Buyers and Consultants Create Niches to Revive Leveraged Underachievers
By Martin Sikora
As analytical and careful with a buck as they are, financial buyers still have their share of stumbles.
Chicago-based turnaround expert Lawrence M. Adelman estimates that one-third of leveraged buyouts are “home runs,” another third are average performers, and the final third are underperformers that “may lose all or part of the money” put up by investors. “Even in a good year, those numbers tend to hold true,” he said.
Until recently, the failure rate had been a little-noticed sidelight of the LBO wave that sprang to prominence in the 1980s and established an important base in the M&A market.
But as private equity firms proliferate, amass more money from investors, and commit funds to more deals, their troubles have not escaped the watchful eyes of a growing number of professionals who sense opportunity in rescue missions. As a result, a small army of specialists has emerged to handle a variety of roles in fixing the troubled highly leveraged company.
Paul Schaye, managing director of Chestnut Hill Partners in New York who specializes in handling acquisitions for financial buyers, says that, “his clients are increasingly willing to take on another private equity firm’s bad apples and turn them around.” He said he is scouting hard for such opportunities.
One of Schaye’s clients is Sun Capital Partners Inc., a Boca Raton, Fla.-based LBO and venture capital firm which has taken at least three troubled businesses off the hands of financial buyers and seeks more of their distressed properties.
Adelman, together with attorney David L. Eaton and former Heller Financial Inc. executive Michael Goldsmith, recently formed AEG Partners LLC specifically to handle turnaround management assignments at the underperformers in private equity portfolios.
And there has been expansion in the ranks of individual interim managers who have the Know-how to shape up the lagging leveraged company before handing the reins to a more permanent executive corps and moving on to another assignment.
“Given the upsurge in leveraged dealmaking and the expanding holdings of LBO funds. It’s inevitable. Schaye said, that some portfolio companies will go south. When that happens, the sponsor may pay less attention to the laggard while committing more time and funds to the sure winners where the returns promise to be greatest, thus accelerating the downward spiral. The subset of buyers who will take over and resuscitate the business offers an “escape valve” for the private equity owners to exit without scuttling the company or losing their entire investment,” he said.
Poor performance, Schaye added, does not mean a hopeless case. “Some of them are basically good companies that have suffered from lack of attention,” he said. “A new owner that focuses on the business can restructure the finances, improve the operations, and create value in a previously distressed situation.”
A key factor, he noted, is that the new owner knows that it is tackling a troubled situation from the start and is able to identify and work on the pressure points that can turn things around.
Rodger R. Krouse, managing director at Sun Capital, says that his firm is seeking “orphan companies” in private equity portfolios that have unrealized potential. “We look for great franchises that are undermanaged,” he said. If that seems like an unrealizable ideal, Krouse said those kinds of hidden gems abound because there are portfolio companies that don’t receive the right attention, care, and feeding. “We can get value out of them because we have more professionals focused on the operations rather than the deal side,” he noted. “We can improve the company dramatically. The lenders are happy and the former owners are not distracted.”
In the latest rescue mission, Sun Capital last February acquired control of JTECH Communications, a producer of on-premise paging systems, from Bain Capital Inc. JTECH was a disappointment despite a 90% share of paging systems in restaurants and strong penetration of other service markets, such as hospitals, offices, churches, and nurseries. “We put in a new CEO and made personnel changes,” Krouse said. “We are working on growing revenues. And Bain’s return is better than if it had retained full ownership.”
While it’s too early to judge results at JTECH, Krouse claims success at two other turnarounds with longer track records. Nailite Inc., a Miami-Fla. based producer of specialty siding panels, was acquired from Kleinwort Benson after a 10-year down spin in which “the equity had gone to zero.” “In the third year, we doubled sales and tripled profitability,” Krouse said. “We introduced new products and improved customer service. We did the blocking and tackling types of things to make it work.”
