph Lauren licensee in Asia. In a February earnings call, COO Roger Farah made it clear that the firm’s $1.3 billion in cash and investments was at its disposal for more investments in Asian markets. Analysts and investors appear to have no problems with that. The stock has risen from the $70s last July to more than $120 this February.

Redistributing work around the World

This investment category is less obvious than the other two, and many companies have ignored it. But others have made substantial investments and have seen sizable returns. It is about redistributing the work of an organization — the activities of the finance department, information technology, customer service and other support functions — to take advantage of such conditions as lower labor costs and preferential tax treatments in other regions. A great example is the $60 billion Danish conglomerate A.P. Moller- Maersk Group. A major ocean shipping and energy firm, Maersk has been slowly but steadily building global “shared services” operations since 2003. Based in six centers in India, China, the Philippines and Denmark, these operations have enabled Maersk to standardize and reduce the costs of support functions, such as finance, accounting, human resources and IT.

In 2008 the global economic downturn produced the most challenging year ever in the container business. In response, as well as taking aggressive steps to cut costs, Maersk accelerated its investments in shared services. The company set a target of increasing the share of finance and accounting work done by the centers from 30% to 70%. Over 18 months Maersk hired 1,200 additional people for shared services, absorbing finance and accounting operations from 85 countries. The result: The operations are better standardized; the costs of those operations were reduced by 10% in 2010; the savings will increase as the remaining countries are rolled in and the new processes stabilize; and Maersk has a cost structure that better positions it to compete as the global economy recovers.

Getting past the obstacles to investing in lean times

Should every company follow the lead of Netflix, Maersk, Polo Ralph Lauren and W.R. Grace and make major investments in new products, markets or operations in spite of uncertain economic times? Shouldn’t some companies hang on to their cash until better times are clearly ahead? For most, we think not. almost every company has opportunities for growth in bad times as well as good.

Take the chemicals industry. Even though it doesn’t seem like a sector with high potential during a global manufacturing downturn, W.R. Grace found prosperity in distant lands. In any event, it isn’t necessary to hold on to a pile of cash for future needs such as making an acquisition. As Tenet Healthcare chairman Edward Kangas says in our roundtable discussion in this edition, “It’s generally better to arrange a large line of credit for that purpose than to keep a lot of cash.” Highly leveraged companies may have more urgent priorities for their cash, such as shrinking their debt. Firms uncertain about repaying maturing loans might consider refinancing and extending maturity dates first. (See “Restricted Access,” page 34.) But once they’ve straightened out their capital structures, even these companies should seek profitable investment opportunities. We do excuse some companies from investing during the downturn. Managers in mature sectors with more capital than they can profitably invest should consider returning it to shareholders through share repurchases or dividend increases. Or they might consider merging or being acquired, especially if they operate in a sector that is consolidating. But there is risk in doing nothing: Companies that are neither acquirers nor acquired may be marginalized by their shrinking market share, or their shareholders may take the decision out of management’s hands by forcing a sale, breakup or return of capital.

We continually hear executives argue against investing too soon. “The economy could tank again.” “Domestic markets are flat.” “Overseas markets are risky.” “We are in a mature sector.” “Deals are too expensive,” and so on. While there is truth in all of these objections, leading companies have managed around them, and in many cases investors are rewarding them for it. Several recent acquirers have seen the values of their shares increase after they announced acquisitions, in contrast to the normal market reaction. Danaher Corp.’s stock rose on the announcement of its acquisition of Beckman Coulter Inc. in February, despite paying a 45% premium on Beckman shares. Cliffs Natural Resources Inc. stock rose nearly 3% on Jan. 11 after it announced the purchase of Consolidated Thompson Iron Mines Ltd. At some point, the majority will follow the minority, and a stampede will commence. Several indicators say it is about to begin. History tells us that companies that deploy their cash before their slower-moving competitors can overtake them.

Managing through crisis has never been easy. But in today’s increasingly complex, interconnected world, the challenges have grown ever more daunting. Climate change, poverty, terrorism, and financial and credit instability are just a few of the intractable issues confronting both heads of state and corporate chieftains, for whom the stakes have never been higher. Two FTI Consulting experts have recently published their perspectives on the issues.

