Potential value of restructuring!
“An instrument to assess the potential value of restructuring”
Amsterdam, May 29th 2006 Gijs Hospers
Potential value of restructuring
“An instrument to assess the potential value of restructuring”
University of Groningen
Faculty of Management and Organization Amsterdam, 29th May 2006
Author: Gijs Hospers
Student Financial Value Management Thesis supervision
Dr. J.H. von Eije University of Groningen Drs. A.B.W. Mintjes University of Groningen Mr. drs. A. Ezinga Plain Vanilla Investments NV.
© The author is responsible for the contents of this thesis; the copyrights belong to the author.
Preface
The last phase of my study Management and Organization includes a research of six months within a company and writing a finalizing thesis about that research. I may case I moved from
“students city” Groningen to Amsterdam and joined Plain Vanilla Investments.
Plain Vanilla invests in companies in financial distress and restructures them and therefore my research is about the value of restructuring. Besides writing my thesis I joined the Plain Vanilla team as a business analyst for the past seven months. An experience I will not forget because it provided me a fine view on the world of restructuring!
My research could not have been completed without the guidance and support of several persons. First of all I would like to thank Plain Vanilla for offering me the opportunity to conduct my research and thereby especially Mr. Andreas Ezinga for his support, valuable comments and understanding. Besides Andreas, I would like to thank Mr. Coen Binnerts for the experiences in Germany, Ms. Hadewych Cels and Mr. Hein Hoogduin for the enjoyable time spent in office! I also like to thank Mr.van der Geest and Mr. Biekart for their time and talks about valuation as well as restructuring.
Besides Plain Vanilla I would like to thank Mr. Henk von Eije for his feedback and guidance during my research. Besides Mr. von Eije, I would like to thank Mr. Bernd Mintjes for his practical insights into particular topics involving my thesis.
Last of all, I would like to thank my family and friends, and especially my sister, “Mari” for her support with my English. I also like to thank my friends in Groningen at the
“Damsterdiep” for their understanding and for being like a hotel for the past eight months!
Gijs Hospers
Amsterdam, May 2006
Management Summary
This research is carried out within Plain Vanilla Investments in Amsterdam. Plain Vanilla is an investment and management company that actively guides distressed companies through restructuring and manages them in a new business development and long term stability.
Although Plain Vanilla possesses expertise in turnaround investments, it is lacking knowledge of what restructuring is delivering to them in terms of value. Therefore the objective of this research is to develop a financial model that enables the management of Plain Vanilla to assess the value of the restructuring actions. The research question formulated to obtain an answer for this research is:
How can the management of PVI asses the value of restructuring?
To formulate an answer to the research question it has been divided into sub-questions which explain and discuss firms in financial distress, the restructuring of firms in distress and the valuation of firms in distress. No company sets out to become financially distressed, yet every year many firms experience the consequences of distress. The causes why companies slip towards financial distress are numerous and depend upon market circumstances. The causes of financial distress can be divided into company defects, management mistakes and symptoms of distress. One company defect always present is bad management. Several companies become financially distressed because of failing management teams. These management teams start for instance too large and ambitious projects without considering the impact these projects have on the entire firm. Besides starting these projects, a symptom of a firm slipping towards financial distress is the practice of creative accounting. Creative accounting practices by management reveals the real results of the company. Plain Vanilla is interested in firms in financial distress because of the following conditions:
Large improvement potential
Buy now with a discount, sell in future with a large premium Relative few other parties interested
Acquiring firms in financial distress carries considerable risks and much uncertainty; a reason why not many investment firms are interested. Because of the identified restructuring
potential Plain Vanilla may decide to acquire a company in distress.
The restructuring of a company in financial distress aims to prevent the firm from more losses or bankruptcy. Besides that a restructuring aims to prevent a company from bankruptcy, the restructuring of a firm has the intention to stop the destruction of value. Value destruction appears when a decline in revenues leads to a situation where costs exceed the revenues.
Three strategies to restructure a firm in financial distress are portfolio restructuring, financial restructuring and organizational restructuring. A company may restructure its business portfolio to continue with only those divisions or product groups that contributes to the net profit and creates value for all stakeholders. Besides the different types of restructuring, two approaches are presented which can be practiced: the top down approach and bottom up approach. If both approaches are used interchangeably by management, each can be practiced to develop solutions for the problems. The management of Plain Vanilla practices 5 actions when it restructures a company in distress, these are:
• Optimize revenues
• Optimize activities
• Optimize overhead
• Optimize capital structure
• Optimize financial structure
One aspect that all these restructuring actions have in common is that they are all intended to let the business grow and deliver more value. Besides the kind of actions PVI implements, the
“time factor” plays an eminent role during the implementation stage. Firms in financial distress need above all cash to pay their creditors in the short run. The goal of restructuring is to create value for all the stakeholders and increase the value of the firm. How to value a firm in financial distress is the next step in this thesis.
Valuation is the process of converting a forecast into an estimate of the value of the firm.
