How a Turnaround Now Can Help You Avoid Business Bankruptcy Later

How a Turnaround Now Can Help You Avoid Business Bankruptcy Later

First, the good news: Corporate bankruptcies in 2022 have been running below average. Now, the bad: That is about to change. Big time.

Government stimulus, post-pandemic demand, and historically low interest rates combined to give companies the edge during the first half of 2022. Organizations that survived the pandemic shutdowns thrived as the world recovered.

In fact, Cornerstone Research, which tracks business bankruptcy trends in Chapter 7 and Chapter 11 bankruptcy filings by companies with assets of $100 million or more, says in its midyear 2022 update report that there were only 20 bankruptcies filed by companies with $100 million plus in asset during the first six months of the year. It’s the lowest midyear total since the second half of 2014.

But the US Federal Reserve is waging war on inflation with historically fast increases in interest rates – more than 3 percentage points in just six months. That, coupled with the threat of a global economic recession, is spelling trouble for highly leveraged companies and underperforming firms.

We asked two turnaround specialists to walk us through the highly charged bankruptcy landscape as 2023 looms.

Dave Mack, principal of Pathfinder Group, a restructuring professional and a private equity investor focused on under-performing middle market businesses, predicts that “the first people that are going to go through the process are the zombie companies or the companies that have run out of money. That’s because of the increase in interest rates and the supply chain challenges. They are not going to be able to pass the cost increases on to customers because the customers just aren’t accepting increases anymore.”

Those small business bankruptcies, Mack says, will start happening in the first quarter of 2023.

Next up will be the big companies with big debt. As interest rates rise, they will be scrambling to restructure their debt. But those reorganization deals will be larger and much more complex.

Signs a Bankruptcy is Looming

There’s a passage in Ernest Hemingway’s novel The Sun Also Rises in which a character named Mike is asked how he went bankrupt. “Two ways,” he answers. “Gradually, then suddenly.”

It’s often much the same for a company headed toward bankruptcy. The key to survival is acting sooner rather than later.

There are signs things are headed down the wrong track, according to Dave Mack and Bob Handler, who has been doing turnaround management for more than 20 years.

Among them:

● You lose a key employee to a competitor

● You miss out on a deal because you can’t price it the right way.

● Your vendors start asking for stricter terms, maybe even cash up front.

● For the first time, you trip a minor covenant in the terms of your business debts.

And then there are the more ominous signs, such as you are worried about making payroll or being able to ship a product on time. That’s when the owner might be asked to put more personal assets into the business. Or the owner may be forced to go to a lender offering personal guarantees to get the money they need to keep the lights on.

Is Filing Bankruptcy the Right Answer?

Most of the small and mid-size companies that are struggling will end up being sold if they are viable. Or, they will be liquidated and/or file for Chapter 7 bankruptcy liquidation simply because they have run out of cash to operate, says Handler.

Those companies may try filing Chapter 11 bankruptcy as a first step in the hope of restructuring, “but they’re not going to last long in Chapter 11 if they are not cash flowing. The writing is already on the wall for companies like this. A chapter filing is only going to delay the inevitable,” he says.

In other cases, they will work around bankruptcy law via an ABC – Assignment for the Benefit of Creditors. This is a type of out-of-court, non-bankruptcy option. It works when the company has identified a buyer willing to purchase the assets free and clear at a price that will satisfy the creditors. The company owners bring in a private party to act as the assignee/trustee to oversee the process.

“That’s usually driven by the lawyers and/or the bank. Those insolvency lawyers see an outcome better than their client does, and realize the best outcome for creditors is an efficient sale and/or a liquidation process,” says Handler. “Other companies may not be as lucky or may believe that they can actually restructure under bankruptcy (with much higher professional costs and more creditor participation than an out of court process) . But the smaller companies are going to have a tough go of it.”

Bigger Is Better in Bankruptcy

What happens if you don’t have a buyer identified? Then you need someone to fund the restructuring – a banker, a buyer, or a private equity investor.

