COVER STORY - Taking a gamble with business turnaround

Management is a tough game. In a world of dynamic markets and shifting consumer patterns, yesterday’s great decisions can turn into today’s millstones and tomorrow’s catastrophes. Against such a background, it might seem obvious that management would profit from having outside consultancy assistance on tap. However, managers have traditionally preferred to keep a stiff upper lip and sort out their own problems. As such, business turnaround services are a relatively recent phenomenon.

The exponents of this fledgling “business turnaround” industry, which came into being circa 1994, are, with one or two notable exceptions, almost exclusively the top accountancy firms. The reason for the dominance of the big firms is simple: you need a good network of skills to put a turnaround team together and you need access to a sufficient base of troubled companies to make it worthwhile.

The big firms meet both these requirements since their global networks provide the resource pool, while their audit client base will naturally contain a fair sprinkling of troubled companies or parent companies with under-performing subsidiaries.

The name given to each firm’s business turnaround service varies from practice to practice, as does some of its features. Price Waterhouse (PW) calls its service “Business Regeneration”, Deloitte & Touche call theirs, “Reorganisation Services”, Ernst & Young’s (E&Y) term is “Insolvency and Recovery Services”, and so on. In each case, however, the common factor is the firm’s desire to act not simply for the creditor, but to make the corporate board itself the prime client.

The underlying intent is to extend business turnaround beyond simply grabbing the reins days or weeks before the incumbent board drives its company over the precipice. In fact, the ideal state of affairs for this new industry would be to have healthy corporates calling upon its services as a kind of fitness check on an annual basis. That scenario, however, is still a pipe dream.

UK board and their counterparts around the world have a natural aversion to asking for help in managing their enterprise. There are at least two glaringly obvious and related reasons for this. First, it is almost axiomatic that turnarounds are only effected by shedding blood, usually at board level. Turkeys, as the saying goes, do not vote for Christmas. So it is with directors; they do not lightly ask consultants in when the result might well be a report that recommends their speedy departure.

Second, even where directors do not necessarily feel themselves to be the likely target of any recommended management change, it can be difficult for them to get over the perception that calling for outside help is, in some measure, an admission of failure. Management is there to manage, and if it can’t do that, what then is its raison d’etre?

These are large obstacles and go a long way towards explaining why business turnaround services are a relatively new feature on the business landscape.

However, attitudes are changing. According to Alan Bloom, E&Y’s UK practice leader for its insolvency and recovery services, one of the major drivers of this change is that UK banks are now considerably more enlightened than they were five years ago.

Specifically, the banks now have better organised books, with far better early warning systems to trigger alarms when their corporate clients are performing below par, adds Bloom. Instead of waiting until things are so desperate they have to call in the receivers to rescue creditor value, the banks are now increasingly giving boards a firm but polite shove in the direction of buying in external expertise to set matters to rights.

And they are doing so at a much earlier stage in the corporate down cycle.

As Bloom puts it: “It generally takes a third party to persuade management to call in outside consultants such as ourselves and the banks are taking up that role.” Nudged or not, the key difference in this scenario, is that it is the Board that is the turnaround expert’s client, not the bank.

Alan Jamieson, head of PW’s business regeneration department, explains the difference between turnaround services and straightforward insolvency services as: “With business regeneration, you are acting over a longer timeframe for the interests of all the stakeholders, which includes employees, shareholders, directors and creditors, and not just for a particular interest group in the shape of the bank.”

When a bank calls in a receiver to protect or recover its exposure, the job is done, from the bank’s standpoint, once that risk has been covered.

This is, in essence, a short-haul affair wherever possible. The receiver’s job is to go in and get the cash back as fast as possible, all things being equal. “Once the bank is comfortable, it is not particularly concerned about how much additional value you go on to create. When the debt is covered, it is covered, and if you add another hundred million, their position is unchanged,” Jamieson says.

The importance of this difference between receivership and the additional value added by business turnaround is hard to overstress, and not just from the standpoint of the client company. The business turnaround departments in the accountancy firms have a strong interest in differentiating themselves from the work carried out by their insolvency colleagues. It is easy to see that if business turnaround is to be taken seriously as a service, the top accountancy firms have to be able to show the world that their “turnaround” departments represent a good deal more than employment opportunities for insolvency staff made idle by a prolonged upturn in the general economic cycle.

A second, and related, point is that it is extremely important corporate boards accept the idea that the turnaround team really does occupy a different position and stands in a different relation to them and their bank than a receiver would. The turnaround team has to be felt to have the board and the company’s interests at heart.