The Unfinished Global Revolution: The pursuit of a new International Politics

(Penguin Press, 2011). Lord Mark Malloch-Brown lays out a road map for navigating an uncertain future. FTI Consulting’s chairman of global affairs, Malloch-Brown draws from a wealth of experience on the international stage — as a World Bank vice president, head of the United Nations Development Programme and deputy secretary-general to U.N. Secretary-General Kofi Annan. A former journalist, Malloch-Brown also has served as minister of state in the Foreign and Commonwealth Office of the United Kingdom with responsibility for Africa, Asia and the United Nations.

In The Unfinished Global Revolution, Malloch-Brown argues that, just as the worldwide economic crisis of 2008 demonstrated that a global economy requires global financial institutions, today’s political and social challenges demand unprecedented international cooperation. In the 21st century, trade, technology, economics and social change continually push people of disparate geographies and cultures together, but national governments aren’t equipped to handle the complex global issues they face, and there are no international organizations empowered to fill the void. Changing that won’t be easy, given the suspicions people and their political leaders have of the U.N. and its like.

Part of the remedy, says Malloch- Brown, is a “simple global social contract” through which individuals, corporations and governments can establish powerful international institutions that value human rights and the rule of law, and offer a voice for participating nations. Through intimate portraits of politicians he has advised and observed, including Bill Clinton, George W. Bush, Jacques Chirac and Tony Blair — and through an engaging political history of governments that have failed to live up to the demands their citizens place on them — Malloch-Brown offers an agenda for managing globalization. And he suggests that the corporate leaders of tomorrow won’t be the imperial CEOs of yesteryear, but rather visionaries who can reach across cultures and engage shareholders to build alliances, bringing together apparently disparate interests. That leadership will require a multicultural sensibility, emotional intelligence, and an ability to listen, persuade and understand different points of view.

Turnaround Leadership: Making decisions, rebuilding Trust and delivering results after a crisis

(Kogan Page Ltd., 2010). Shaun O’Callaghan, senior managing director in FTI Consulting’s Corporate Finance/ Restructuring business segment, lays out a proposed framework for coping with crisis, drawing on more than 15 years of experience as an adviser, executive and board director and as a founder of Quartet Research, a leadership research and development organization for senior executives.

In Turnaround Leadership, O’Callaghan starts with the premise that all companies, if they’re in business long enough, eventually will go through a period of upheaval resulting from shifting consumer preferences, economic recession, management scandal or some other kind of shake-up. Whatever the cause, crisis presents an opportunity for managers to become leaders and to develop a recovery plan that will put the organization back on its feet as painlessly and productively as possible. O’Callaghan outlines five key areas of leadership he considers mandatory in building a successful recovery plan: beginning anew by making the right promises to stakeholders, including customers, investors and lenders, employees and suppliers; gathering a range of alternative perspectives, no matter how contrary; developing core business skills necessary for recovery, including cash flow and time management, strategy development, sales management and cost-base restructuring; delivering results through savvy relationship building; and rebuilding trust through authentic communication with all stakeholders. One of the most common mistakes managers make is failing to recognize and challenge their own assumptions about a business, O’Callaghan says. For example, had CEOs of financial firms questioned their assumptions — that the wholesale lending spigot would remain open and that property values would continue to climb — the 2008 housing market collapse might have been averted. While hindsight is always 20/20, Turnaround Leadership contends that with the right tools in their belts, corporate leaders can be prepared forwhatever comes their way.

• First, we faced a credit risk when a part of the American domestic mortgage market went into default.
• Second, a liquidity crisis was brought on by counter-party risk. The fall of Lehman Brothers was its most visible manifestation, along with the rescue of AIG, but inside the crisis the fact that the wheels seemed about to come off the capital markets was more mundane but perhaps more frightening. We all remember the last months of 2008 and early 2009 when a simple letter of credit for routine trade exports became almost unobtainable. As Prime Minister Gordon Brown’s envoy for the G-20 at the time, I remember the scramble to get some official money behind the world’s oldest, and until then most routine,  international financial transaction. World trade plummeted 20%. In a globalized world, we feared, if trade stops, the world stops.