Although there are several valuation methods, the discounted cash flow method is chosen in this research to valuate the value of restructuring and the firm. Although forecasting cash flows for companies in financial distress is surrounded with uncertainty, DCF is preferred. A forecast of these future cash flows is essential to value a firm in distress, since past cash flows are negative. The determination of the value of a company is a process surrounded with
uncertainty because of the information aspect. In case of PVI the information aspect is even more crucial as the management acquires firms in financial distress.The management of PVI considers a firm in distress interesting, when through a restructuring a substantial increase in the value of the firm is reached.
Although restructuring is necessary to improve the performance of the company in distress, first the restructuring potential of the company is to be measured before the management of PVI considers investing in a company in financial distress. This valuation process starts with the “value as is” and with the implementation of restructuring actions the value of the firm likely changes. A model is developed which enables the management of Plain Vanilla to assess the impact of different restructuring actions on the firm value. By changing the restructuring variables, built into the model, the management is provided with results that influence the investment decision.
When returning to the objective of this thesis to build a model that enables the management of Plain Vanilla to assess the value of the restructuring actions. The model developed throughout this thesis provides the management of Plain Vanilla with data that supports them in their investment decision.
Table of contents
PREFACE... 4
MANAGEMENT SUMMARY... 5
TABLE OF CONTENTS... 8
CHAPTER 1: PLAIN VANILLA INVESTMENTS ... 10
1.1INTRODUCTION... 10
1.2PLAIN VANILLA INVESTMENTS... 10
1.3CORE BUSINESS... 10
1.4KIND OF INVESTOR... 12
1.5FIRMS IN DISTRESS; A FOCUS... 13
CHAPTER 2: RESEARCH FRAMEWORK... 15
2.1INTRODUCTION... 15
2.2RESEARCH BACKGROUND... 15
2.3PROBLEM DEFINITION... 16
2.3.1 Objective ... 16
2.3.2 Specifications and restrictions... 16
2.4THEORETICAL CONCEPTS AND CONCEPTUAL MODEL... 17
2.4.1 Introduction of the conceptual model... 17
2.4.2 Detailed explanation of the conceptual model... 17
2.5RESEARCH QUESTION... 18
2.6MEASUREMENT AND OBSERVING METHODS... 19
2.7ORGANIZATION OF THE THESIS... 19
2.8CONCLUSION... 20
CHAPTER 3: COMPANIES IN FINANCIAL DISTRESS ... 21
3.1INTRODUCTION... 21
3.2CAUSES OF FINANCIAL DISTRESS... 21
3.2.1 Company defects ... 22
3.2.2 Financial mistakes ... 23
3.2.3 Symptoms of distress ... 24
3.3COSTS OF FINANCIAL DISTRESS... 24
3.4PLAIN VANILLA AND COMPANIES IN FINANCIAL DISTRESS... 25
3.5CONCLUSION... 27
CHAPTER 4: RESTRUCTURING OF FIRMS IN FINANCIAL DISTRESS... 28
4.1INTRODUCTION... 28
4.2WHAT IS RESTRUCTURING?... 28
4.2.1 Objective of restructuring... 28
4.2.2 Differences among restructuring, a turnaround and a redevelopment... 30
4.3RESTRUCTURING FIRMS IN FINANCIAL DISTRESS?... 32
4.3.1 Three strategies to restructure a company ... 33
4.3.2 Two contrary approaches in restructuring ... 35
4.4PLAIN VANILLA AND RESTRUCTURING... 39
4.5SIDE EFFECTS OF RESTRUCTURING... 40
4.6CONCLUSION... 41
CHAPTER 5: VALUATION OF COMPANIES IN FINANCIAL DISTRESS... 42
5.1INTRODUCTION... 42
5.2VALUE OF COMPANIES IN FINANCIAL DISTRESS... 42
5.2.1 Value “as is” ... 43
5.2.2 Potential value of internal improvements ... 44
5.2.3 Potential value of portfolio restructuring... 44
5.2.4 Potential value of financial engineering... 44
5.3.1 Discounted cash flow ... 46
5.3.2 Intrinsic value... 47
5.3.3 Multiples... 49
5.3.4 Real option analysis ... 50
5.3.5 Liquidation value ... 50
5.4ADDITIONAL COMMENTS ON THE DISCOUNTED CASH FLOW METHOD... 52
5.4.1 Discounted Cash flow and Adjusted Present Value ... 52
5.5PLAIN VANILLA AND VALUATION... 53
5.5.1 Valuation process ... 53
5.5.2 The value of a company according to sellers vs. acquirers ... 55
5.6CONCLUSION... 56
CHAPTER 6: VALUE OF RESTRUCTURING, CONCLUSIONS AND RECOMMENDATIONS ... 57
6.1INTRODUCTION... 57
6.2FINANCIAL DISTRESS, RESTRUCTURING AND VALUATION REVISITED... 57
6.3STRUCTURE OF THE MODEL... 58
6.3.1 Explaining the scenarios ... 60
6.3.2 Results of restructuring ... 62
6.4CONDITIONS FOR AND CONSEQUENCES OF RESTRUCTURING... 64
6.5INVESTMENT DECISION... 65
6.6CONCLUSIONS AND RECOMMENDATIONS... 66
REFERENCES ... 69
Chapter 1: Plain Vanilla Investments
1.1 Introduction
In today’s financial world the activities of mergers and acquisitions as well as of private equity still grow1. The question ‘how to value attractive opportunities? ’ was, and still is, essential to many investors who seek a way to let their business grow. A subject that has been getting less attention is the valuation of distressed companies that require restructuring. This research report puts its focus on the valuation of these companies. An important question is whether a standard model can be developed for this kind of valuation. The background of this question is a recent article2 that stated that the valuation of a target company can not be calculated using a standard model because in most of the situations the reality is too complex.
