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“What you don’t know will kill you” when it comes to investing in distressed companies, according to Joyce Johnson-Miller, senior managing director at The Relativity Fund, based in New York City. “All your modeling and all your forecasting analyses form a very, very, very small part of investing in distressed companies…. I learned that the hard way.”
Speaking as a panelist at the 2007 Wharton Restructuring Conference in Philadelphia, Miller said that turning around a distressed company starts with a solid understanding of its business environment. The “level of unknown [and] dated information” is among the most important things to keep in mind in approaching troubled assets, she added. “If you don’t understand what is going on in the boardroom — domestic, international, the moon — you won’t get anything done.”
During the conference, other investment experts shared their insights on the unique characteristics of specific global markets for distressed assets and the international issues that crop up on financial, legal and operational fronts. They noted that each market calls for strategies carefully calibrated to local culture, that sourcing accurate information is critical, and that extracting value from distressed assets is more about people skills and trust-building than clever spreadsheets and financial engineering.
Facing the Unknown
Homer Parkhill, a director at private equity firm Rothschild Inc. and a panelist at the conference, said that all restructuring deals have two ingredients — “the presence of leverage, and the inability of the company in question to meet the contractual obligations of that leverage.” To extract value from a distressed company, he said, turnaround managers first look at operational issues, benchmarking the company’s performance with leaders in its industry to get a sense of where opportunity lies. People issues come next, but that is a “controllable element. When you have a situation where there are operational issues and people issues that you can control, that’s better in terms of investor confidence in the long-term prospects of the business versus [situations] where you have macroeconomic factors at work.”
Macroeconomic issues — such as competition from China — are really outside a company’s control. Such phenomena have “a lot of ripple-through effects in terms of commodities, currencies and the competitive position of the company,” he said. “The China story and the inability to stay competitive is certainly a recurring theme…. You are seeing the impact of globalization rippling through manufacturing centers throughout North America and Europe.” Getting around these fundamental factors “will require more than just tweaks to the operating model” at each of the companies involved.
Most international restructuring cases are complex because they involve creditor groups that are far more diverse than in a typical U.S. situation, Parkhill added. One challenge restructuring professionals usually face is managing the various constituencies in a company needing a turnaround, “but when you take it to an international level, generally those constituencies are multiplied by a factor of at least two, maybe three.”
Another potential complication in foreign settings is the lack of tested insolvency laws, Parkhill said. “The multi-jurisdictional nature of many of these constituencies requires extremely solid [legal] counsel to think about where the leverage points are, and oftentimes legal counsel that is familiar with cross-border and local insolvency laws.”
Parkhill noted that often, investment firms are the first to test a country’s insolvency laws. “In the international marketplace … the laws [are evolving] to U.S. standards,” Parkhill said. “They are not there yet, but understanding where they are and the influence and implications of those legal codes and standards is critical to assessing value or leverage.”
The upside of markets where insolvency laws are still evolving is that the owners of troubled companies tend to be easier game for opportunistic investors. “The fear of taking a company into an in-court process in a jurisdiction that is not tested leads people to be more conciliatory in terms of their willingness to cut a deal and stay out of court, so that’s helpful,” said Parkhill.
Deals over Beer
According to David Heller, partner at the law firm Latham & Watkins and co-head of its insolvency practice group in Chicago, investors in international restructuring deals need to understand cultural differences, especially when they have an American perspective. In most of the developed world, debt is given priority over equity in restructuring deals, but that is not necessarily true in all cases, he noted. One example is Eurotunnel, which operates the channel tunnel between France and the U.K.: A group of U.S. hedge funds had acquired its debt, “believing that the debt, purchased under stress, would have tremendous value.” Because the debt was purchased at a discount, they also assumed that shareholders’ equity wouldn’t have any value, and that restructuring would be about reinstituting a certain amount of debt and converting that debt to equity, Heller recalled.
That situation, however, played out differently. “Many, many restructurings are only about converting the debt into equity with a wiping out of the old equity,” said Heller. “But at the height of the Eurotunnel negotiations, the CFO-equivalent of the company said to the press: If people invest money in Eurotunnel, it’s for their children or their retirement — not to give it to jerks in Manhattan who buy champagne by the case to fill up their bath tubs. This is the fight of good against evil.” Eurotunnel was granted bankruptcy protection by a French court in August 2006, which essentially disabled creditors from blocking restructuring plans that could lose them money. Heller’s moral: “You can be the world’s best lawyer. But if you don’t understand these cultural distinctions and pressures, you’re never going to get through it.”
