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The turnaround business

With the slowdown in the economy, there are plenty of turnaround deals out there for private equity firms. But investors should be wary of firms that claim to be experts in this difficult – and sometimes dangerous – field.

Economists may argue over whether Europe is set for a recession, but one message is coming across loud and clear: there could be great business right now in turning around ‘distressed' companies. ‘Most accountants have been telling us that their insolvency businesses have been extremely busy this summer,' says John Harris, chief executive of the newly formed Society of Turnaround Professionals. ‘And they're saying that it's unlikely to let up over the winter. There have been a lot of ambitious investments over the last two to three years, many of them over-leveraged. They tend to come home to roost when things start getting difficult, as they have now.'

And, if there is great business to be done, you can bet that the venture capitalists - the finance world's opportunists - will be on the trail. As more companies start falling by the wayside, private equity firms raising funds could well start emphasising their turnaround capabilities to potential investors. Hardly surprising when you look at some of the numbers that can be achieved. Talk to some players and they'll tell you that they can generate 60 to 70 per cent compound rates of return by investing in ‘special situations'.

You may even find some firms rebranding themselves as turnaround specialists, according to one industry observer. But make no mistake. Most things are best left to the professionals, and turnarounds are no exception. Many private equity funds claim to work with distressed companies; there are startlingly few in Europe that actually specialise in investing in them - only a handful operate in the whole of the UK. ‘If there are potential opportunities to be had in a sector, then private equity firms won't be slow on the uptake,' he says. ‘Just look at what happened a couple of years ago when the dotcom mania was happening. A number of venture capitalists started branding themselves as specialists and raised internet funds. As we're seeing now, it was the limited partners that suffered and not the firms.'

The basics
If you're thinking about investing in a turnaround fund, it's worth taking time to understand what people managing a turnaround fund actually do and the kind of difficulties that they encounter.

Like all private equity firms, they need to find the right business in the first place. But unlike many firms, turnarounds often go for ‘old economy' companies. ‘The market is very lively at the moment,' says Alchemy's Jon Moulton. ‘There's a lot of stuff in trouble, but a lot of it is depressingly difficult to work with. We're seeing two financially distressed telecoms deals a day, but most of these suffer from the disadvantage of having a business model that has no inherent value. No matter how clever you are, you're never going to be able to turn them around. So far, we've only done one telecoms deal.'

Harris agrees. ‘For a turnaround to be successful, the business has to have a product or service for which there is a customer who is prepared to pay at the other end,' he says. ‘If you've got that, pretty much anything else can be solved.' This could mean restructuring the finances, he says, and more often than not, it'll mean changes in the senior management: ‘You have to be a born optimist to believe that the same team will produce a different result.' There are also likely to be severe lower level staff cutbacks.

The idea is to be able to buy an essentially good but struggling business at a knock-down price, put it back together again, and then sell it at a premium. It's an easy concept; it's rather harder to put it into practice, which is why so few funds actually specialise in this type of deal.

Dangerous money
At their most extreme, turnaround situations can be dangerous. ‘This is a rough business,' says Gary Klesch, chairman of European turnaround firm Klesch & Co. ‘We've had guns pulled on us, we've been barricaded in offices by the tax authorities before. We've had everything. Why do you think Warburg and the like don't do these kind of deals?'

Klesch admits that these dangerous situations don't happen every day. But there are plenty of other irritants in turnaround deals that only those with the right expertise would know how to handle well. Companies that need turning around are often already in administration or administrative receivership. This means that a fund getting involved would need to know insolvency laws inside out. And by all accounts, it's the insolvency procedures that cause most of the problems for turnaround funds.

To understand the difficulties, it's worth looking at the system in place across the Atlantic. In the US, Chapter 11 insolvency proceedings effectively ring fence a company in difficulty, preventing creditors from claiming the money they are owed for a set period of time. This allows those turning around a company some grace to get the company back up and running before it has to repay its debts. This makes life comparatively easy for turnaround funds in the US and explains why there are so many more there than in Europe. ‘The US has very successful turnaround funds largely because of the Chapter 11 system,' explains Moulton. ‘This invites compromise between groups of creditors and has a substantial court component. People there are also more used to large, complicated financial structures, which drive the need for this type of system. Nobody has ever said that we are going to develop this over here.'

By contrast, in the UK and the rest of Europe, if you take on a company in financial difficulties, you are instantly responsible for its debts. You have to find some way of negotiating more time with your creditors. ‘You need experience to do that,' says Klesch. ‘How else would you deal with an irate supplier who lost a lot of money? You're not the one at fault, you've come in, you've bought the business out of insolvency and yet they're coming after you.'

The UK government is currently reviewing insolvency laws. It would like to see a system in place that allows companies in difficulty more breathing space to put together a rescue plan. It has also outlined plans to remove some of the stigma that surrounds bankruptcy by reducing restrictions and disqualifications on all but ‘culpable' bankrupts.

