the Evolving Landscape of the Turnaround Industry [Secured Lender, The]

Turnaround and restructuring professionals and lenders share their observations on the challenges the turnaround industry has faced, their thoughts on how the industry has evolved and what needs to change.

The turnaround and restructuring industries have not been without challenges in recent years. The industry has felt the effects of the weak economy since 2008, coupled with bankruptcy reform and new players entering the distressed marketplace, leaving turnaround professionals with no choice but to continue to adapt and innovate.

"The biggest challenge to anyone in the restructuring world is the current economic challenges," said Lee Diercks, partner at Clear Thinking Group, LLC, a boutique restructuring financial advisory firm. "We still have a slow-growth economy. The healthcare mandate is now putting a lot of pressure on companies as to what they should do. We've had a number of clients in the past few years that have significant pension program issues. Tax issues and immigration reform are also affecting the marketplace, and so it's creating challenges in a variety of different ways for many companies."

William Lenhart, chairman of the New York Chapter of the Turnaround Management Association (TMA) and an executive consultant at BDO Consulting, recalled how everyone in the turnaround industry thought they were going to be busy long after Lehman filed for bankruptcy in 2008, but this became short-lived after 2010.

"In 2009 and partially in 2010, we were incredibly busy with filings," Lenhart explained. "But then lenders became more apt to ?kick the can down the road'. They were less likely to proactively make their borrower do something to restructure which could cause lenders to recognize losses. At that point they didn't want to hurt their own capital position any worse than it was. So they were willing to amend and extend with many of their borrowers.

"The government got much more involved in the overall capital structure by keeping interest rates artificially low and, even today, people are talking about the impact of the Fed's various quantum easing and when it will end," Lenhart continued. "So lenders, through loan amendments, don't have to recognize the losses and they move on to other opportunities, as their struggling borrowers push off principal payments and only have to keep current on their interest payments at historically low rates.

"The turnaround industry actually needs the economy to do better because then there will be more alternatives for lenders and businesses, and investors will be interested in trying to correct the business and spend some money to do it. Right now values are so depressed that the current lender is the only one that's going to stay in a distressed situation; and, if they don't want to sell out at a reduced price to a hedge fund, they're kind of stuck and in this frozen mode where nobody wants to do anything. If the economy improves and interest rates start going up, there will be more activity in the turnaround industry, contrary to what people typically would think."

Van Conway, CEO of Conway Mackenzie, a middle-market restructuring and financial advisory firm, noted that the turnaround industry has become very mature compared to 20 years ago.

"In 1987 when Conway Mackenzie started, it evolved from what I call a nomad industry," Conway explained. "A lot of ex-CEOs could parachute in for six months and fix the company as a sole practitioner. That was the industry for a long time. And then in the late ?80s, it started to get more formalized. Users are very sophisticated in terms of knowing the difference between the other parties and my firm. We actually grow during good times as much as we could grow potentially during bad times. While people may think we are the grim reaper, the reality is we like money to be active in the marketplace. There are a lot of dynamics outside of the economy that can cause a company to experience difficulty, which brings Conway Mackenzie the opportunity to go in and help the company. Even with active money and all good intentions, things happen in certain industries and some deals just don't work."

Thomas Osmun, managing director at AlixPartners, noted that the frothiness in the capital markets appears to be settling down. "We're seeing deals printing wide of price talk and, in some instances, being pulled altogether. Fund outflows from the leveraged loan and high-yield bond markets in recent months would seem to support this view. The overall trend appears to imply that there may be fewer capital markets rescues for companies facing pending maturities or liquidity crunches, meaning more defaults and restructuring transactions. On the flip side, we've seen a host of covenant-lite and covenant-less transactions in the past 12-18 months, and such borrowers often file chapter 11 before reaching an actual default."

Skadden Arps Slate Meagher & Flom LLP partner, Jack Butler, has observed a significant decline in recent years in the number of business bankruptcies, both in the middle market and larger cases altogether.