1.2 Plain Vanilla Investments
Plain Vanilla Investments NV (hereafter “PVI”) is an investment and management company that actively guides distressed companies through restructuring, and manages them in a new business development and long term stability. PVI acquires and/or supports midsized (production) companies in distress that require active hands-on involvement. In addition, PVI assists multinationals with regard to subsidiaries that are considered to be non-core, end-of- life-cycle or loss making. PVI has the objective to turn these companies into organizations that generate healthy returns and become attractive acquisition candidates. A distinction when compared to most private equity firms, PVI also manages the acquired companies instead of only acting as an investor.
1.3 Core business
PVI is an investment firm that focuses on restructuring of companies with continuity problems. PVI invests in mid-size production companies that need active hands-on management. Besides this, PVI acquires subsidiaries of multinationals that are loss making or no longer considered strategically valuable by the multinational. Essential for the activities of PVI is restructuring, something frequently used in the newspapers these days. Many companies announce they will restructure their businesses to deliver more value to the
shareholders. Although one standard definition is not available, PVI defines restructuring as:
“carrying out all necessary actions to turn a company from one, loss making, situation, in a new, profitable, situation3. Among many possible actions, the most recurring are: adjusting management information, decreasing the labour force, cost cutting and decreasing the number of product lines. It is the combination of investing followed by a course of restructuring actions that is considered to be the core business of PVI. The PVI business model, as shown in figure 1.1, visualizes the different steps carried out during the restructuring process.
First of all the company business (es) is (are) analyzed to find reasons for the bad results.
Such an analysis includes a due diligence, wherein PVI analyses and assesses the results precisely. This is needed to identify possible drawbacks that are not visible in the balance sheet and/ or profit and loss account. A due diligence is performed to prevent serious drawbacks for the management, of the acquiring firm, in the future. A due diligence is crucial in the analysis, since the outcomes have a substantial influence on the decision making process of the management of PVI. If during the due diligence serious shortcomings are identified the project may be turned down or will undergo substantial delays. However, if after the due diligence the management of PVI is convinced about the chances of success of restructuring, negotiations are started with the selling party.
When an agreement is reached to take over the company, starting with the recovery of the business will be the first step. Recovery means creating a (stable) foundation for the future by negotiating new contracts with creditors and steering on cash inflows from receivables.
Steering on cash inflows is required to continue the daily operations. These everyday
3 Interview A. Ezinga
Analysis Recovery Restructuring Business
Development Process steps to
corporate recovery
& turnaround investments
Value destruction Value creation
Figure 1.1 PVI Business Model
operations form a starting point in bringing a company back in business4. When management succeeds to create a steady basis, the restructuring of the firm is the next step in the process.
Restructuring is a process on itself and the different actions required to restructure a firm will be dealt with in detail in chapter four. Chapter four also discusses several theories and practical cases that explain restructuring from two different perspectives. Together with the restructuring of the firm, management needs to focus on new business opportunities. These new business opportunities and the existing business combined should generate the cash flows needed that guarantee the survival of the firm. To conclude this part, restructuring as well as business development are the value drivers that may deliver fine results for a company, however only when managed in a proper way.
1.4 Kind of investor
PVI was established in 2003 as an investment firm. During the first years, the investment opportunities for PVI had in common that the companies were facing bankruptcy. As mentioned before, PVI focuses on firms that face continuity problems. Bankruptcy can be seen as the worst continuity situation. According to Van Amerongen (1995) insolvency is a situation in which one isn’t capable of paying its debts. However, PVI believes it can manage these companies to a profitable situation and returns on investment are substantially larger compared to most other investments. An answer to this issue will be formulated during the next chapters.
From the start, PVI did not have a special industry focus although it had a special interest for manufacturing companies. Since 2005 PVI made a strategic choice to focus on two industries;
the food business and care industry. Other industries can still be a possibility, but considering the experience of the PVI partners makes the two chosen industries more attractive. During the first years of existence PVI could be seen as a financial investor acquiring stand-alone companies, but with a clear focus on the food and care industry.
One of the first investments PVI made was the acquisition of a chocolate factory in The Netherlands. The factory was in financial distress and went bankrupt. Because this transaction was the first in the chocolate segment, PVI acted as a financial investor. Since its acquisition in the end of 2003, the partners of PVI managed to come up with a steady profit each year after the acquisition. The factory now delivers value to their stakeholders. Although selling or
maintaining the company were the options available, PVI chooses to implement a buy and build strategy for the chocolate factory. When applying a buy and build strategy Plain Vanilla seeks to consolidate the sector in which it operates, in this case those of chocolate coins. The goal of a buy and build strategy is the transformation of a group of small companies to an efficient network on larger scale (Smit, 2002). Additional value in these is created by the integration of processes, cutting in the costs and the enlargement of the market share.
Due to intensive contacts in the industry, PVI was approached by another chocolate company.
