When economic waters are calm, it is hard to imagine the effect that financial disruption can have on an enterprise. A CEO and owner of a company borrowed to expand his business during profitable times. He believed that taking on debt had relatively low risk when compared to the equity returns that profits from expansion would deliver. Unfortunately, 12 months later a major annuity customer switched to a competitor and the company couldn’t recover the lost revenue elsewhere. The CEO told us:

On reflection, I should have taken immediate steps to cut costs and reshape the business for lower volumes, but I thought another major contract win was just around the corner. Anyway, the debt was three-year money, and I assumed the business was still making a profit.

After six months of negative cash flow, the business breached the terms of its lending agreement and had insufficient cash to make a debt payment. The lenders urgently requested a meeting and a proposal from the company on how to handle the situation. The business had developed a new product line, and the CEO was confident that market appetite was strong, although there were no actual sales in the pipeline. He asked the banks to increase their exposure to fund the company’s future.

I see now that I was overly optimistic. The lenders asked all the right questions; unfortunately, I was not well prepared and did not have proper business plans, cash flow forecasts, and commercial due diligence to demonstrate why they should support the business. That also meant I had nothing to show other capital providers.

Within two months, the business was on the verge of bankruptcy and its debt had been sold to other financial institutions—principally credit funds—which took a clinical view of the loan and demanded repayment. Through a consensual debt-for-equity swap, the funds took control of the business, put in a new management team, and subsequently funded a merger with a competitor.

I thought I was in control. It took me too long to realize I wasn’t, and by then it was too late.

Every restructuring situation starts as a healthy business with all the hopes of being successful. It is a complex process to return a business to viability after suffering through a period of financial and operational distress. Most restructurings are multidimensional and require a combination of capabilities, including strategic planning, stakeholder management, operational transformation, cash flow management, and M&A expertise—essentially every element of the Capital Agenda. In addition to bringing a diverse set of capabilities together, restructuring increasingly involves an international legal dimension. Legal regimes in developed economies differ, sometimes significantly, in how to address corporate rehabilitation. Understanding the options, strategies, and pitfalls of one restructuring regime versus another requires broad knowledge of multiple legal systems and their relative merits in a particular situation. All of these factors converge to create a rich but complex environment for restoring corporate health—once described as akin to playing chess on a three-dimensional board.

The intricacies of restructuring affect each company in a unique way. However, successful restructuring processes have a common set of characteristics. These include:

• Understanding the nature of operational turnarounds versus financial restructurings.
• A recognition of how to manage the human dimension of corporate distress.
• A plan for marshaling recovery.
• The ability to maintain control of the situation.

We discuss each in turn below.

Turnaround versus restructuring

The term restructuring is used in a variety of ways to describe how a company deals with financial and operational distress. In some contexts, the term is interchangeable with turnaround and transformation. However, it is important to use precise definitions because turnarounds and restructurings are distinct concepts.

Recognizing corporate distress and the human dimension

The first step on the path to recovery is coming to grips with the psychological effect of corporate distress.

Though no two restructurings are identical, most go through certain general phases, with the details differing from one company to the next. These phases have consequences on many different levels: some are apparent in financial and operational performance; others are more subtle and play out on a psychological level. Let’s look at the seven general phases of corporate distress:

• Phase 1. The seed of a problem becomes apparent to management, even though they may not verbalize it or take action.
• Phase 2. The problem grows, while being rationalized away. This phase can last for weeks or years, depending on how well capitalized the company is, and whether performance in some units serves to mask underperformance elsewhere.
• Phase 3. Cash resources begin to dwindle as problems persist.
• Phase 4. The cash crisis drives management to realize that something radically different needs to be done, and it is no longer business as usual.
• Phase 5. The board and outside accountants recognize going- concern issues. In other words, after reviewing the financials, they’re forced to reveal that the viability of the business as a going concern is in doubt. Debt covenant breaches may also trigger this result.
• Phase 6. Creditors and lawyers get together and begin to dictate—not suggest—terms by which the company must now operate.
• Phase 7. By this late phase, management’s options depend on the specific circumstances. Next steps could include divestments, recapitalization, management changes, or liquidation of the company.

Many businesses are born, live, and die without any effort at rehabilitation. When businesses do need help, it is a regrettable fact of the turnaround profession that practitioners generally get called in during the later phases of the process. Though there are many reasons for this, it usually comes down to a need to overcome psychological inertia around recognizing difficult times. Corporate distress is a form of loss and, like any form of loss, the human mind has certain defense mechanisms that may or may not help the situation.