"There has been not only a decline in the absolute number of cases, but also a desire to do more restructurings out of court," Butler said. "Making sure that you're able to understand and adapt to out-of-court techniques, proceeding under state law as opposed to federal bankruptcy law, dealing with consensual restructurings and negotiations, and collective governance arrangements in loans, are all issues that people are going to be much more focused on going forward."

Theodore koenig, president and CEO of Monroe Capital, said that the sheer amount of capital available in the market and liquidity poses the greatest challenge to the turnaround industry.

"It creates very few opportunities for turnaround firms," koenig said. "There's very few large cases like there were years ago, and if there's not large cases, it's hard for turnaround firms to staff up in the way that they had in the past."

In addition to overall economic concerns and increased liquidity, many turnaround professionals mentioned how the denial of a distressed company's management limits the options to properly assess and fix the troubled company.

Often comparing this situation to a trip to a hospital's emergency room, turnaround professionals struggle with management who wait until it's too late to call in a turnaround firm to help, leaving them with too few options, had they been asked to help sooner.

"It still amazes me today, after having been doing this for 15-plus years, that there still seems to be reluctance by companies, private equity firms and lenders to get restructuring professionals involved much earlier in the process," said Clear Thinking Group's Diercks.

Lenhart stressed that, when management waits too long to take action, they've lost credibility with their creditors, and it makes it much more difficult to come up with a plan and a restructuring.

"A turnaround professional can be beneficial by getting in there six months before you have to meet with the banks to renegotiate your debt and before you are running out of cash and can't make payroll. That way the turnaround individual can help work with management, because oftentimes management's not used to a liquidity-restrained position and/or distressed situation. Management is usually more about growing a business, not contracting it or dealing with creditors and banks."

PEGs, Hedge Funds and ABLs in Turnarounds

With bankruptcies having evolved into more deal-related transactions, as opposed to a rehabilitative or restructuring business, the willingness for lenders and private equity funds to be involved in bankruptcies is expected to continue.

"Distressed companies have multiple options for capital, from the asset-based lenders, regulated and nonregulated, to the private equity, hedge and mezzanine funds that lend to and/or acquire the debt related to distressed businesses," explained Mitchell Arden, senior managing director, Phoenix Management Services Inc. "The various funds continue to alter the landscape for distressed businesses by providing access to much needed capital, but often with a control mechanism that will trigger ownership changes if certain milestones are not achieved by the borrower. As a result, management teams and shareholders might have a higher tendency to manage for near-term liquidity and earnings, rather than a longer-term, sustainable business model."

Lenhart stressed that distressed debt buyers and hedge funds have a completely different viewpoint on what they want out of a situation and it's mostly focused on return on investment and getting something quickly done.

"They don't want to spend money on actually fixing the company or doing the operational turnaround that a lender in the past, if they had proper collateral, would let the borrower do," Lenhart explained. "Hedge funds and distressed debt buyers are going to stick around because they make good money on these deals. It's not your traditional banks that are doing asset-based lending; it's hedge funds and smaller boutique-type lenders. As long as they feel that they have collateral, they're okay; but, as soon as that collateral cushion is uncomfortable for them, they pull the plug."

Robert Katz, managing director at Executive Sounding Board Associates Inc., agreed that private equity groups and hedge funds provide more options for companies seeking capital. He discussed the challenges that accompany having more providers in the capital structure. "It can make it more difficult to manage for all the parties involved as entities enter or exit more frequently," Katz stated. "The organizations have different costs of funds so their ultimate profit levels to generate a required return differ. Also, the fact that there is a segment of the market that follows a ?loan-to-own' strategy introduces complexities. However, rarely does anybody complain about having more choices."

Katz also added that asset-based lenders play a critical role In providing a source of capital to fund a reorganization, 363 sale or an Article 9 sale.

"Non-bank ABL sources are not regulated like banks and can provide more flexibility; however, they are usually more expensive than traditional banks," Katz said. "If the DIP market is competitive or ?hot', offering favorable pricing may give traditional banks an advantage."

Lenhart noted, as long as you have strong collateral, asset-based lenders are a distressed company's best opportunity to get financing.