This company was in severe financial trouble. The reasons for these losses were caused because two large customers cancelled their orders. Due to these cancellations the revenues declined too sharp in comparison with the operating costs. In February 2006 the acquisition of this company was realized resulting in a sales increase of 25%. When Plain Vanilla decides to invest in a company, it should be seen as a strategic investor rather than as a financial investor.
1.5 Firms in distress; a focus
Although the research could be applicable for the general valuation practice, this thesis focuses on the valuation of firms in distress. Valuation of firms in distress is different from a valuation of a healthy company, mainly because of the larger risk involved. The larger risks are explained by volatile or negative results. Negative results presumably have reasons, and for purchasers those reasons may be invisible or difficult to assess. The effects of these uncertainties on the valuation could be substantial as well as the associated risks. But it is the concrete question of PVI to focus the research on firms in distress while the information-flow problem in this kind of situations is the most compelling one. The different phase’s companies experience before financial distress occurs is shown in figure 1.2. Firms in distress show negative results because total costs exceed total revenues. The increase in costs may be the result of the amounts of debt firms need, to finance their operations and investments.
Firms with more debt will experience financial distress earlier than firms with less debt because of a higher leverage (Ross et al., 2005). However firms with low leverage will experience financial distress during a later stadium and may be even forced to liquidate more often. Firms in distress face a variety of situations that may have different effects on the value for the claimholders (debt + equity).
The impact financial distress has on the daily activities of a firm are large, since there is a lack of money to spend on for instance marketing. A shortage of money usually leads to accumulating problems that push a firm into even larger problems leading to a situation in which firms may find themselves in a vicious circle. Communication in this stage of the process with the main suppliers and customers is essential, to guard the image of the firm and preventing it from bankruptcy.5 Communication is also important in order to minimize the chances of information problems between the stakeholders of the firm. Due to information problems decisions are postponed and unclear situations arise that harm firms even more in their daily operations. Firms can avoid these negative consequences by an open and direct communication attitude towards their stakeholders. In certain cases the management just focuses their attention on the ongoing business and pays no attention to the liquidity problems the firm faces. This leads to even more problems and has a devastating effect on the value of a firm.
The causes of financial distress are diverse depending on the specific situation of a firm.
Therefore the valuation of a firm in distress is a difficult process (Wruck, 1991). Negative cash flows and the uncertainties need careful consideration in order to deliver an accurate valuation. Although firms in distress have received much attention, a valuation model that focuses on this particular situation has not been provided to PVI yet.
Growth
Stagnation
Decline
Crisis
Turnaround
Bankruptcy/liquidation
Growth
Distress
Figure 1.2 Life cycle phases and distress
Chapter 2: Research framework
2.1 Introduction
This chapter explains the fundamentals of this research. The research background (2.2) discusses the reason of performing this research and who is interested in the results. The problem definition (2.3) is focusing on the problem that confronts PVI in their activities. It defines why and for whom the results are relevant. A problem definition consists of three elements: the objective, a research question and the restrictions and limitations. The first element, objective, describes the desired output of the research (2.4). The research question itself is divided into sub- questions. These sub- questions are discussed in different chapters and generate answers for the central question. Thereafter (2.5) a conceptual model is developed and visualizes all the elements that together form this research. One of the reasons conceptual models are frequently used is it clearly visualizes the elements included in the research. The limitations (2.6) must ensure that the research is relevant and comprehensive.
Finally (2.7) the data used during the research and how these data are gathered is explained in the last paragraph of this chapter.
2.2 Research background
PVI possesses expertise in turnaround investments but is lacking knowledge of what the restructuring is delivering to them in terms of value. Since the main goal in turnarounds is to create value for the shareholders this question needs an answer. In a turnaround the management of PVI deals with a variety of aspects that need careful consideration. What value the restructuring actions deliver to the companies in distress6 is the central question in this research. When firms are in distress quick action is appropriate to save the firm from bankruptcy.
To be able to assess the value restructuring creates the management of PVI needs a tool to find an answer to this problem. The managers of PVI definitely need a scientific as well as a practical model that allows them to assess the value of restructuring actions. This research
6 Distress can be defined as a situation in which a firm is unable to pay its creditors in spite of the cash inflows it receives. Also the term insolvency is frequently used when a firm finds itself in such a situation.
aims to provide the managers of PVI with a model that allows them to assess the added value of restructuring. Such a model should give the management more confidence during the decision process of investing or not investing.
2.3 Problem definition
The problem PVI deals with and requires an answer for is what restructuring delivers in terms of value is. Although restructuring is often applied in turnaround cases it still is difficult for the managers of PVI to assess the impact these actions have and consequently the value the actions create.
2.3.1 Objective
The objective of a study explains to the owner of the problem why the study is performed, what the consequences should be and why the end result is of relevance to them. PVI is the owner of the problem in this study and the objective for this study is:
Develop a financial model that enables the management of PVI to assess the value of the restructuring actions!
2.3.2 Specifications and restrictions
The specifications and restrictions limit the research in its scope and scale in order to ensure the quality of the study.