In the face of distress, people often are overly optimistic about future results and the ability to achieve them. In many cases, executives may realize they have a problem and even that they’re ill-equipped to deal with it. However, they don’t seek expert assistance because they worry that the very act of doing so will trigger even more problems. Some companies may seek assistance in phase 3 when cash is short. On the other hand, because cash is short, they may assume that they cannot cover regular expenses, much less afford experienced restructuring talent. All of these are symptoms of the need to come to grips with the reality of the situation and what can be done about the loss associated with the decline of business.

For both senior executives and restructuring practitioners, being sensitive to the human dimension of corporate distress is a prerequisite to being effective. Though it is important to be decisive during difficult times, traditional leadership models of command and control rarely get the best out of an organization. Even in midsize companies, a team of restructuring professionals will constitute only a small portion of the available management resources. One of the critical balancing acts of any successful restructuring process is to find ways to identify with and motivate a larger management team while remaining disciplined about results.

A key element of this balancing act involves understanding the difference between management and leadership. Management is generally about maintaining the status quo. Leadership, in contrast, is about motivating change. A company that needs to change in order to survive requires clear leadership. Part of the leadership challenge of a turnaround or restructuring involves getting a management team to willingly adopt new ways of working. Among other things, this involves projecting a positive vision of the future, measuring and celebrating successes, and rewarding positive outcomes. The conventional notion of restructuring as a negative activity is completely at odds with the reality of how corporate health is restored. The job of senior executives and restructuring practitioners is to define the “finest hour” for the organization and to direct everyone’s energies to the most important objectives.

Marshaling the recovery

Successful corporate rehabilitation almost always involves both an operational turnaround and a financial restructuring. Problems usually are specific to culture, operating model, market position, and financial strength. Despite these challenges, stakeholders will agree to a restructuring only when they are confident that a company’s plan to maximize enterprise value will be executed successfully.

Leading a campaign to restore corporate health involves addressing six critical turnaround and restructuring activities. These points are listed roughly in the order in which they should be addressed, but in practice many must be managed in parallel.

1. Establish and maintain stability.
2. Diagnose what needs to be fixed.
3. Formulate a compelling and actionable turnaround strategy.
4. Adapt the capital structure to realistic cash flow forecasts.
5. Build implementation around clear leadership and operational discipline.
6. Communicate openly with external and internal stakeholders.

2. Diagnose what needs to be fixed

With a degree of stability in place, management needs a clear, concise understanding of what needs to be fixed. A rigorous diagnosis builds stakeholders’ confidence that the company knows what actions need to be taken to restore value. In some cases, it is useful to look back in time to when an enterprise was profitable and formulate a bridge to the present in order to see in clear relief what revenue and cost items have changed. Figure 14.2 provides an example of an EBITDA bridge.

Boiling down the diagnosis to a few key causal factors early in the process helps focus turnaround execution efforts later on, and provides an explanation to stakeholders unfamiliar with the details of a company’s operations.

Remaining in control

Restructuring and turnaround competencies are built not just by mastering certain functional skills, but also by mastering specific situations while working in difficult conditions over many years. These holistic experiences are needed to address critical challenges promptly and to create confidence among employees, shareholders, creditors, and other stakeholders whose support is essential for a successful outcome. For example, lenders and other creditors in particular must be convinced the company understands the scope of the challenges ahead and that management’s expectations for an achievable outcome are thoughtful and realistic.

With individual elements of the Capital Agenda, it’s common for a company to undertake actions on its own initiative. With sufficient resources and experience, a company can build a strong M&A department, or become quite skilled in working capital optimization, tax structuring, or other important capabilities. However, because of its multidisciplinary demands, compressed time frames, and infrequency, restructuring is altogether a different endeavor, requiring a nearly simultaneous application of the entire Capital Agenda.

An advisor’s independent views on how distress affects a company from a financial, operational, and human perspective are critical during all phases of a restructuring. Marrying this understanding with a knowledge of how various external stakeholders respond to corporate distress is invaluable when executives are navigating the difficult waters of a complex restructuring for the first time.

Turning around a company while wrangling a diverse set of external stakeholders is an extraordinary task, even for the most skilled management team. Employing independent help, such as a chief restructuring officer, to coordinate the restructuring process enables senior management to focus on the day-to-day business. This provides the space to pursue new business opportunities, develop new markets, and reinvigorate the company while turnaround and restructuring actions are advanced by a professional with experience in urgent corporate change. A single point of accountability also helps to ensure that the restructuring effort receives the necessary level of senior attention.