It works best when the process starts early. “That’s when a turnaround person, and lawyers, and with the whole management and ownership team needing to be involved focused on a restructure/recapitalization months ahead of time,” Mack says.

Generally, companies with $50 million or more in revenue will need to work through the bankruptcy process, he says. There simply are too many secured debts, unsecured creditors, and other stakeholders. Mack says that he has pushed a $200+ million in revenue use the ABC in a sale process.

Small business owners operating companies with less than $50 million in revenue often end up “winging it” because they don’t have the controls in place and they suddenly realize cash flow has dried up.

For client companies with less than $50 million in revenues, Handler’s and Mack’s firms tells business owners “don’t even think of trying to restructure in bankruptcy because you don’t have the time nor the cash to fund the professionals much less the companies cash needs.

The Role of Private Equity

Private Equity funds could be the savior for some troubled mid-sized companies, Handler says.

“They’re going to be making the plays to the banks on the bigger deals to buy out the loans, perhaps at cents on the dollar, with the goal of ultimately owning these companies,” he says. Mack indicated that a lot of PE firms and/or Hedge Funds may buy a portfolio of loans at a discount and would optimize their returns by sorting through the portfolio and deciding whether they want to control company, sell the company or hold a loan on a loan by loan basis.

That is true for PE funds that are flush with cash. But without access to a seemingly never-ending stream of cheap money, private equity deals have slowed to trickle in 2022, especially for the big multi-billion-dollar deals. The university endowments, pension funds, and other institutional investors may now see heavily leveraged PE deals as too risky as a recession looms.

It means a huge cultural shift for private equity investors, many of whom got into the business in the wake of the 2008 recession and have known only an era of easy money.

“Think about it,” Handler says. “You could have gotten your MBA in 2010, and you’ve never had to go through any sort of restructuring until now. You don’t know what to do. You’ve never had to chase a guarantor, for crying out loud. You never had to repo your collateral. Where are these guys going to go to figure these things out?”

Mack notes, the deals are mostly handled by unregulated lenders and, unlike in 2008, “I don’t think the government is going to bail these guys out. They’re going to have to take the hit.”

No “Greater Fool” Option

So what is an owner facing the end of the runway but hoping to save the company to do? Bring in a neutral third party, the turnaround experts say.

Chances are the owners have cut layers of staff to keep the doors open. They suddenly find themselves “totally beyond the capacity of what they can do. They need to run the business and they need help,” Mack says. “We represent that help.”

If the firm is funded by private equity with some bank loans and there is “no greater fool” jumping up to buy it, a neutral third party that has been through the process can offer advice and tell owners what to expect from the process.

Meanwhile, other professionals can analyze which of the business entities are working and which aren’t and create a plan for maximizing the business assets.

In some cases, the lenders will demand even more control and put the turnaround expert, rather than the board, in charge of the reorganization plan.

Whatever the structure, expect it to move quickly. All of that can happen in a month or less.

Can This Company be Saved?

When Mack or Handler are contracted to work with a struggling company, the process is predictable.

First, they do a 13-week or 26-week cash model to determine how much time they have to figure out a restructuring plan. They take that information to the ultimate stakeholders – it might be the board, the bank, or the investors – “and we say, ‘Look, we can stay open for another three, four, or five months and nobody gets hurt,’’ Handler says.

Once there’s consensus around the plan, the turnaround experts can begin to execute the restructuring plan.

But it all requires time. The sooner company owners and managers admit there’s a problem and bring in outside expertise, the greater the chance of saving the organization.

Finding the right help could be a challenge in itself. The restructuring and turnaround business has shrunk significantly in the last 10 years, Mack says.

It’s another reason to start the process sooner rather than later, he says.

“A number of our competitor firms that had 150 people went down to 50 people. Another firm was 55 people during the Great Recession and they worked their way down to 10,” Mack says. “It’s going to be interesting as bankruptcies increase. That capacity is going to get sucked up pretty quick.”