"It's all about the collateral versus the amount of secured lending that is on the books," Lenhart said. "That's the difficulty in a lot of these companies that went into financings in 'os-'07 and subsequent extensions or amendments; they over-projected what the asset values and company profitability were going to be, so they had way more debt at the end of the day than coverage under the asset collateral basis. So, really, there wasn't anything there for the asset-based lender to lend into because there wasn't any cushion. I see that changing as the economy slowly improves."

Arden observed asset-based lenders stepping up to the plate in providing DIP financing, and thereby a capital lifeline, in a number of cases that Phoenix has been involved with.

"Many of these same lenders have been called upon to successfully provide emergence financing for those debtor cases where a plan of reorganization is filed and the debtor emerges from bankruptcy," Arden said. "Many asset-based lenders have become extremely aggressive and competitive in growing their portfolios, and are stretching their credit capabilities for well-secured deals in order to compete with non-regulated asset-based lenders. From a pricing perspective, the ABL groups within the regulated banks clearly have an advantage over the non-regulated lenders."

Butler said bank lenders have always been a critical part of the restructuring process, but asset-based lenders' roles have changed over the last 20 years.

"When I started practicing law 30 years ago, ABLs were in the driver's seat in restructurings in the sense that they provided most of the capital and called out the rules," Butler recalled. "These days, asset-based lenders often structure and syndicate these transactions, but they no longer keep the same kind of exposure on their books they used to. In fact, ABL claims are often traded quite actively in a restructuring. This means that parties and interests change rapidly. As a result, the direct influence of ABL lenders is not as dominate as it used to be.

"However, ABLs remain a primary point of contact in being able to introduce capital into restructurings, and their creative and innovative involvement in solving complex restructuring problems continues to be very important to the industry."

Thoughts on BAPCPA and Reform

Although almost nine years old, The Bankruptcy Abuse and Protection Act (BAPCPA) in 2005 still remains a controversial topic and is regarded as a drastic change in the turnaround industry, especially in regard to strict time limits.

"BAPCPA really limited companies' ability to use the restructuring process," Diercks said. "I think that's really created some additional challenges, not only from the restructuring side of the world but also from the capital market's perspective. It's made it so difficult for companies to reorganize in chapter 11 just due to the time pressures. To me, the biggest challenge facing the turnaround industry is the reform of the Bankruptcy Code. If the concept of chapter 11 is a reorganization or a turnaround, we have to be able to give those situations more time. Then, with the same token, I think there's got to be some level of cap to the fees that the professionals charge.

"It set some very strict time limits on which to be able to put forth a restructuring plan and getting all of your constituents to agree to it. Especially in large, complicated cases, where you have many different kinds of constituents, it may be a number of senior lenders or different tranches of debt, and to get all of those people on board takes time. Since we deal with a lot of retailers, being able to have to renegotiate leases with all landlords quickly is extremely difficult. I think it creates much more expense because you're trying to do so many things so much faster to try to get it all done. Fortunately, we've had some reasonable success with some retail reorganizations even since the 2005 Bankruptcy Reform Act where we've had companies in and out of bankruptcy in 120-140 days."

Kyle Shonak, senior vice president, manager of special opportunities at Salus Capital Partners, LLC said, "Given the mandate to assume or reject leases at such an early stage of the case and the requirement to file a plan quickly, a company does not have the luxury of staying in chapter 11 for multiple selling seasons or business cycles to test legitimate operational changes and strategies. Most retailers could use multiple holiday seasons to test strategy but this is not possible.

"The inherent risk in the transactions often outweigh potential lenders'appetites to consummate the transaction; thus, there are limited ?offensive' DIP loans done," Shonak continued. "Instead, many are defensive in nature by the incumbent lender, which have very tight DIP lending arrangements and are often dual track short-term loans, which require strict adherence to a business plan or a sale/ liquidation process. A reorganization that is not pre-negotiated is rare."

Alix Partners' Osmun said chapter 11 is not as much a tool for fundamental organizational change and restructuring and the Act altered the nature of chapter 11. Troubled companies can no longer find a safe harbor in which to take the time to genuinely reorganize, dispose of unprofitable lines of business and uneconomic contracts, stabilize the remaining organization, including retaining critical personnel, and truly fix their problems.