Heller also recently learned how local connections can determine the outcome of legal matters in particular markets. His firm is currently representing General Electric Credit Corp. for a project in Mexico, where for a certain legal matter the company has been unable to get access to a court. “We have won everything we need to win in the United States, but in Mexico we are being politely told, ‘You’ll get to the court [tomorrow],'” said Heller. “It occurs to me that maybe somebody down there is friends with the judge.”
Miller noted that from an investor’s standpoint, it is helpful if a fund’s advisors are born and raised in the country where it is trying to buy a company. “Why? To the exact point you made,” she said to Heller, “…they know the judge, they know the plaintiffs.” She spoke of a recent German investment her company was involved in. “Our ability to get the data and the real story was candidly over a beer or two — to find out what was really happening,” she said, adding that the German-to-German conversation was translated for her.
Knowing how companies and managers elsewhere in the world view insolvency is also useful in devising strategies, Miller said. “In the smaller [European] companies that we are involved in, bankruptcy or insolvency is still viewed as a bad thing. For us [in the U.S.], it is a competitive advantage, because hopefully you can talk people through an out-of-court restructuring or through doing a deferred equity or a quick transaction.”
Oftentimes, European managers are worried about their risks of personal liability, which people like Miller have used to their advantage. “That threat could be a real driver, or a return, to getting a deal done, but also a push if that individual knows that they need 10 million or 20 million Euros as capital,” said Miller. “Or, if they face some personal liability, boy — that can accelerate the discussion. We have used that as a lever to buy companies.”
Corinne Ball, a partner at Cleveland, Ohio-based law firm Jones Day and head of its global reorganization practice, said the biggest worry for corporate managers in Europe is exposure to civil liabilities. “An individual officer or director can become personally liable for keeping the [company’s] doors open instead of throwing the business into court. In Germany and Austria — in theory, although we’ve only seen it done twice in the past three years — you can go to jail; there’s criminal liability for running a business that can’t pay its bills.”
Those fears played out dramatically in the case of Peguform GmbH, the German auto parts subsidiary of Venture Holdings in Fraser, Mich. Venture ran its subsidiaries across several countries “as one business,” Ball recalled, which meant that when any one of the businesses needed cash, the transfer was booked as an inter-company loan. At some point, Ventures began defaulting on its bank loans in the U.S.
But Peguform, which was solvent, wanted to protect its finances as the parent floundered. “If you take any more cash out of Germany … we’re going to put [the company] into bankruptcy,” Peguform’s management told Venture, according to Ball. Venture didn’t take the threat seriously and continued its cash management system among the various European enterprises, including dipping into Peguform’s cash reserves. That was a mistake in Europe, where Ball said cash flow is considered more important than in the U.S.
“Rather than risk criminal liability … the management of Peguform walked right into German bankruptcy court, ended up with a trustee, and dragged U.S. and Canadian businesses into a prolonged and extremely expensive Chapter 11,” said Ball. “Peguform will [go on to] become the [symbol] for what we call in the business ‘the rogue subsidiary syndrome.’ It can happen to you anywhere; it can happen to you with a French subsidiary, it can happen with an Italian subsidiary.”
U.S. investors and turnaround managers also need to acquaint themselves with the limits of the American legal system in foreign settings, Heller said, noting that the “automatic stay” that Chapter 11 filings give restructuring companies in the U.S. means nothing in some other countries. That happened with his client AT&T Latin America, which went through a Chapter 11 program starting four years ago. Although its operations were in five Latin American countries, the company was based in Washington, D.C., and was worried about possible delays in Colombia and Mexico — so it filed its case in Miami. “We thought it was the smart thing to do; politically, it showed a certain amount of deference [to Latin America],” said Heller.
But that move didn’t get AT&T far. Chapter 11 proceedings automatically prevent or “stay” any action from being taken against a company’s assets. The company was building a case to pay pennies on the dollar to its U.S. creditors, and expected the same thing in Brazil, too. But its lawyer in Brazil warned Heller that local creditors there might start seizing the company’s assets.