• This thesis puts its focus on the value of the restructuring actions deliver;
• The research and the model are custom made for PVI;
• The model allows PVI to use it in valuing companies in financial distress as well as companies which may be interesting from a strategic point of view;
• The goal of the research is to give PVI a feeling in the valuation process and in using the model to deliver a deeper ‘feeling’ based on an instinct approach for investing or not investing;
• Data that contributed to this research are partly confidential
• The time frame for writing this thesis is six months;
Since the background and objective of the research are explained, the next paragraph will
Valuation
Value of Restructuring
Financial Distress
Restructuring
2.4 Theoretical concepts and conceptual model
2.4.1 Introduction of the conceptual model
A conceptual model is pragmatic and fulfils an important role in the research on behalves of a management problem (De Leeuw, 2001). Such a model is used to visualize how the research is divided and what elements form the core of the research. The conceptual model outlines the research question that is formulated in a search for an answer to the main question. The research question will be dealt with in paragraph 2.5.
Figure 2.1 conceptual model
Figure 2.1 shows the conceptual model with the essential elements, together they form the core of this research. The elements are discussed in the next chapters and will provide answers to the core issues of this study. The model visualizes PVI on top of all the other elements. Since PVI influences all the aspects involved in this study because it is the owner of the problem the model starts here. After the introduction of PVI and its business model valuation and restructuring are explained in detail. Both subjects, valuation as well as restructuring, are essential for the development of the financial model and therefore need considerable attention. The problem is the value of restructuring and how the various restructuring actions influence this value. The financial model will be developed with the intention to provide the management of PVI with answers to their questions. Finally a conceptual model is provided to make the research more comprehensible by showing the different elements and the relationships between them. The different elements of the model will be described in detail in the next section.
2.4.2 Detailed explanation of the conceptual model
This paragraph provides a more detailed description since the model itself only visualizes the subjects and relationships that exist between them. PVI is on top of the model since it is the starting point for this research and is interested in the results of it. Leads are offered to the management of PVI and here the process of the investment analysis starts. The focus in this
research is on firms in distress and this leads to a different analysis compared to healthy firms.
Companies in distress are therefore treated as a special subject during this research. This also limits the scope of the research. The central question in this research is how to assess the added value of restructuring and the consequences it has for the valuation of a firm in distress.
As valuation is important in this thesis so are the restructuring actions that the management of PVI use to create more value. These actions are important in the development of the model because these actions are expected to deliver better results and create more value. The model itself serves as a tool to assess what restructuring really delivers in terms of value but nonetheless is of excellent use. When, finally, the added value of the restructuring has been assessed, this will be reflected in the entrance of the model. Based on the results of the model the managers of PVI gain better understanding what the restructuring shows in terms of value creation.
2.5 Research question
The research question should demonstrate what the research should offer (De Leeuw, 2000).
The management of PVI asked the researcher to develop a model that assesses the value of the restructuring actions. The research question is therefore formulated as:
Research question:
How can the management of PVI assess the value of restructuring?
Sub- questions:
1. What are the characteristics of companies in financial distress and what are the causes of financial distress?
2. What is restructuring and what restructuring strategies can be applied during the restructuring process of a firm?
3. Which valuation methods exist and which method(s) is (are) suitable to value firms in distress?
4. What kind of model can be developed that enables the management of PVI to assess the value of restructuring?
2.6 Measurement and observing methods
Desk research
The desk research which was performed mainly in the beginning of the research process articles, books, newspapers and other documents were consulted to provide the author of the thesis with sufficient background knowledge.
Field research
In assisting the partners of PVI in their daily practices practical experiences have been gathered and how the various elements that include this study are performed. To give the research a more pluralistic character interviews with people in the investment world are held to search for answers on the central questions.
Analysis and reporting
After all, this thesis and the result will be presented to the principal of this thesis, the managers of PVI. The principal will give feedback on the content and use the results in the process of investing. Also the whole process of internship and writing this thesis with their guidance will be evaluated. This is important to learn from each other.
This thesis will also be presented to the supervisors of the University of Groningen, faculty Management and Organization. In a graduation meeting the contents of the thesis will be presented and discussed. Also the process of internship, the process of writing the thesis and the guidance from the University during the thesis will be evaluated.
2.7 Organization of the thesis
This thesis searches for answers to a question that is crucial for PVI to remain in business and create value for the shareholders. For an overview of the thesis and the chapter’s figure 2.2 is presented. The research question and the objective are explained in this research framework in chapter 2. After the objective and research question are presented financial distress will be explained in chapter 3 since firms with liquidity problems form a core issue during this research. The restructuring actions that get a firm in distress back in business are explained and discussed in Chapter 4 this forms an important input for the model that will be developed in Chapter 6 Chapter five starts with an important theoretical part of this thesis; the valuation
methods that can be applied in valuing firms. After the methods are explained and their advantages and disadvantages have been discussed, together with chapter three about restructuring it forms the input for the development of the financial model. A difficult issue for PVI in the valuation, chapter 5, of firms in distress is the assessment of the added value of restructuring. Chapter 6 will explain PVI how to deal with this issue and aims to show the value restructuring delivers.
2.8 Conclusion
This chapter explained and discussed the central problem of PVI. The objective to find a solution for the problem is explained and in an attempt to find answers, a research question and sub- questions have been formulated. The goal and the central question of this research are put together in a conceptual model that visualizes the different issues that need an answer.