“When the bank is the primary client and puts a team in, no matter what the recovery team does, the people who come in are seen as the bank’s people. It is very difficult to say to the board, ‘You need to do x or y, and we can help you to implement it’, since the board will always hold the view that when push comes to shove the consultants will look after their primary client, the bank, and not the company,” Jamieson points out. Since protecting the bank is what a receiver does, the turnaround team has to make it quite clear that while some receiver-type skills might be appropriate to their activities, their portfolio of skills goes well beyond that of a typical insolvency practitioner.

Given the long history of the profession in insolvency matters, and the relative brevity of its entry into this new world of business turnaround consultancy, it is not surprising to find that the accountancy firms are battling to reverse a certain cynicism out there in the market as to their motives. Trevor Swete is the managing director of Postern, apparently unique for being the only large-scale business turnaround specialist in the UK that is not part of a large accountancy practice. He points out that the figures for insolvency cases through the 1990s make an interesting backdrop to the top firms’ decision to grow “business regenerative” arms to their practice.

In the early 1990s, he notes, the insolvency arms of the Big Six made a substantial contribution to overall practice income. The figures from the Insolvency Bulletin show 1,507 companies went into receivership in 1989; 3,988 in 1990; 5,734 in 1991; 5,104 in 1992; 3,226 in 1993; 2,107 in 1994; 2,013 in 1995 and 1,594 in 1996. The clear implication of this is that from a peak in 1991 and 1992, receivership work has dropped five-fold, almost back to 1989 levels. Therefore, one might infer that there are a number of receivers kicking around the Big Six looking for gainful employment.

“It seems as if the whizz-bang wheeze for the profession these days, given the dearth of insolvency work, is to switch foot and act for the other side, the debtors, – showing them how to avoid the receivers,” Swete says. He acknowledges that certain of the Big Six, (he cites KPMG and E&Y) have long had an effective recovery side to their operation, in one shape or form, but he does not believe business turnaround is going to be a growth area for the profession.

“Accountants are people that companies like to avoid when they get into trouble,” Swete says. This might be for all the wrong reasons, but it does point to the uphill task facing the profession as it tries to change attitudes among its desired client base – the troubled corporate board.

PW’s Jamieson agrees that it is only natural for people to wonder at the outset whether a practice’s business turnaround team is going to turn out to be a home for re-badged insolvency folk. The proof that it is far more than this, he points out, will come with time as the accountancy firms’ turnaround arms continue building an impressive track record. “The plain fact is that acting for all the stakeholders in an enterprise over a longer period of time is a much deeper job than insolvency and requires a much broader range of skills,” he says.

What this means is that just as they have done with, say, corporate finance, where they plundered the human resources of the merchant banks, the accountancy firms are using their muscle and their global network to recruit the specific skills mix they need to make business turnaround a viable consultancy activity. Their turnaround departments are hiring ex-chief exec types, skilled managers with good pedigrees and other folk who bear little or no resemblance to either auditors or receivers.

When it comes to the nuts and bolts of business recovery, the firms split into two groups, depending on whether they are willing to take a hands-on role, which can mean putting in people on the client company’s board, or whether, like Deloittes, they stick to advice and leave the implementation to the incumbent management. A further differentiator is the degree to which they are prepared to “invest” in the client company in order to help effect the turnaround.

This last point is a particularly delicate one since there are clear rules designed to protect auditor independence which prevent firms from taking an equity stake in their audit clients. However, a softer form of investment, in the form of a negotiated success fee, which would allow a firm to take a share in the upturn they have helped to engineer for the client, is now standard practice. There are considerable differences between the approaches of the business turnaround arms of the Big Six and Postern’s practice.

Postern claims some 40 successful turnarounds since it commenced business in 1991. The company has four full-time directors, 38 associates under contract and seven full-time executives below director level who fulfil the finance and analytical functions. Its typical client starts at #10m turnover, with the largest turnaround to date being a #550m turnover company.

Unlike the accountancy arms, who are bidding to get involved at the earliest possible stage in a business turnaround, Postern sees itself as specialising in companies in dire trouble and its fees and business practice reflect this approach.

In addition to a “small” weekly fee (according to Swete it is less than the company would probably be paying for an interim manager or accountant), Postern works on the basis of a 7.5% charge on the difference between the value of the company when it goes in, and the value when it leaves.

It generally insists on taking board-level executive control, (something the Big Six do not seek, since they are keen to cultivate the board as a client). On occasion, however, Postern will seek to exercise control in a manner more akin to that of its competitors in the Big Six, by assisting an incumbent managing director in sorting out the mess, but only where it and the said MD are very much on the same side.