• Third: Last year investors saw their safe haven, sovereign debt, buffeted by weakness in the eurozone. This year, that credit crisis continues to play itself out as so-called rescue packages still avoid addressing the real sustainability of the public finances in Greece or Ireland or Portugal or even U.S. municipal finances. The recent Economist cover spoofing fictitious U.S. state names, such as Califoreclosia, New Yoke, No Hopeshire, Mess (for Massachusetts), Horrida and I.O.U.wa, is the satirist’s and cartoonist’s art at its most effective. It tells a story we would prefer to overlook: America’s states are drowning in red ink.
• And hence to the fourth crisis: geopolitical risk. The Arab world is convulsed. Petrol flirts with $100 a barrel. Food prices have risen above their 2008 peak. Natural disasters are omnipresent. It’s suddenly a dangerous place out there.

So what have these four crises done to expectations and a generation of investors, especially those looking at Asia? The answer is not simply bulls vs. bears. Rather, I believe we have undergone an undernoticed shift in psychology that makes us warier of indiscriminate grand trends in investing, embracing whole countries or sectors, and more cautious and careful “opportunity pickers.” Of course, trends still matter: Are we shifting our global economy onto an IT-enabled platform? Almost certainly, so that gives the technology sector a step up before you get to evaluate individual companies. Similarly, the long-term future of highgrowth markets — namely Asia, Latin America and parts of Africa — seems on a stronger trajectory than, say, Europe or North America.

Seeking Markets Without Morals

But let me scratch a bit further at this somber new psychology before applying the same lessons to Asia in particular. In my view, two of the apparently hardwired assumptions about the recent past that came from the 1989 fall of the Berlin Wall have been changed by the 2007– 11 credit shock. First, governments
are no longer necessarily safer than companies, which throw on its head the most basic principle of portfolio allocation between safe but low-return government bonds and corporate debt and equity. And that came to pass in considerable part because the socialization of Western bank bad debt has implications for Western political systems that have not yet played out. Look out, for example, for the return of hard-left political parties demanding much more draconian anti–Wall Street and -business measures than anything we have seen so far.

Gordon Brown, who, as England’s Chancellor of the Exchequer, presided over the dramatic expansion of the London financial services sector, in his post–prime ministerial memoir waxes angrily about irresponsible and reckless banker greed and demands markets with morals. For a man from Adam Smith’s hometown whose political career is behind him, a call for morals may be enough. I suspect younger Labour leaders harbor hopes for taking a clenched fist to markets.

In this way, the “popular capitalism” model of growth that drove social cohesion in Europe from Margaret Thatcher’s day onward — where people got richer, bought their own houses, put a second car in the garage and saw their children off to fine, and largely free, university educations — may be ending in tears.

Shadows over Asia’s rise

Although Asia has embarked on a similar inclusive period of political and economic growth, where, despite vast income disparities, everybody feels they could be part of an Americanstyle aspirational dream — where each generation is better off than its predecessors — it, too, will be affected if European markets grind to a halt and a new “them” and “us” politics metastasizes from Europe into Asia.

But at a time when we are anxiously peering through the telescope and trying to understand future risk, we need to look hard at Asia and the geopolitical factors that threaten to cast long shadows over Asia’s rise. What are Tunisia’s and Egypt’s lessons for Asia? The first thing to say is that it probably is not the democracy deficit that will trip up Asia in the way it recently has the Arab world. For all its exceptionalism, Beijing remains sharply attentive and responsive to local issues, as though its political life depended on it — and it probably does.

Rather, the roots of Asia’s risks are growing income inequality, border disputes, environmental and natural resource pressures, and the scramble to control the strategic commodities that feed the Asian manufacturing engine. On each, there are clouds. Though East Asian incomes have increased by 1,100% between 1970 and 2010 compared with an average of 184% in developing countries, income inequalities have also grown sharply in a number of East Asian countries. These inequalities create new disparities, new winners and losers and new tensions. The 2010 confrontation in Bangkok between angry rural supporters of the opposition and the more prosperous urban groups that supported the government reflected this reality, and it clearly lies behind many of the tens of thousands of social protests each year in China. Asia entered the 21st century with a positively European, beginning-ofthe-20th-century list of unresolved border and sovereignty disputes: the South China Sea, Taiwan, Kashmir, the Korean Peninsula and so on. If Europe’s experience a hundred years earlier tells us anything, such disputes are exacerbated by differential rates of economic growth. Germany’s industrial success fed its resentment at unsatisfactory border arrangements. It wanted more room and power. The other analogy to Europe is that when a region is a global economic powerhouse, its disputes have a nasty habit of going global. Germany’s border grudges led us into two world wars.