Labtec Inc., a manufacturer of computer peripherals including speaker headsets, in which it has a 50% market share, was acquired from Stephens Inc. and Northern Group. While Nailite was an internal regeneration, Vancouver, Wash. -based Labtec also has benefited from two add-on acquisitions – Connector Resources Unlimited, a computer data storage products concern, and Spacetec IMC Corp., in 3-D controllers. “Sales have doubled and profits have more than doubled,” Krouse stated.
“We just have a different focus from other private equity buyers,” Krouse said. “Forty-nine out of 50 deals they do may be terrific,” he said. “But they are largely deal people. We are largely operating people. We bring our own management to the game.”
Guessing wrong on company managers
How do these companies get into trouble in the first place? The consensus is bad management. “The primary reason is poor management,” Adelman said. “Everything else is a distant second to poor decision making by management.”
Erwin A. Marks, an operations and turnaround veteran who has served as interim CEO at several leveraged firms in trouble, agrees, saying that many managements can’t handle the challenges of running a business in the increasingly complex economy of the 21st Century. The old strategy of focusing on cash and stability no longer works as well as growing the business, and some executives can’t do both at the same time. “If it goes sideways, you can run out of money awfully quick,” Marks asserts.
Although LBO sponsors pride themselves on judiciously sizing up the managements they want to invest in, “they are not always right in what they believe is good management,” Adelman said.
The reasons for analytical miscues are varied, ranging from overestimation of talent to psychological problems not apparent when the deal closes. “For example, if you are buying a divested business’ the management may not know how to run a business in totality,” Adelman said. “They may not know how to run it on a cash basis. The private equity firms may be fairly knowledgeable about managers, but people change. A gov may develop ego problems. He may want to grow too fast. Or he may not impart all the information he has to the owner.”
Even historically good managers may face problems navigating the current complexities and turmoil in the economy, Adelman added. “The bar has been raised the last few years,” he said. “Management needs to apply new technology. There is competition from the Internet. Unless you are really good in a sector or have a new paradigm, you are going to have a problem. By just being marginal it is harder to get by now. Every sector sees companies that run into problems by not being aggressive.”
Marks, head of Northbrook, IL based Marks Consulting, sees a plethora of pressures on business that can be aggravated in a highly leveraged situation where a primary focus is working off the debt overhang. He also notes that several roll-up plays executed at whopping multiples, are becoming frayed because their industries are showing a much more concentrated level of competition. “Bigger companies are being created in areas where there used to be fragmentation,” Marks said. “Pricing has not kept up with volume because of fiercer competition.” Meanwhile, said Marks, Costs have increased and the “rise in SGA has been dramatic.”
“In some cases,” he added, “the buyers didn’t understand the amount of capital investment needed to make these companies viable.”
And across the board, Marks said, there is the ever-present problem of overpaying for deals without a reasonable prospect of recouping the investment. “They are still looking to leverage overhead and back- office costs,” he said, “and they are willing to pay higher multiples to put themselves on the same level as the strategic buyer.”
Ominous signs from the junk market
Both Adelman and Marks think that a lot more problem situations are in the offing. “The default rate on public debt is rising,” said Adelman. “There is a 4.2 % default rate on junk bonds. That means there are many problems out there. If you combine the normal percentages of deals that perform and those that don’t, that means there are a lot more problems out there.” When the junk market is in trouble, he said, “it means that it can’t support asset-based financing.”
That, he said, means a lot of work for a firm like AEG that assumes the managerial headaches. “Problem deals take a huge amount of time, which draws the sponsors away from their focus,” Adelman points out. “We’re really focusing on managing investments for them that reach a good conclusion for everybody.”
Marks, who has been in the LBO turnaround game for more than a decade, says that his consulting assignments are mounting and notes an interesting shift in the trend that suggests that financial buyers are spotting trouble more quickly and moving to fix it before things get too far out of hand. Ten years ago, in the midst of a recession, most work came from lenders that had over-advanced and were eager to salvage their investments. “The market has heated up substantially for this kind of work, and most of my clients now are coming from the buyout group side,” he said.