Corporate restructuring: Five common pitfalls

Francisco J. López Lubián, Head of Finance Department, IE Business School

In the wake of the financial crisis some of the worst hit nations – including Greece and Ireland – had to restructure their debts.  Their incomes could no longer cover their debt payments.  They were not alone.  Recession pushed many companies to the brink.  Some failed, others restructured their finances and operations and emerged on the other side.

 Among those who restructured their way from the precipice was the Spanish toy company, Famosa. The onset of the financial crisis in 2007 decimated Famosa’s sales and narrowed margins. The company racked up losses in 2007 and 2008.  After more losses in 2009, bankruptcy beckoned. But, after restructuring, Famosa was able to survive. It set up a negotiated process so that the company optimized operations and adapted payments to its ability to generate cash flow.

 Over recent years, many firms like Famosa have escaped bankruptcy and closure by restructuring their liabilities.  They are the fortunate ones, but corporate restructuring is never easy.  It is an arduous task which is fraught with difficulties and takes up a great deal of senior management’s time.

 The stakes are high. During any restructuring, the very future of the company is at risk. Each restructure is unique, dependent on the company and executive team, but to succeed five common pitfalls need to be avoided:
 
1. It’s more than refinancing
Restructuring a failing company means introducing changes that will make it viable and profitable once again and to implement changes so that it will generate enough free cash flow (FCF) to cover the service of debt and satisfactorily remunerate shareholders. While any corporate restructuring implies financial changes, it is not only about refinancing. It is important to understand the underlying causes of the liquidity problem and not to blame others (for example, the lack of support from banks). Furthermore, because restructuring comprises the implementation of improvements in the scope of the firm, its asset management, and capital structure, the process is more than a matter of changing the terms and conditions of the debts.
 
2. Choose economic profitability over accounting profitability
Accounting profitability is normally measured with a Return on Equity (ROE) ratio, defined as a ratio of Earnings to Book Equity. Conversely, economic profitability is related to the real money (cash flow) that the shareholders receive. Economic profitability is measured by the Internal Rate of Return (IRR) of the FCF to shareholders, meaning the FCF left after covering all the payments related to the service of the debt.  When restructuring economic profitability is king.
 
3. Preparation is essential before the negotiation starts
Every negotiation requires preparation and a strategy. Managers cannot walk blindly into negotiations.  They need first to think of specific requests as well as the guarantees they can offer, before negotiation with the banks even begins. During their preparations executives can propose and determine how the possible refinancing is going to be distributed, under what conditions, and subject to what limits and guarantees. Negotiating strategy and tactics should include identification of the negotiable points, possible counter-proposals from the banks, and matters kept in reserve (if possible) to be raised during the process.
 
4. Consistency will deliver results
At this crucial stage in a company’s life, inconsistency in communication or strategy can be fatal.  Some ways to be consistent:

• Draw up a consistent and credible action plan to improve the company’s liquidity. Determine the financial needs in the short, medium and long term.
• Be consistent in your financial plan: try to cover short-term needs with short-term funds, and long-term needs with long-term funds. Negotiate your plan following this approach.
• Do not equate restructuring with debt renegotiation. Long-term needs can and must be financed by converting debt to equity, whenever the level of leverage is excessive.
• When converting debt to equity, negotiate in detail the value of the stake held by the new shareholders or look for alternative sources of capital (venture capital, for example).
• Finally, the success of the restructuring depends to a large extent on the company surrounding itself by qualified advisors who can offer the benefit of their experience.

 
5. Don’t get lost in the process
Independently of the legal, technical and tax complexities involved in a restructuring, don’t forget what the process is all about. Remember:

• A restructuring process consists in reaching a private agreement in order to prevent legal proceedings. It is also possible to base the agreement on corresponding bankruptcy law, although it would have to be under judicial protection and subject to regulations that are often more rigid (creditors agreement).
• A restructuring is a special refinancing agreement for when a payment plan has not been met (distress), rather than the simple refinancing process used when there is no financial tension.  
• The objective is to render the company viable and to ensure its continuity.
• It only makes sense if the value of the debt is greater after the restructuring than the value of the company in liquidation.
• It is assumed that certain operational restructuring measures have already been implemented, but proved insufficient to generate the required cash flow to avoid financial distress.
  
  

Successful restructuring is a team effort.  Success requires that companies work closely with their investment partners. In a restructuring, investors are not only shareholders, but also supporting financial entities. For managers the challenge is always to be a step ahead by preparing the (eventual) next round; to be transparent; and to communicate effectively. Follow these rules and avoid the common most restructuring pitfalls and they might just save their company’s life.

Francisco J. López Lubián, Head of Finance Department, IE Business School, Author, Executive Guide to Corporate Restructuring (Palgrave Macmillan June 2014)

[This research paper has been reproduced with permission of the authors, professors of IE Business School, Spain http://www.ie.edu/]