Regarding the scale of fees, as everyone in this business recognises, what might look expensive when a company is a long way from the precipice, can seem sweet reason itself when the turnaround team is the only thing standing between the company and oblivion. When shareholders are staring at a worthless hand, it is not so hard to sign away 7.5% of any value that might be created. They can always comfort themselves with the idea that once value is regenerated, they will be infinitely better off. Nevertheless, boards have to be in dire straits before they can be expected to agree to discuss percentages of their company’s market value!

Postern’s practice of taking board-level executive control has a number of interesting features. No one in their right mind would take up a directorship with a company that was already in extremis without careful consideration.

(The provisions of the Company’s Act, which make directors personally liable for the company’s debts if they trade when they know, or should know, that the company is insolvent, bear just as heavily upon turnaround directors as they do upon the rest of the board.) Postern’s practice is to form an executive committee in the first instance and it will only go on the board once it has unearthed the real figures and has a sense of the company’s actual position.

“Very often, we find the numbers we have been given are inaccurate. There is no surprise about this, since if the management accounts were accurate, they would have forecast the imminent demise of the company at an earlier stage and prompted earlier action,” Swete points out.

Once the true position is known, Postern ensures it has sufficient executive control to push through whatever reconstruction plan its analysis leads it to believe is most likely to restore value to the company.

“It is not our aim to rack up the turnover by, say, 30% in order to crank up our fee,” says Swete. “We look to get out as soon as things have been stabilised and value has been restored.”

In contrast, in the case of Deloittes, the issue of control of the client board simply does not arise. Unlike PW and E&Y, the firm is not in the business of seconding staff to clients. Analysis and advice, broadly speaking, are what it offers. The softer approach seems to go down well with boards.

According to Ian McIsaac, the partner who heads Deloittes’ Reorganisation Services, the firm expects to get involved in one or two new turnaround exercises each month – a “hit rate” that will rapidly see it passing Postern’s tally of 40 cases in six years.

McIsaac argues the corporate sector as a whole has a great deal to gain from the accountancy firms’ efforts to produce turnover specialists geared to operating much earlier in the downturn cycle than Postern’s customary, eleventh-hour entry into the archetypal, white knuckled, nails-clinging-to-the-cliff-edge, turnaround scenario.

He stresses the fact that the earlier companies seek to engage a specialist turnaround team, the better it is for everyone concerned. “When corporates leave matters to the point where they have run out of their credit lines, they have lost almost all their flexibility. If problems are recognised early on, there is much more for the turnaround team to work with,” McIsaac notes. The problem with cliff-edge manoeuvres is that companies that are strapped for cash are likely to find themselves having to sell the things that are most readily saleable in order to buy time for the turnaround to be effected. By definition, what is sold will usually be the most attractive parts of the business, ie the most cash generative parts. Once they are gone, the company has lost a good part of the motor it will need to drive the subsequent turnaround.

The logical alternative, of course, to achieving a cash injection through selling off the corporate equivalent of the family silver, is to bring in a transfusion of new money from outside. A turnaround team that can call on its own fund for a cash transfusion can add power to its turnaround effort by retaining the cash generative parts of its client instead of flogging them off. This is why Postern created its own “rescue fund” last year, backed by several large venture capital houses.

Thanks to the rule about not investing in your audit clients, the accountancy firms have – with one notable exception, PW – shied away from the idea of setting up their own dedicated rescue funds. The firm caused something of a ripple in the press recently by letting it be known that it was considering setting up such a fund, perhaps with outside participants, perhaps using partner monies alone.

According to Jamieson, this idea is still in the kite-flying stage and is unlikely to turn into a reality just yet. However, the firm has for some time been prepared to break ground ahead of its professional rivals, as its practice of accepting an equity stake, on occasion, in lieu of fees, demonstrates. Even here, however, as Jamieson stresses, it can only accept such a stake when dealing with clients who are not PW audit clients.

In any case, McIsaac and others have another, more theoretical objection to turnaround operations owning their own rescue fund. Such a fund, they say, has the potential to confuse the issue by generating a second, and potentially powerful revenue stream for the turnaround arm.

The number of cases being dealt with appears to be stable rather than rising, and the figures cited by McIsaac of one or two cases a month appear to be broadly typical. When pressed, the accountancy firms all claim the split between when they are called into a turnaround by the board rather than the bank, works out to something approaching a 50:50 ratio in the present, favourable economic climate.

None expect to see dramatic growth in demand from UK boards for their turnaround consultancy services just yet, though they all hope to see a gradual thawing in board-level reluctance to ask for outside help, with a consequent slow but steady increase in the volume of turnaround business put their way.

As a consultancy service, however, it still has a steep hill to climb before its natural constituency will feel free to call upon its skills as a matter of course. As Bloom puts it, “I can dream of a situation where every company of #50m turnover or more buys a month’s consultancy every year, but do I believe it will happen? No, not really.”