Protecting Your Interests

Changes in ownership can ignite trouble when lenders shift from having a reasonable debt coverage ratio to financing the same company that is highly leveraged. That was the case of a 15-year-old industrial coatings firm where the senior secured lender moved from helping the founder with traditional bank financing to providing new owners with a revolving line of credit backed by accounts receivable and inventory, a term loan collateralized by equipment, and a mortgage on the building. However, the senior debt didn’t provide enough capital to adequately cover the purchase price, so the new owners located a mezzanine lender to provide subordinated debt. The deal closed with a celebration, a toast to the business’ successful future and smiles on everyone’s faces.

For many years, companies have looked for subordinated debt from mezzanine lenders to supplement traditional bank financing because financing needs required to close a transaction exceed the amounts obtainable from the senior secured banks. This higher risk money carries a higher rate of interest and often warrant coverage to provide additional equity, providing a way for the mezzanine lenders to be compensated for their level of risk.

However, within 15 months of the purchase, a changing economy combined with the new owner’s inexperience spawned cash flow problems and mounting losses. They were in trouble. The resulting default notice from the senior lender caused the mezzanine lender to exercise its rights to become more personally involved in running the company to assess what actions were needed to turn it around.

Turnaround decision

When businesses are highly leveraged, there isn’t much “wiggle room”. Senior secured lenders are compromised when the collateral changes in nature and amount; Decreasing liquidation values of equipment in a slow economy don’t help the matter. And mezzanine lenders find themselves exploring their alternatives, including the selling of the business, working with current ownership with the hope of bringing about the needed changes, or bringing in a turnaround specialist.

In this case, the mezzanine lender would have liked to sell the business, but he knew he would not get out of the deal “whole”. Working with the owners wasn’t an option as they were considered part of the problem. Rather, he retained us to oversee the financial management, run the company on a day-to-day basis and develop a plan to bring it back to health.

Although senior secured lenders have ultimate control in these situations, it is important that all lenders understand and support the work of those brought in to lead the troubled company. Although they will be involved in protecting their own preference rights and interests (and their interest, as well), they can benefit by considering four key actions:

1. Understand the relationships.

A plan to restore financial health starts with one of the more important parts of the equation: an assessment of the organization’s people and overall culture. The lenders can help assess the organization’s health by providing insights regarding the various relationships of the people involved — then stepping out of the way. Turning around a company is actually more about people than finances. The new leader must develop rapport and trust with employees, customers, vendors, investors, and outside advisors before making major changes.

In this instance, our first round of interviews with key employees did not provide a true reading of the situation. It took several weeks of working side by side with them before they realized we just might be there to help the overall company and not just push one party’s agenda. Employees were afraid. Many were long-term workers who were having difficulty adjusting to the new owners’ leadership style. The fact that a large portion of the workforce did not speak the same language also contributed to this fear and unwillingness to speak frankly about what was going wrong in the company.

Sensitivity was important as employees confided in us about why the company was in trouble. The owners, after acquiring the business a year and a half earlier, started to make changes right away, including firing the general manager who had built a good reputation with customers and employees throughout the years. Within two weeks after the acquisition of the business, two key managers left and another left soon after. It was the “kiss of death” for this company to have four key employees leave because this resulted in customers becoming nervous and taking their business elsewhere.

In addition, these inexperienced owners tried instituting a new compensation system for plant employees. Miscommunication of the new compensation system and poor management in general eventually led to the plant workforce becoming unionized.

2. Allow time for due diligence.

Depending on the size of the organization. financial and operational assessments can take up to several months. Assumptions made from a cursory review of financial statements may lead to inappropriate actions resulting in no improvement or even a worsening of business results.

In other words, things aren’t always as they first appear.

The plan needed to consider these key financial issues and stakeholders:

  • First, the senior lender wanted us to jump in and quickly fix what appeared to be wrong. His collateral was “under water” and he was understandably nervous. Instituting a quick fix without a thoughtful process or a willing management team wasn’t going to bring about a positive result. And taking a “hit”, writing off a large portion of his credit, although an option, wasn’t the outcome he wanted.
  • Second, the mezzanine lender was considering two options: shut it down or put in more cash, and it had to happen quickly. He was waiting to hear from us regarding which way to go. We had previously worked with this sub debt lender and had walked this road before.
  • Third, trade creditors were clamoring for payment and putting significant pressure on certain employees. Conserving cash and negotiating with suppliers were important first steps.
  • Fourth, the seller, who had strong opinions about how to fix the problems, was nervous about the state of affairs because a significant portion of his payment for the business was provided for with term notes.
  • And the owners, the last ones in the pecking order, had made some early decisions that contributed to poor cash flow, such as outsourcing maintenance that could have been easily, and more economically, handled by employees.

Based on previous experience in dealing with conflicting interests, we encouraged all stakeholders to “stand still” and give us time to design a plan that had a chance of succeeding.

Key to our plan was to bring back prior management, which required new employment contracts. This was a bold move. Managers had to resign their positions and join a troubled company. However, this proved to be the right move. These managers’ new contracts made provisions for them to gain stock ownership in the company. Over time, these individuals would own 70% of the company after retiring the loans; the remaining 30% could be purchased at a formula price based on an EBITDA multiple. And, the mezzanine lender held a put option as a way to eventually obtain a return on its investment. By creating an equity earn-in based on EBITDA targets and retiring of debt, the senior lender could also see reduced risks down the road.

3. Be willing to make painful concessions to protect your investment.

As a senior lender, for example, it may be necessary to issue a forbearance agreement and renegotiate terms that will ultimately improve the financial strength of the company by reducing cash needs. In this case, the senior lender let the principal ride an


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