"Today, chapter 11 is more of a balancesheet fix," Osmun said. "It's a means to facilitate a quick sale to new owners, which are frequently creditors that have invested in the company's distressed debt as a means to acquire the business, or even an outright liquidation."

The cost of filing and administrating a case has become one of the greatest impediments to successful reorganizations, Arden noted.

"Many businesses that could, and should, find their way to the filing of a successful plan of reorganization, and ultimately emerging as a vibrant and streamlined business, are finding instead that the willingness of lenders to provide the financial support necessary to achieve a successful outcome just isn't available. Lenders have grown weary of funding costly bankruptcies, and are requiring rapid resolution, often through a liquidating 11 or a sale of the debtors' business and assets through Section 363. Asa result, businesses that should successfully emerge are being cut short. The overall cost of administrating cases, including the cost of debtor, secured and unsecured professionals, will need to be addressed.

"Part of the problem is the amount of reporting that the bankruptcy process requires is extensive," Arden continued. "Most borrowers don't have the resources or expertise internally to handle the reporting requirements. The way the bankruptcy reporting process works is part structural, and part of it is everybody has a say-so when you're in bankruptcy, with all of the constituents involved."

"BAPCPA is old news at this point, although it continues to have an impact and people can continue to point to it," Butler said. "But we've navigated through a whole generation of loans, business plans and management, creditor and equity holder expectations under these new rules. Rather than focus on BAPCPA, we need to propose reforms to chapter 11 that will better balance the goals of effective business reorganization - including the preservation and expansion of jobs - and the maximization and realization of asset values for stakeholders.

"Unfortunately, the Bankruptcy Code does not serve small businesses or even small- to mid-cap companies particularly effectively, both in terms of its cost, the time involved, the procedural inefficiencies and friction that occurs," Butler continued. "While I think we have a bankruptcy code that more or less handles larger cases in a pretty effective and efficient way, we can always improve it and make changes. The bankruptcy code will need to be reformed if mid-size and smaller companies are going to be able to restructure effectively and preserve jobs in this country. We have to fix the system for smaller companies because it looks broken."

What Lies Ahead

Looking ahead as the economy continues its slow recovery, it's clear that only the strongest turnaround firms and assetbased lenders who continue to offer new products and adapt will survive. Turnaround firms and reorganization profes sional teams are expected to become leaner and more focused on individuals who have a unique skill-set specific to that turnaround.

"The days of financial firms dropping in a team of 10 or 20 people to run numbers for a company are over," Shonak said. "The operational turnaround is trumping the financial turnarounds. Many turnarounds in big industries, such as automotive, airline and manufacturing and the wave of municipal bankruptcies like Detroit and others that have filed or will be filing, are driven by the need to successfully deal with restructuring legacy liabilities. The successful reorganizations in this space have come and will come from hard-nosed negotiators who can deal with all constituents and address their unique needs.

"The ability to execute is paramount in working through a turnaround; being paralyzed by the inability to make a decision can be the difference in a lender losing money," Shonak continued. "Communication is key, having unfettered access to management/turnaround professionals within the organization is important. Realtime access to information and hands-on collateral monitoring is the core of our business where preservation of capital is first and foremost."

"Being able to differentiate yourself and find opportunities through out of-the-box thinking and creativity is critical to success, whether for a lender or turnaround practitioner" Katz said. "It is not just a cliché - it truly is the difference maker today. The lenders who are the most creative and flexible will provide the best value for customers. Some borrowers may deem pricing to be an important factor in their selection process; however, the majority prioritize creativity and flexibility, and most importantly, a lender's ability to provide additional liquidity. Turnaround practitioners must continue to find ways to provide exceptional value by helping customers improve or enhance their gross margins through strategic operational changes. Facing fee pressure, shorter engagement durations and a shortage of traditional chapter 11 reorganizations, turnaround professionals need to adapt."