The region also faces destabilizing environmental and resource trends: Water scarcity in India is one of several factors having a major impact on Indian agricultural productivity; changing dietary habits in China, India and the rest of the region with the substitution of meat for grain requires heavy increases in the use of both grain and water. Environmental destruction of the Indonesian rain forests has made this one of the top hot spots for global climate change. The fact that more than 80% of the world’s natural disasters occurred in Asia in the past few years indicates how population growth, poor location of expanding human settlements, soil degradation and the loss of forest cover are combining with more extreme weather patterns to create an enhanced level of human vulnerability to natural disaster.

Beyond these kinds of issues, as Asia faces new competitors, Africa embarks on a low-cost, commodityexport- led boom backed by a lot of internal diversification. Many Asian countries seek strategic partnerships to secure access to Africa’s minerals and energy, but this also forces them into mounting a much more global national foreign policy than in the past. There are Indian peacekeepers in Congo,

Chinese traders and development experts in Malawi, and both countries’ engineers and diplomats, along with those of South Korea and Malaysia, pursuing resource deals across the African continent. Without the same
ambition for political control, this Asian scramble for African resources emulates Europe’s similar late-19th-century scramble. Asia has its hands full.

Investor, Tread Carefully

What does all this mean for the investor? My own view is that none of this undermines the long-term bet on Asia, but it does suggest that investors should be discriminating. The world is a tricky place. Although Asia’s concentration of people, wealth and growth makes it an indispensable centerpiece of any global investment strategy, that strategy must be accompanied by a tolerance for risk and the tools to manage it. Too many Western investors still assume that growth will banish politics and that a vast consumer suburbanization is under way across this large and varied region. This way of thinking assumes that with growth, every country will become a Singapore or a Hong Kong, forgetting that both have unique histories and geographical opportunities that enabled them to become high-end service providers and trade centers for their regions. Neither is a replicable model for its much larger, teeming neighbors that are still struggling to make growth inclusive and government viewed as fair and legitimate. For much of Asia, the real dramas of development, political as well as economic, lie ahead. For the investor, this is not a reason to stop but rather to proceed through these dangerous seas with the right charts. Above all, it requires rigorous understanding of individual corporate strategic plans, financial strength and market positioning. The big trends are sufficiently prone to geopolitical shock, sector risk and continued financial volatility that the lifeboat is the investment target within the trend. Is it the IT company that will survive a bubble or the construction business that can now weather a long downturn?

And in cases where the investment is essentially a bet on a country’s stability and growth, investors need to do their homework, and above all not fall victim to the wishful thinking that growth equals stability. If the political system is not expanding to represent both the new middle class as well as those who fear they are getting left behind, prepare for trouble. Asia has enough variety of political systems operating effectively that the key test is not a neat Western democratic form but broad representation, accountability and legitimacy.

Growing Pains

Growth will propel this region forward, as well as Africa, Latin America and other emerging regions, even as the mature Western markets fall back. But at times this growth will fall into that category of things we warn our children about: Be careful what you wish for because growth brings the stresses and strains of new inequalities, resource scarcities, infrastructure bottlenecks,inflation, pressure on borders from growing populations, and competition between countries. In the long run, people will look back and see a generation of difficulties and wonder why we had not seen it coming, and why, when it came, some probably lost sight of the more lasting truth. These difficulties were growing pains and not a lasting threat to Asia’s rise. What investors must surely do is keep their heads and hold on to their wallets in the coming years, while never losing faith in the region’s transformation. Markets have never been so global and yet local knowledge so important.