“What about the automatic stay? Won’t they honor the automatic stay?” Heller recalled asking the Brazilian lawyer. “He said, ‘Well, they may be interested in that when they’re done laughing.'” As it eventually turned out, AT&T Latin America paid its creditors in the U.S. pennies on the dollar, but “each creditor in every country outside the United States was paid in full,” said Heller. “Restructuring is just not successful when creditors in the U.S. are going to be treated one way and the creditors in another country in another way.” His endnote on that case: “The courts in America believed that [Chapter 11] will be taken seriously by everyone all over the world, which in my judgment is an act of unparalleled arrogance.”
Within the European Union and in the U.S., there exist agreements and bankruptcy codes on how to proceed with cross-border transactions, Heller added, but that can prove challenging in Latin America. U.S. courts get around this by sending Latin American courts formal requests — but Heller has found that informal cooperation works equally well. “I’ve had [U.S.] judges call their counterparts in Latin America to simply talk through some kind of agreed protocol and system to accomplish [our] goals.
“I believe restructurings are all about P&L — and it’s not the P&L that you might think of: It’s ‘people and leverage’ — not the leverage on the balance sheet, but the leverage to hurt some other constituent,” Heller said. “In Latin America, that is the predominant force. People who are negotiating have out-of-court, informal ways — they can sit around a table and cut a deal and implement it.”
Eyes on the Patient
Bryan Shapiro, a managing director at Bear Stearns & Co., said that in some European markets, local networks can help win the confidence of management teams at distressed companies or banks before U.S. investors present their restructuring plans. Often, middle-market European banks “get suspicious about why you are trying to buy their loans at a certain price.” The banks feel there must be some value in the deal, he said, “even though they don’t see the value and won’t take the proper steps in a restructuring to create that value.”
U.S. investors don’t always get to wrap up a deal even if they promise to relieve a distressed company of its debt and wire it fresh capital, he added. “[The company will worry] that Americans will sell it to a hedge fund, which will shut down the plant, fire all the people — even though it is not easy to do all that. They will trace [their argument] to some case where another American fund did something bad — and it has to come back to me because I am from that community.”
Claudio Galeazzi, of turnaround consulting firm Galeazzi & Associates based in Sao Paolo, addressed why some of these trust gaps occur. “I am distressed to see a lot of attention being given to creditors, a lot of attention to investors, a lot of attention to lawyers, but very little attention is given to the patient,” he said. “If you don’t restructure the company, the lawyers will be paid, I will be paid, but you guys will not get the value of your investment,” he added, addressing fellow panelists who represented investor interests.
Galeazzi said he has led several turnaround cases successfully keeping in mind a few basic principles. “There are no secrets and no standard formulas. But there are five points. First is common sense. Second is back to basics, simplicity. Third, adopt sound principles of administration. The fourth is negotiation. Turnaround of a distressed company is pure negotiation — with suppliers, employees, creditors and even with yourself to see if you are on the right route. The fifth is teamwork.”
On that last point, he noted that turnaround investors tend to walk into a company and not interact with the local team. “Usually, the local middle management has no idea what you guys are doing,” Galeazzi said to his co-panelists. “Therefore, they don’t know what they are doing themselves.” Turnaround managers should avoid “hard power” at the companies they seek to revive — “walking in with a SWAT team and occupying every space.” Instead, he prefers to use “soft power, where there is communication, transparency, participation and integration with the local team.”
Galeazzi said this approach has worked very well: As turnaround consultants in Brazil, his firm closed 10 industrial plants, including one in Ecuador. “We were able to do that without ever being paralyzed by a union strike or real disagreements with unions,” he said. “We had tough negotiations with them, but always [with] humility and humanity. We obtained our goals with negotiation.”
Even so, the biggest challenge investors face these days is finding the right opportunities. William Quinn, principal at Chrysalis Capital Partners in Philadelphia, said he is seeing “some cracks in the lower end of the middle market around housing and mortgage finance, but generally the economy is good.” Even so, his firm is on alert to pick up on the slightest hint of trouble that could be an investment opportunity. “Somewhere in the country, there is a management team that is making a big error or failing to execute, and that is going to create opportunities for everyone on this panel,” he said.