Before it's too late

Whatever other accolades it may lay claim to, there is little doubt that London-based private equity firm Alchemy Partners deserves plaudits for its choice of name. The process of turning base metal into gold is a powerful image which the company probably likes to think imbibes it with a kind of mystical aura. Whether by accident or not, it also perfectly encapsulates the role traditionally played by European private equity investors in turnaround situations. Commodities traders will tell you that base metals are far from worthless. While Alchemy backs companies that typically need a fair amount of work to put them back on the right track, they are not necessarily car wrecks at the point of investment.

In the US, there are a considerable number of restructuring specialists prepared to roll up their sleeves and embed themselves in the cut and thrust of bankruptcy proceedings. Many of them work for firms that buy debt positions in order to secure influence at the negotiating table where they subsequently hope to convert the debt into equity on emergence from the process. It is a high-risk, high-reward strategy that has rarely been seen in Europe to date, but which appears to be gradually finding its way across the Atlantic (see also p.48).

In Europe, the standard approach has traditionally been for private equity firms to invest in businesses with either financial and/or operational issues before the problems become so acute that they hover over the precipice. “We don't normally buy bankrupt companies,” says Hans Albrecht, managing director of Munich-based turnaround specialist Nordwind Capital. “We frequently come across companies making good niche products but run by engineers who find it difficult to identify which of the products will make them money, for example.”

One might have expected that of all European countries, Germany would be the one where you would be most likely to find specialists sifting through the wreckage of bankruptcies at present. Europe's largest economy only just appears to be emerging from recession. German banks, which traditionally could be relied upon to prop up domestic industry in times of trouble, are now under increasing pressure from shareholders to modernise their operations and achieve more competitive returns from their lending. This is at a time when corporate balance sheets are showing considerable signs of stress: were investment rating criteria applied to the German Mittelstand, 41 percent of companies would be rated BB- or worse, according to research from Nordwind Capital, Standard & Poor's, Lehman Brothers and Deutsche Bundesbank.

But across Europe, there is reluctance on the part of domestic investors to ride to the rescue in situations where a company is completely in the mire. This may in part be due to bad experiences in the past. UK private equity firm Close Brothers Private Equity became something of a turnaround pioneer in 1996 when it invested £2 million in shirt manufacturer Sussman as part of a £5 million refinancing. The plan was to revive the firm's ailing UK production operations under a new management team. But the execution of the plan went awry, ending in the closure of the firm's last UK factory three years later, and the transfer of production to cheaper sites overseas. CBPE has completed only two more turnarounds since, the most recent of these being a successful investment in golf trolley maker European Golf Brands, which was sold to Graphite Capital for £26 million in January, and which at the point of investment was making small profits.

Meanwhile financiers and advisers from across the Atlantic have been gathering in Europe in greater numbers. Some recent newcomers may have arrived with the grisly ambition of feasting on the remains of terminal cases, but others have adapted to the more “touchy-feely” stance of the natives by offering a helping hand to those with relatively minor ailments. Hence the favoured approach described by Peter Fitzsimmons, a principal at US-based turnaround and restructuring consultant Alix Partners, which moved to Europe in 2002 and now has offices in London, Milan and Munich. He says: “We could be brought in the day before a company runs out of cash, or it could be when the firm is just starting to experience problems. But the scenario we like best is where an issue has just been detected and you can take a number of measures, such as adding to the management team or reducing costs, in order to halt serious decline and increase profitability.”

Fitzsimmons says winning the trust of management teams in struggling businesses means being non-confrontational. This is the reason why US consultants imported to Europe the concept of a chief restructuring officer, who would normally be appointed from within the ranks of the consultancy to join the client company's board only for as long as necessary to right the ship – ensuring that existing management do not feel their positions are under threat.

While there are situations where Alix will identify weaknesses in the management team and bring in replacements if necessary, Fitzsimmons stresses his firm's willingness to work with management, including on comparatively “soft” issues such as effective communication of the plan for the business to lenders, suppliers, financiers and customers, and subsequently keeping them abreast of developments.

Another US consultancy to have spread its wings is Alvarez & Marsal, which has four European offices alongside ten in its home market. Managing director Antonio Alvarez III, who led the firm's push into Europe in 2001, concurs with Fitzsimmons on the need to empathise with incumbent management, as well as to develop close relationships with an ailing firm's lenders in order to “buy some time.” He is also keen to communicate and reassure the firm's employees, and has a pragmatic response for anyone tempted to think that such relationship building bears little relation to the cold hard logic one would expect to find in the turnaround and restructuring game: “In Europe, a primary focus is often on job preservation because the cost of severing employee contracts can be so high,” he points out.

Last year, A&M launched a private equity sponsor group to work with general partners on management of portfolio companies – specifically to avoid the need for later-stage restructuring. Headed by Vincenzo Morelli, a former adviser at US private equity firm Clayton, Dubilier & Rice, the group has since worked with CD&R as well as Bank of America and European secondaries investor Coller Capital. “A&M has been working increasingly with equity sponsors because we have what they're looking for: a focus on maximising the value of portfolio companies by power boosting operational and financial performance,” says Alvarez. “It's what we've always done. Equity sponsors are starting to realise that what we do is different and adds measurable value.”