Don’t close off options

No company anticipates needing an urgent restructuring. Management may have worked several options for recapitalizing the company, improving operations, or both. For whatever reason, these efforts were not successful and then the reality of limited liquidity started to close in.

What typically happens next is leadership goes from being optimists to pessimists in short order. Once cash runs out, their sincere but unsuccessful efforts can cause the organization to see only darkness ahead.

However, in practice there is rarely ever just one option. A well-orchestrated restructuring process can create options that aren’t apparent at the start. Creditors often become willing to negotiate from a previous position of intransigence when presented with facts that clarify their true options and position.

One key tool in any restructuring is a stakeholder map, which is an overview of all the parties—suppliers, customers, employees, shareholders, and debt providers—along with their repayment priority and potential magnitude of loss. Figure 14.3 shows how the estimated value of the company aligns against the secured and unsecured claims. Where there are “value breaks” within the capital structure is a critical component to understanding the position of various stakeholders, their likely reaction to a restructuring proposal, and their ability to contribute new capital. In this basic example, the value break is at the subordinated notes. Assuming an enterprise value for this company of US$200 million—represented by the vertical arrow—only the senior debt has a good chance of being repaid in full.

Sometimes so many stakeholders stand to lose so much—like the subordinated debtholders in Figure 14.3—that they’re willing to work through a solution. This is especially true when many creditors rank side by side, so they all stand to lose a lot. It’s not unusual for every bank, subcontractor, and employee to realize they can expect only 2 or 3 cents on the dollar if the current trajectory runs its course and the company fails.

Complex restructurings involve multiple stakeholders who have lent to, or who have equity interests in, different companies within a group. In cases like this, an entity priority model can illustrate returns under different scenarios and valuations. This model shows which stakeholders have a financial interest and those who may be out of the money. It provides an economic framework for negotiations and can support proposals in both consensual and court-driven restructuring processes.

With the right mix of interventions, businesses can often be financially restructured on a sixpence. Those actions include developing an unvarnished and comprehensive stakeholder map, coupled with a strategic plan that paints a realistic vision for the future. Senior management must be credible and communicate very crisply on the planned route through the current situation, and answer difficult questions about what the company will look like post-restructuring.

Early detection is the best prevention

As good as a successful restructuring can be, it is even better to avoid the precipice altogether. What are some ways to do that?

Businesses rarely get into profound trouble overnight. It’s possible to find the occasional situation where product prices crater and a sudden liquidity emergency arises. Even then, creditors often have enough perspective to know that businesses with sudden drops in pricing are the same ones that can enjoy a sudden jump. Those types of situations involve financial restructurings that can often be worked out.

In contrast, we see financial distress caused by structural problems that go well beyond temporary price volatility. In retrospect, they often could have been detected many years earlier.

Take a major industrial company as an example, where a young engineer invented not a mere line extension but a radically new technology. Though the company earned royalties from patents on the technology, it did not seem to value its own disruptive invention as much as the marketplace did. A number of years later, the company found itself in major financial trouble, as its core business continued to erode in the wake of competitors making the most of that technology. Although the company stabilized its decline and continues to exist, one wonders what could have been.

It would have taken an exceptionally strong and persuasive leader to argue for increased investment in a disruptive technology that had the potential to destroy the company’s main business. As part of a regular stress test, senior executives should have tasked a small group with articulating and constantly refreshing ways to maintain a market-leading position in the main business versus other technologies.

Whether disruption affects the whole company or an underperforming business unit, most CEOs usually have a reasonably honed instinct that something is wrong. They sense it fairly early on but rarely react to it. Maybe it’s due to ego, or to the fear of having something fail on their watch; either way, when your gut tells you that you’ve got a problem—even though you think you’re on top of it—it’s important to get a third-party perspective.

Remaining in control requires early detection and decisive action. In our experience, the longer problems go unaddressed, the narrower the company-controlled solutions become. Once those options evaporate, creditors will dictate the outcome.

CEOs remark to us that it has become increasingly challenging to operate in an environment of lower growth, greater global competition, pop-up competitors with lean, digitally driven business models, sector and commodity price dislocations, and more activism in the equity and debt capital markets. Speed and agility have become fundamental to attaining and preserving competitive advantage See Chapter 10.

These same qualities drive successful turnarounds and restructurings. A company can remain in control of the process, manage external stakeholders, and maximize its options if it promptly identifies underperformance and solicits outside perspectives. The path to recovery is difficult, but with the right combination of experience, fortitude, understanding, and luck, there is almost always a brighter way forward.