A Note On Turnarounds

A number of bankruptcies have been filed in, and due to the business effects of, the ongoing COVID-19 pandemic. Well-known consumer names include Avianca, Gold’s Gym, J. Crew, John Varvatos, Neiman-Marcus, and are expected to be joined by many others. A broad systemic event such as COVID-19 as a trigger of bankruptcy is a rare event that has no precedent in world history. But as unemployment skyrockets toward 20%, and the American economy faces a threat not seen since the Great Depression, many other filings are expected.

The United States is perhaps the best place in the world for a business whose results have not been as expected, to get a second chance. In the worst case, such as all those companies previously mentioned, the US bankruptcy code provides for what’s called a “Chapter 11 reorganization”: the opportunity for an insolvent business to clear its financial troubles and reemerge with a fresh start. Most business turnarounds are not this dire because only in the face of insolvency is a Chapter 11 a considered path. In most cases, turnarounds have to do with operating better.

1. Declining Revenues. Some companies need turning around because their Revenues (Sales, and other sources of Revenue) are down. They may remain profitable, but the trend of their Revenues has a negative or flat slope. They may even be intentionally unprofitable, but the slope of their Revenues is less positive than before. In these turnarounds, the question is why. When the root causes are known, then the team performing the analysis can assess whether those root causes can be overcome. What company management teams ultimately choose to do depends on what their equity owners prefer.

2. Declining Profits. Some companies need to be turned around because their Profits are down. There are several types of Profits that businesses look at: Gross Profit, which is the difference between Revenues and the costs of goods and services required to deliver what was sold. Operating Profit, which is the difference between Gross Profit and most of the other “overhead” type spending that was needed for the company to run. There are many other ways to look at Profit depending on the type of business, including “EBITDA.” Overall, if one or more kind of Profit is declining, the team performing the analysis will determine the reasons why. A common reason is that the Revenues are also declining. If they aren’t declining, then various costs may be up. Root cause analysis will determine what is happening, then management and ownership can determine what to do to reverse the trend.

3. Too Much Debt. When a company owes too much in loans and it cannot reasonably be paid back on the previously agreed schedule, it must find ways to reduce the loans, and/or change the repayment schedule. In some cases, the company may need a financial turnaround called a workout. In a workout, the various financial stakeholders rework their agreements with the company such that the company resolves its financial liabilities outside of formal bankruptcy proceedings.

Prudently managed companies try to avoid the prospect of falling too far into debt. How much is “too far”? Alternately, how much is “enough” debt? The answer varies. It’s likely not what is available from lenders, which depends on many factors, including industry and market trends as well as the lenders themselves. Appropriate debt level for a company is a calculation based on management’s confidence in delivering a consistent profitability (EBITDA, for instance), adjusted for known risks of the business. The available supply vs. what the company demands don’t usually match, and companies may choose to forego some available debt that is more than what their management believes to be “enough.” Market-wide, some scholars of finance regard a 6x debt to EBITDA ratio to be the upper limit of “enough.”

4. Other Change Management Issues. These aren’t usually talked about in terms of a classic turnaround, but a turnaround may be needed for many other reasons. Because the company is underperforming other similar companies, because management is better suited for another phase of the company’s development cycle, because underlying organizational or cultural issues require attention, and so forth.

While the term “turnaround” often conjures dire possibilities of existential wrongs at a business, executing “turnarounds” and executing “change management” have many similarities. All require a change in the status quo, including processes, roles, and often the people asked to take on the changed roles and undertake the changed (or changes in) processes. Sometimes the change to the status quo is so fundamental that it alters the very purpose of the business – in startup parlance, a “pivot.”

In all such change, the people driving the change and who are part of the change must embrace the new, and part with what was previously the norm. These orchestrated changes in a business are often needed because businesses that do well for a time can drift along gently, not noticing or adjusting to natural changes in environment, market, competitive set, team, and others that amount to slow growing vulnerabilities. Particularly for long serving team members, such vulnerabilities and the attendant need for change may not be readily apparent, and any change efforts may be seen as threatening or unnecessary.

Change of the “turnaround” or “change management” variety has a singular purpose, which is to improve the business’s prospects and ability to compete. Sometimes the needed improvement is indeed existential, which heightens the urgency of the change activities. Regardless, the more rapidly and enthusiastically a team participates in organization-wide change efforts, the more efficient and more thorough the prospective improvement in business quality. In such a season of a business’s life, the team is called upon to start anew – to carefully till the ground and sow new seeds, in hopes of a better future harvest.