When you make the wrong acquisition at the wrong time you end up with over-leverage

Naturally inclined toward cash conservation, private equity firms will often make whatever changes are required to the operations of a portfolio company off their own bat rather than bring in external advisers. Nonetheless, Alvarez insists that the extent of demand for its services in Europe could see the firm's private equity group expand worldwide. He also says the appeal of its advice is helped by the inclusion of a success-only fee in the compensation structure.

While activity in the European turnaround market has remained relatively stable in recent years, one wonders what might happen if economic conditions worsen. Interest rates in the US, the UK and the European Monetary Union are already on an upward slope and are tipped to rise further in the near future, fuelling fears that greater pressure on debt repayments will take its toll on European businesses.

In addition, there is a residual pipeline of, for example, technology and telecommunications companies that hit trouble several years ago having been over-leveraged on the basis of unrealistic growth expectations. Of those that survived, many have already been re-capitalised, but others are still wandering the savannah, wondering whether they will be able to cope with deteriorating economic fundamentals.

For others, excessive gearing remains a concern, especially in situations where private equity firms have used leverage to finance consolidation plays. “The roll-up has become highly popular but the problem is that every acquisition adds a new layer of complexity to the capital structure and when you eventually make the wrong acquisition at the wrong time you end up with over-leverage,” says Fitzsimmons. “Building a pan-European business can work wonderfully well, but rollups are not always well integrated – sometimes they just look good on paper.”

As a result of these factors, there is undoubtedly balance sheet pressure building on many businesses, which when combined with operational weaknesses should create plenty of deal flow for turnaround practitioners. Consequently, the turnaround part of the market has had increasing allure for institutional investors in the asset class. With Germany seen as the European market with possibly the greatest potential, it is no surprise that Nordwind Capital's debut fund was oversubscribed when it closed on €300 million in March this year. The firm was following in the footsteps of Munich-based Orlando Management, which in 2002 raised a €163 million special situations fund: surpassing a €125 million target.

Explaining the apparent interest from investors, Nick Morrill, a director at UK turnaround-focused private equity firm Rutland Fund Management, says: “Our perception is that fund investors are placing a greater emphasis on active management of investments, as opposed to financial engineering. Many are changing the balance of their portfolios as a result, and feel that funds focused on distressed situations act as a useful counterweight to the traditional buyout fund.”

This is not the only reason why more money could find its way into the turnaround space. Alvarez says one should expect a migration of capital from mainstream private equity sources as traditional buyout firms seek less competitive terrain, otherwise known as the promised land of proprietary deal flow. “There's a lot of money that could come downmarket. I see private equity firms generally becoming more attracted to turnarounds and operational fixes because there is an overhang of capital and pressure to invest,” he says.

But however attractive turnarounds look to would-be participants, there are solid reasons why only a relatively small band of investors have taken the plunge thus far. One of these is the difficulty of assessing the prospects of a troubled company whose books may be riddled with complexity as a result of the problems it has run into. Observers might have wondered why it took Rutland Fund Management over a year to complete the £33 million purchase of Boosey & Hawkes' musical instruments unit in February 2003. Morrill explains that because the unit had been the subject of accounting fraud, auditors could not verify the numbers for longer than the preceding 18 months. Only a gutsy investor would be prepared to set aside the conventional private equity firm's demand for evidence of at least a three-year track record.

Hans Albrecht believes the turnaround arena is an exclusive preserve: “A lot of private equity firms say they want to be operational, but hiring a guy who's been a good CFO in one firm for the last 20 years is very different from having the ability to implement radical change in an organisation in six months. You also need to know how to behave in local waters and develop good union and banking relationships. To a lot of people it appears sexy, but there are high barriers to entry.”

Another quirk of turnaround investing that the uninitiated may find difficult to master is the importance of timing. “We like to invest as early as possible because it gives you more options,” says Philip Weston, a director at ([A-z]+)-based distressed investor Kelso Place Asset Management. “But get in too early and the entry price may be prohibitive. Leave the investment until later and the price is lower but you are running a greater risk of losing employees and customers and a negative perception begins to build in the market.”

Accessing deals early – whether for a good price or otherwise – is no easy task. “Financiers want to learn about the situation as early as possible, but it is often only when the business in question is in a real crisis that its existing shareholders are willing to feel the pain of a low return,” says Philip Davidson, head of restructuring at KPMG in London.

But whatever the difficulties of turnaround investing, there is a real sense of optimism among incumbent players stemming from possibilities that make the rest of us feel gloomy: tightening monetary policy and continuing geopolitical instability are just a couple of eventualities that could help populate the feeding pool. If that happens, management teams across Europe will be hoping to find friendly advisers and financiers to lend them a hand – before the bankruptcy vultures start sharpening their claws.