From the model one can see that distress, restructuring and valuation form the core issues in this research. The chapters following the research framework will treat these core issues and provide answers to the sub-questions. The answers are the input for the development of the financial model. The intention of the model is to enables the management of PVI to assess the value of restructuring. Finally historic and recent cases will be used to test the level of applicability of the financial model.
Chapter One Plain Vanilla Investments
Chapter Two Research Framework
Chapter Three Financial Distress
Chapter Four Restructuring of firms in distress
Chapter Five Valuation of firms in
distress
Chapter Six Valuation of restructuring actions
Figure 2.2 Overview structure of the thesis
Chapter 3: Companies in financial distress
3.1 Introduction
No company sets out to become financially distressed. Yet, every year, many public and private companies default on their indebtedness. Companies that cannot fulfill their obligations, often slip towards insolvency sometimes resulting into bankruptcy. The causes of financial distress, company defects, management mistakes and symptoms of distress are explained in paragraph 3.2. Paragraph 3.3 explains and discusses the costs of distress, since these have side effects. Paragraph 3.4 mentions a few motives why companies in distress might be interesting for the management of PVI. Finally paragraph 3.5 summarizes the context and impact of distress in this thesis.
3.2 Causes of financial distress
Why do firms fail and what are the variables that lead firms to become financially distressed?
According to Altman (1983) there is a distinction between insolvency and failure. He defines failure as a situation were a company does not earn an adequate return on risk capital, but it can go on doing this for years without closing the company.. However, insolvency arises when a company fails, due to its obligations and all assets have been refinanced to cope with previous losses. This paragraph and table 3.1 present an overview of some common defects, mistakes and symptoms explained and discussed during this chapter.
Company defects Financial mistakes Symptoms of distress Bad management Too high level of
leverage
Deterioration of financial ratios and cash flows Bad accounting
practices
Overtrading Creative accounting
Organization lacks change
Starting too large, ambitious projects
Non financial;
deteriorating product quality
Table 3.1 Defects, mistakes and symptoms of distress
Some authors investigating the causes of financial distress conclude that management is usually responsible for the crisis. Miles and Snow (1994) speak about “misfit” when analyzing the behavior of management teams in distressed companies. Miles and Snow (1994) divide “misfit” into two categories; external and internal initiated misfit. They identify the first misfit as the inability to respond to major environmental changes. The inability to respond leads to partially taking advantage from the future opportunities available. A second externally initiated misfit, identified by market leaders, is the unwillingness to respond to major environmental changes. Market leaders hesitate to make changes, since they have the most to lose. An internally initiated type of misfit is extending the organization beyond its operating limits. Strategy, structure, process, operating logic and managerial ideology are closely interconnected and need careful consideration by management. Decisions taken by management teams may have unintended consequences which are not visible in the short term. Therefore careful consideration with respect to the start of new projects is necessary.
3.2.1 Company defects
People on the street often wonder why companies suddenly seem to fail in their objectives and announce employee lay- offs or even go bankrupt. Firms in financial distress do not suddenly fail. In several occasions the failure is a process of months, years or even decades. A first defect appearing according to Argenti (1976) is that management is always responsible for the problems that brought companies in financial distress. Among several management defects these are the most evident:
• The chairman of management is an autocrat; he or she dominates his colleagues
• Most of the management team members do not participate in the decision-making process
• The skills and knowledge of the management team are unbalanced; there is no diverse mix of expertise among the team members
• In particular the finance function is weak
While most of these defects appeared in firms that failed, not all of them were present plus they can also be replaced by other defects.
Second, defects in accounting systems, in addition to bad management, are frequently found when analyzing why firms failed. Companies in financial distress are often deficient in three financial areas. First, they have non-existent or inadequate budgetary control systems. It is not clear to management and other stakeholders where the company is heading to and how far it has been going into that direction. In addition planning and control systems in companies in distress are non existent or highly inadequate MacKenzie (1981). Secondly, in several occasions the cash flow plans are defective and therefore the management is not able to predict when the next peak in demand for cash will come. A last accounting defect is that firms in distress use costing systems that do not show the required information. None of the systems for example show information about the actual product costs. The defects in accounting systems mentioned, manage a firm to a desperate situation, which often results in financial distress.
The third and remaining defect is that firms which do not adequately respond to change bear the consequences of such an attitude. A change in customers’ wants and needs and changes in world economy for example needs to be covered by companies. If change is neglected the consequences may be declining sales, a decline in market share and lower profits (Lorange, 1987).
3.2.2 Financial mistakes
According to Argenti (1976) three fatal financial mistakes emerge within the range of all the mistakes companies can make. It appears that very few firms that fail fall short because of any other mistakes than the three mistakes discussed hereafter. The first immense mistake is to allow the financial leverage to rise to a dangerous level. At this level any random mistake will cause serious problems, since there is less space for additional financing. Debtors and other financiers will start getting nervous, if they find out the level of leverage. They will obstruct to additional financing, also when desperately needed by the firm.7 A second large mistake is to focus exclusively on sales targets, thereby neglecting the sales margins. Companies that suffer from a decline in sales often expose this strategy; pushing their sales forces to sell against every price. Such a strategy takes a firm even closer to bankruptcy, whereas the opposite was intended. A third mistake is launching projects that become a burden when something goes wrong. Although during the start of the project, it was not that large. Along its path it grew and management did not respond adequately to control the process. Once
7 Interview, C. Binnerts
projects reach such a status, management is often no longer in control, and hesitates what actions to take.