"Lenders to distressed businesses really need to understand their borrower's business, cyclicality, conversion cycle times, management team and shareholders," said Arden. "Assuming that the lender is supportive of retaining the borrower's business, their understanding of the borrower's cash cycle will enable them to provide credit capacity at the most important points in a borrower's business cycle. And, making sure that the borrower has a realistic and achievable plan is critical, as is confirming that the company has a strong management team that is capable of implementing the plan. Of equal importance, the lender and the borrower's ownership must have a solid working and trustful relationship. This is vital in all lending relationships, but becomes even more so when dealing with distressed borrowers."

Diercks stressed the importance of education and training, especially for the frontline portfolio managers or account executives, many of whom are inexperienced in seeing different credit cycles.

"Having the education of how to deal with a distressed borrower, how much emotion you bring to the table or how much fact-checking and prudence about things, is critical," Diercks said.

Butler also encourages lenders to have more rigorous portfolio management review and taking a proactive portfolio management role in monitoring the loans that they are invested in, even in the absence of defaults.

"Asset-based lenders oftentimes today continue to be one of the facilitators and mediators, to a certain extent, between companies with whom they have relationships and with the debt-holders who hold the claims. I think to remain an industryleading asset-based lender you want to be known as someone who is thoughtful and who is able to help structure a deal in a distressed situation that can get broad-based support in the capital markets and with companies and their other stakeholders.

"I think some asset-based lenders have looked at portfolio management as more of a risk-management exercise and, if not a risk management exercise, then an expense center that can be pared back when they're looking for profits. Some have missed the boat in not understanding the crucial role they can play in actually helping lead transactions and provide innovative solutions in distressed situations."

Koenig added that the turnaround industry needs to continue adapting to the new normal, post-financial crisis.

"There needs to be an alignment of interests among the turnaround firms and their customers, mostly in regards to the definition of success and then compensation," Koenig said. "There needs to be a focus on more profit improvement and value add or value creation. I think the firms need to develop new products and services. I think litigation support, evaluation and due diligence for lenders and private equity firms are going to be much more important as new products and services. These firms are going to have to adapt to a smaller company-client's mindset as opposed to the very large companyclients." TSL

"There's very few large cases like there were years ago, and if there's not large cases, it's hard for turnaround firms to staff up in the way that they had in the past."

- Theodore Koenig, president and CEO Monroe Capital Á

"It still amazes me today, after having been doing this for 15-plus years, that there still seems to be reluctance by companies, private equity firms and lenders to get restructuring professionals involved much earlier in the process,"

- Lee Diercks, partner, Clear Thinking Group, LLC

Ifthe DIP market is competitive or ?hot*, offering favorable pricing mag give traditional banks an advantage.

These dags, asset-based lenders often structure and syndicate these transactions, but they no longer beep the same kind of exposure on their books they used to. In fact, ABL claims are often traded quite actively in a restructuring.

Our Participants

Mitch Arden

Senior Managing Director, Phoenix Management Services Inc.

"Part of the problem is the amount of reporting that the bankruptcy process requires is extensive,..."

Lee Dierckft

Partner, Clear Thinking Group, LLC

"The biggest challenge to anyone in the restructuring world is the current economic challenges."

William Lenhart

Chairman, New York Chapter of the Turnaround Management Association (TMA)

"A turnaround professional can be beneficial by getting in there six months before you have to meet with the banks...

*lack Butler

Partner, Skadden Arps Slate Meagher & Flom LLP

"There has been not only a decline in the absolute number of cases, but also a desire to do more restructurings out of court."

Hubert Katx

Managing Director, Executive Sounding Board Associates Inc.

"Non-bank ABL sources are not regulated like banks and can provide more flexibility"

Thomas Osmun

Managing Director, AlixPartners

"We're seeing deals printing wide of price talk and, in some instances, being pulled altogether."

Van Conway

CEO. Conway Mackenzie

"In 1987 when Conway Mackenzie started, it evolved from what I call a nomad industry."

Theodore Koenig

CEO, Monroe Capital

I "...and if there's not large cases, it's hard for turnaround firms to staff up in the way that they had in the past."

Kyle Shonak

Senior Vice President, Manager of Special Opportunities, Salus Capital Partners, LLC

"The days of financial firms dropping in a team of 10 or 20 people to run numbers for a company are over."

Eileen Wubbe is senior editor of The Secured Lender.