That’s not an unheard-of approach for private equity firms, of course; successfully resurrecting a dysfunctional business is one reliable path to maximizing investors’ returns. Yet Cerberus differs from many traditional firms in that it has developed a proprietary team of operating executives on which it relies to help it perform due diligence, underwrite, evaluate, execute and monitor its operational control investments. Because of its team, Cerberus can focus not only on traditional buyouts of distressed companies but also on corporate carve-outs — taking only a piece of a company rather than buying a stand-alone business. In part because carve-outs have little existing management structure — a deficiency that must be quickly remedied — Cerberus can take a different approach from that of many firms, which tend either to avoid carve-outs completely or to look outside for the expertise to rebuild companies. Cerberus depends on its proprietary team of 85 industry-hardened executives and only a small, handpicked group of Tier 1 consultants. Led by Robert Nardelli, former CEO of The Home Depot and Chrysler, the firm’s internal team works out of an affiliate called Cerberus Operations and Advisory Co. (COAC). “COAC is populated with former operating executives, including CEOs, CFOs and COOs,” says Neporent. “And we have about 100 other former COAC members who are currently situated in our portfolio companies occupying key management positions.”

What are the advantages of maintaining a large staff?

NEPORENT: We can take on projects in which the entire management infrastructure must be built from scratch. That includes installing complete systems for accounting, IT, sales and marketing, and human resources. One of our recent successes involved Talecris Biotherapeutics, a blood plasma company we bought from Bayer. The transition services agreement covered a very brief period, and we had to get everything in place right away. Thanks to our internal team and support from strategic consultants such as FTI Consulting, the outcome was highly successful.

Yes. That was a very successful transaction, with more than 20 times return on investment reported. Touching further on the topic of exiting from investments: With the IPO market still slow, do you end up holding companies longer these days? Do you get more involved, even after a business is up and running?

NEPORENT: In the past, we tended to exit investments after we completed our restructuring task and restored the company to operational and financial health. In this market, we are often holding our investments longer. So once we have fixed a company operationally, we have to figure out how to grow it during what could be an extended holding period. That means we are paying much more attention to the top line and sales and marketing than we have in the past. Since Bob Nardelli came onboard full-time a year and a half ago, we have stepped up our surveillance of the companies in our portfolio. The technology we have developed is unmatched. We try to spot problems and see trends much earlier than we did when the economy was more robust and there was more room for error. You have to be able to measure things, and Nardelli and his team have deep experience and use comprehensive models that they check every day.

But doing an IPO is just one of many exit strategies. If that can’t happen, maybe you sell to a strategic buyer. Each investment is unique, and conditions vary from industry to industry and region to region. We have had exits and partial exits this year in all forms of transactions and industry sectors. You need to be nimble and resourceful. For example, one European deal collapsed because the IPO market reacted badly to the Greek financial crisis. Two weeks later we got a deal done in a different industry sector elsewhere in Europe despite the lingering crisis.

Has the economy also affected your ability to make acquisitions? Financing has got to be tight.

NEPORENT: Blue-chip companies are expensive now, and capital is dear. We were able to source and sign up three significant middle-market deals so far this year. And though you have to put up more equity, financing is available for the right acquisitions and the right sponsors. Our sweet spot is the middle market, despite all of the media attention paid to iconic transactions such as GMAC and Chrysler. We target the corporate widows and orphans. These are noncore businesses that good companies are shedding because they want to focus on their core competencies. That creates opportunities for us that others may shy away from because they don’t have the management and operating talent in-house.

How are your companies performing this year?

NEPORENT: There are pockets of good news and areas in which sales are flat or down. Auto supplier revenues are up, but sales at paper companies are down. We have been able to enhance earnings by continuing our relentless focus on operational efficiencies. But there is a limit to how much you can cut costs. You have to worry about cutting so deeply that you start to impinge on what a company can do.

What about new markets? Are there different geographic regions you are focusing on now?

NEPORENT: We spend a lot of time thinking about Asia, looking at relationships and opportunities. We’ve invested billions of dollars in acquisitions and debt in Japan. And though we have yet to make any meaningful acquisitions on mainland China, we are actively looking there. And our portfolio companies are constantly looking for opportunities for outsourcing and efficiency.

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.