3.2.3 Symptoms of distress
The symptoms of a firm in distress appear as a result of the company defects and mistakes made by the management team (Argenti, 1976). These symptoms become obvious in the first place, as most liquidity ratios start to deteriorate. Leverage rises, the sales vs. fixed assets ratio weakens, and also cash flow versus debt weakens. Another signal, indicating that a firm is bearing towards financial distress, is the deterioration of cash flows (Lurie and Ahearn, 1990). A company is continuously short of cash. However, a shortage of cash is not always a problem. Many financially healthy companies experience a shortage of cash because they finance their growth with it. The causes of financial distress need to be investigated to discover if this is the main problem. Secondly, although these symptoms may be observed, due to the operation of creative accounting, their deterioration may be visualized so gently that no one doubts if the company recovers from this temporarily “setback”. In general, well run companies cut their dividends when they are in trouble. Besides financial ratios, a third symptom of distress, non-financial symptoms, appear and these are not easy to camouflage.
For instance product quality weakens, offices need to be painted, factory repairs are neglected, market shares fall and suppliers become suspicious and restrict delivery. The symptoms mentioned here demonstrate that a company is slipping towards a situation of financial distress.
This paragraph explained some of the causes, divided into defects, mistakes and symptoms, why firms slip into financial distress. In addition paragraph 3.3 discusses the costs of financial distress will be discussed and explained.
3.3 Costs of financial distress
If companies increase their financial leverage, the likelihood of financial distress increases.
Due to a higher leverage, firms increase the probability they are unable to meet their payment obligations (Palepu et al., 2000). Besides this negative consequence, financial distress can be expensive, since the negotiations about the claims of a company may be costly. The most common kind of costs that come along with financial distress will be briefly discussed here.
Costs of forgone investment opportunities
When a firm is in distress and particularly when it went bankrupt, it may be a real challenge to raise additional capital for new investments. Even if the management itself intends to invest in the company, the firm is likely to be capital constrained. In addition, potential investors and creditors are not keen on investing in firms in distress because of the high uncertainties that come along with firms in financial distress. Overall, the probability that the firm will be able to make the much required investments is small.
Costs of conflicts between creditors and stakeholders
Within companies that show excellent results, the possibility of a conflict between stockholders and creditors is less likely than when firms are in financial distress. This is because of opposite interests between creditors and stockholders when a firm is in financial distress. Creditors become concerned if the firm is still able to meet its obligations. However, the stockholders become concerned that their equity will revert to the creditors. Therefore managers likely face increased pressure to make decisions which serve the interests of only creditors or stockholders.
3.4 Plain Vanilla and companies in financial distress
What is so appealing about companies in financial distress for the management of PVI? The underlying principle for the management of PVI to acquire firms in distress is a result of the following conditions:
Large improvement potential
Buy now with a discount, sell in future with a large premium Relative a small number of other parties interested
A first reason for the management of PVI to acquire firms in financial distress is the upside potential it contains. The management of PVI, when acquiring a firm in distress, has the opinion that much value can be created since there is a large improvement potential. The improvement potential is among other factors a result of the experience the management of PVI has with managing firms in distress. The management of PVI thinks they can improve the results of a firm in distress since they have large experience with the restructuring of these
types of firms. This improvement potential will be explained in detail in chapter four were restructuring of firms in distress is discussed and explained.
Secondly, firms in distress are desperate for additional capital, to prevent the firm from bankruptcy. This enables the management of PVI to acquire a stake in a company for relatively less money. In these cases the management of PVI acquires the assets of a firm in distress with a so- called discount. However, this discount is not offered when a firm presents healthy results. On the contrary, if a company with good future prospects is acquired, a premium on top of the value of the assets is not an exception. The strategy of the management of PVI when acquiring firms in distress is to buy the assets against a low price and sell against a high price. Figure 3.2 typically visualizes the process of distress, the results of restructuring and the moment when PVI acquires the company in distress.
Figure 3.2 Distress and restructuring
A third reason why the management of PVI is particularly interested in firms in distress is because there are relative a small number of buyers for this kind of companies. Because of the large risks and highly uncertain gains involved in the acquisition of firms in distress, not many investment firms are interested.
Concluding this section; if for some reason, the acquisition of the firm does not prove to have the desired results; the management of PVI always possesses the assets of the firm. These assets can be sold at their liquidation value and the payment obligations, to debt and equity holders, can be fulfilled.
Plain Vanilla Acquires a firm Slipping tow ards distres s & Res ults of re structuring
-1000000 -500000 0 500000 1000000
1 3 5 7 9 11 13 15 17 19
Months
Euro Cash Flow
3.5 Conclusion
This chapter explained the characteristics and tries to investigate the causes of firms in financial distress. According to Altman (1976) firms in distress are companies that cannot fulfill their obligations and often slip towards insolvency and need some kind of restructuring actions to prevent bankruptcy. In most occasions firms do not slip into distress suddenly. In several occasions it is a process of months or even years before a firm becomes distressed.