Making it worse
However, turnaround players don't believe that these changes will make their lives easier. ‘Most of the proposed changes will protect existing management,' explains Moulton. ‘Therefore, companies that are run by less than good managers will actually be allowed to get into a worse state before we're able to get our grubby hands on them to turn them around. We won't always succeed of course, but we have a better chance of doing so.' But what about becoming more tolerant of failure, as in the US? ‘That won't have much bearing on turnaround funds. It doesn't have much impact on us whether people are prepared to give a bloke a second chance or not. Even in the US, they rarely give them a second shot in the same job.'

These problems are made worse by the fact that insolvency laws differ from country to country. By its nature, private equity is a local business. To operate successfully in a particular country, you have to be familiar with that country's particular business culture, tax and legal system, you need to know who the local competitors are and be sure of what your exit opportunities are. Investing in distressed companies adds another layer because funds must know exactly how insolvency proceedings work in each jurisdiction. For this reason, most turnaround funds are usually focused on a particular country.

Klesch is unusual in this respect. Although originally from the US, he has invested in distressed companies in 15 different countries around Europe, but he's only been able to do this because he's been in the business for over 20 years here. Naturally, he's sceptical of others trying to do the same thing. ‘People have tried to set up turnaround funds in Europe and they got burned,' he says. ‘There's no homogeneity here. It's not like the US. You've got 15 countries and you can rest assured that there are 15 different insolvency codes, companies acts, cultures, languages. The poor Americans who come over and land on Normandy beach really don't realise that we don't do things like they do in Kansas City.'

Managing the managers
But running a successful turnaround fund is about more than knowing laws and local markets. One of the most important elements is management experience. Venture capitalists come from a variety of backgrounds, but generally, they have a financial bias in their experience. To turn around a company that's in difficulty, the financial skills are important but management experience and an operational bias are essential.

Venture capitalists in this arena have to be much more hands on, says Olivier Lemal of Plantagenet Capital. ‘To be successful, you need not only financial and fiscal skills, you need to be a great manager. All of our people have company backgrounds - many of them as CEOs. For example, one of the businesses in our portfolio is an industrial bakery in the north east of France. We control the company. We own 85 per cent of it and it is run by one of our fund managers - full time. He is the CEO. I'm also the CEO of one of our other portfolio companies.'

It's only by really getting under the skin of a distressed business and managing it that a private equity firm will be able to add value. In a turnaround situation, the value is to be able to spot new opportunities for the business that others haven't been able to spot, and be what Lemal describes as ‘creative'. ‘Most people will have a goal and then build a business for that goal,' he says. ‘If things don't go according to plan and if they don't reach that goal, they think that they have lost everything. Our job is to find another goal and use the assets - tangible and intangible - to build something else.'

All change
But the really difficult part is managing the company through the necessary changes - quickly. ‘When we first go into a company, we get very melodramatic,' says Klesch. ‘We paint a big line down the middle of an auditorium and we say: “Those that are with us get on the right; those that aren't get on the left. Let's get on with this thing.” You really have to inject change. Whatever happened in the past doesn't matter. It's what you do in the future that counts.'

So the ability to act and make difficult decisions quickly in this environment is key, but so is the ability to accept the occasional failure. Again, these skills are much more to do with management than finance. ‘A good turnaround manager needs to be highly decisive,' says Moulton. ‘But he needs to be tolerant of getting ten to 15 per cent of his decisions wrong. He'll also have to have an extremely strong sense of humour because he's going to need it.'

Nevertheless, if you find a management team with the right knowledge and qualities, there are still other factors you should bear in mind about turnaround funds.

Going native
An important point is to make sure that the people managing a turnaround fund aren't going to ‘go native'. This can happen if venture capitalists spend a lot of their time managing one of the fund's portfolio companies. The idea is that they sometimes end up - quite unintentionally - putting the interests of the business before the interests of the fund's limited partners.

You also need to be sure that you can tie up the capital you commit for a serious amount of time. The difficult nature of turnarounds means that investors should be much more patient than with conventional funds - in Europe at least. It is possible for turnaround funds to exit investments within three years, but that isn't the norm. For the really tough deals, it could be up to eight years before you start seeing any return on your capital. ‘The last five years has unfortunately conditioned investors about how money can be made and what the time horizons are,' says Klesch. ‘There's a real lack of understanding about what it really takes. They're so used to getting a fix every year, that they start getting impatient after the fourth year of commitment. They don't understand that it's a long haul. Returns are great, but you've got to have patience.'

So it's down to patience and understanding. An opportunist firm that is inexperienced in doing turnaround situations is unlikely to tell a potential investor that. They're also unlikely to tell them that the first businesses that fall when times start getting difficult are often the ones that aren't worth saving because they're likely to be the weakest. Much of the fall-out we're seeing at the moment is in internet and technology companies, many of which didn't have a sustainable business model. These aren't subjects for turnarounds. ‘It would be incredibly difficult to turn around a virtual company,' says Lemal. ‘As a turnaround fund, you don't need to make your life any harder. It's hard enough already. You need to choose the right market, one that's mature and predictable.' As with any private equity fund investment, if the team doesn't have a track record in the area they're selling to you, you'd be taking an enormous risk by investing in them.

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