The main causes of financial distress are failing management teams, too high leverage and denial to anticipate to the changing wants and needs of customers (Argenti, 1976). A side effect of financial distress is the difficulties firms in distress experience when additional capital is needed to finance its operations. Potential investors and creditors are not keen on investing in firms in distress because of the high risks involved.
However for the management of PVI firms in distress are interesting because of a large improvement potential. A first reason is that the management of PVI expects to be able to improve the performance of the firm based on earlier experiences with restructuring cases.
Second firms in distress are of strategic importance since the assets can be acquired with a relative small investment compared to the acquisition of the assets of a healthy firm. A third and last reason why the management of PVI is interested in firms in distress is these firms are not popular among investment firms. Although the management of PVI sees large improvement potential, the risks associated with these investments remain considerable large.
Chapter 4: Restructuring of firms in financial distress
4.1 Introduction
This chapter examines what restructuring is and what instruments can be applied during the restructuring of a firm. Corporate restructuring is defined by Hoskisson and Turk (1990) as a major change in the composition of a firm’s assets combined with a major change in its corporate strategy. Companies in financial distress need depending upon the circumstances specific and for all quick actions. Paragraph 4.2 discusses restructuring and introduces a definition of restructuring. 4.3 discusses the article Bowman et al (1999) wrote about three different strategies of how to execute a restructuring, as well as two contrary approaches by Tomasko (1993). Paragraph 4.4 explains the strategies and actions PVI uses during a restructuring process. The so-called side effects of restructuring are discussed in 4.5. Finally 4.6 concludes the most important findings about restructuring.
4.2 What is restructuring?
Companies that lack the warning signals that it is slipping towards financial distress, as explained in chapter three, in the end need a total restructuring of the firm. An analysis which business unit (s) or business line (s) deliver the most of value and which do not should be performed. The core issue for many firms during those periods is to focus their attention on the business lines that showed fine results in the past and abandon the business lines that did not. In economic terrible times, management teams implement so-called focus strategies to safeguard the future of their firm8.
4.2.1 Objective of restructuring
A slowdown in operating revenues and declining margins are signals that a company is slipping towards a distress situation (Wruck, 1991). Distress is in this thesis explained as a situation where the costs exceed the revenues. To return the money to the shareholders and debt provides and to safeguard the firm from bankruptcy, restructuring of the company may be a feasible option. What a restructuring involves is discussed in this chapter from a theoretical as well as a practical perspective.
According to Donaldson (1994) restructuring is needed when firms have to cope with significant problems that cause financial harm. Those financial problems are sometimes that large, that the overall business is in jeopardy. The goal of restructuring is to eliminate the financial harm and save the firm from going bankrupt.
During the last years the management of PVI managed to restructure a few firms in distress into profitable companies. The restructuring actions implemented during these cases had the desired impacts on the costs and revenues. Total costs declined, whereas total revenues grew steadily through an active acquisition strategy. Today these companies are leading in their segment.
Figure 4.1 visualizes a PVI case from the past were the results of the restructuring actions are obvious. The figure depicts enormous losses during the years 1-3 whereas, through the restructuring by the PVI team at the end of year 3, a modest operational profit is shown in the fourth year. The effects of the restructuring actions will be explained in detail in chapter six where a financial model is presented that aims to calculate the effects.
PVI case
-4000 -2000 0 2000 4000 6000 8000 10000
1 2 3 4 5 6
Years
X 1000 euro's Total Revenues
Total Costs Profit Lineair (Profit)
Figure 4.1 PVI Case
Besides that a restructuring aims to prevent a company from bankruptcy, the restructuring of a firm has the intention to stop the destruction of value. Value destruction appears when a decline in revenues leads to a situation where costs exceed the revenues. A reason why value destruction occurs is that firms in distress are busy with the survival of the firm, instead of
selling products9. However, the causes of value destruction differ per situation and depend on the problems a company deals with.
With the implementation of different restructuring actions the PVI team aims to stop the destruction of value. Without a doubt restructuring actions are supposed to create value for the company. The sort of restructuring actions that create value for the company will be discussed throughout the chapter. Although restructuring, turnaround and redevelopment are used interchangeably, there remain differences between the three subjects. These differences will be discussed hereafter.
4.2.2 Differences among restructuring, a turnaround and a redevelopment
History showed us that during a recession, companies reconsider their strategy in an attempt to survive in a declining market (Wruck, 1991). The business plans and strategies presented to the stakeholders contain subjects like restructuring, turnarounds and redevelopments.
Although there are similarities between these terms, there exist clear distinctions between the three of them. Figure 4.2 visualizes in which phases of the lifecycle a firm restructuring, a turnaround or a redevelopment applies. As can be seen from the figure a restructuring is required after a decline in revenues, a turnaround is needed in times of liquidity crises and a redevelopment is a prerequisite to gain a rise in the market share. The three intermediating subjects will be discussed separately to explain the differences between them.
Growth Stagnation
Decline
Turnaround
Growth
Restructuring Redevelopment
Crisis
Figure 4.2 Lifecycle of a firm
R e v e n u e s
Years
