249 The investment was realized through a NewCo owned by two venture capitalists, the founder family, and the new management team, which has acquired 100% of HAIR & SUN with an EV of 40 million and a debt raised of 19 million. The potential exit strategy is to list the company or, if this option cannot be realized within three years, a trade sale of the total company. A16.4.3 Critical elements of the investment HAIR & SUN was targeted because of its brands, the realistic possibility of expansion of the foreign market share and into the global sector, and a potential IPO to be realized within a pre- defi ned amount of time. A16.4.4 Management phase activity and exit The investment is ongoing. Appendix 16.5 A business case: BOLT A16.5.1 Target company BOLT was founded in the 1970s and originally focused on manufacturing fasteners and related products adding, over time, a set of value-added services including quality control and logistic and category management. It has become a leader in the domestic market. Because of this strategy, half of the revenues come from the value-added services and half from traditional trade activity. A16.5.2 Investment structure The deal was closed during the third quarter of 2004 and structured as an MBO with the involvement of two private equity investors. The NewCo acquired total control of BOLT with private equity subscribing 87% of the shares, leaving the remaining shares in the hands of the managers that built a longstanding relationship with former BOLT shareholders. This structure provided private equity investors full freedom of the private equity to create an exit strategy. The equity value of BOLT was valued at 22,5 million and the fi nancing acquisition was 13,3 million with a debt to equity ratio equal to 0,60. A16.5.3 Critical elements of the investment BOLT was acquired because of its leadership position in the domestic market and high poten- tial growth rate, its previous positive economic results, the strong and healthy relationship with important domestic industrial groups, the qualifi ed and motivated management team, and the appealing multiples used for valuation. 16.4 Conditions for a good and a bad buyout 250 CHAPTER 16 Financing buyouts A16.5.4 Management phase activity BOLT ’s revenues during the holding period signifi cantly increased but it needed additional investments to realize a new logistic structure to better satisfy demand. A16.5.5 Exiting Venture capitalists disinvested at the end of 2006 with a 100% trade sale signed with an inter- national logistic group. Appendix 16.6 A business case: WORKWEAR A16.6.1 Target company WORKWEAR , a leader in the European market of protective and work wear made of poly- cotton, was founded in the late 1960s. It has gained a strong position in the rental clothing market with more than 50% of the European market. WORKWEAR’s customers are located mainly in the UK, Italy, France, Belgium, Germany, and Scandinavia. A16.6.2 Investment structure The LBO, launched during 2004, was built through a NewCo owned by two venture capital- ists (91%) with the equity capital of the former CEO of WORKWEAR. The NewCo acquired WORKWEAR for an EV of 34 million with a debt structure of 10 million. A16.6.3 Critical elements of the investment This main advantages of WORKWEAR’s acquisition were the appealing entry multiples, its posi- tion as the leader of the European work wear market, its technical skills, the stable relation- ship with important European companies, the recently completed manufacturing investment, and the realistic opportunity to enlarge the market because of strict regulations on work wear safety. A16.6.4 Management phase activity After the deal, WORKWEAR had unexpected increases in production costs and low sales prices due to competition from the Far East. This resulted in several years of bad performance. To deal with this negative situation, WORKWEAR executed a reorganization of the manufactur- ing and production process with positive fi nancial results in 2007. A16.6.5 Exiting A successful exit strategy was realized in 2008 by selling 100% of WORKWEAR to a Middle Eastern textile group. 251 Appendix 16.7 A business case: TELSOFT A16.7.1 Target company TELSOFT , founded in the 1980s, develops software applications for fi nancial and industrial use such as credit risk management and pay and cash systems. It was the target of another company, CONSULTIT (founded in 2000), which offers consulting servicing to fi nancial and corporate institutions such as IT consulting, process and system design, package implementa- tion, and customer development. It has also expanded its business into the travel management industry. A16.7.2 Investment structure The LBO launched in 2008 was sponsored by CONSULTIT management and a venture capi- talist that purchased 35% of its equity capital. The value of the deal was 17 million, fi nanced partially with debt of 11 million. The remaining investment was realized by a private equity fund and CONSULTIT’s management. The shareholder agreement provides an exit strategy of listing the company within a fi xed period of time or a buy back from the majority shareholders. A16.7.3 Critical elements of the investment This deal was realized because of the opportunity for CONSULTIT and TELSOFT to became one of the leaders in the fi nancial services market in terms of increasing products and ser- vices offered. This deal is considered a strategic industrial project between two complementary businesses. A16.7.4 Management phase activity and exit The investment is ongoing. 16.4 Conditions for a good and a bad buyout This page intentionally left blank 253 Private Equity and Venture Capital in Europe: Markets, Techniques, and Deals Copyright © 20xx by Elsevier, Inc. All rights reserved.2010 Turnaround and distressed fi nancing 17 INTRODUCTION This chapter discusses two types of deals: turnaround or replacement fi nancing representing more than 50% of the private equity market and distressed fi nanc- ing, which includes deals realized when the target company is in bad condition or in a crisis. These deals are discussed because they both concern companies facing management, economic, and fi nancial problems that have a direct impact on their survival. 17.1 GENERAL OVERVIEW OF TURNAROUND FINANCING As previously mentioned, replacement fi nancing is 50% of the private equity market. This type of fi nancing is given to fi rms that need managerial support to reorganize and restructure a mature company without fi nancial resources. There are three main subcategories of replacement fi nancing that are widespread with different and specifi c risk profi les: 1. Succession and transformation strategy — Manages a transformation or property transfer in a company. Existing shareholders involve private investors as a third party that can lead the decision process to make changes. The investor must be part of the Board of Directors to have a formal and substantial position in these decisions. To guarantee the return from this type of investment, shareholders must have contractual certainty that the venture capitalist will sell his shares at an established price within a predefi ned period of time on exit. This provision allows the private equity investor to obtain the desired capital gain. CHAPTER 254 CHAPTER 17 Turnaround and distressed fi nancing 2. Buyout operation — This type of deal is specifi cally studied and analyzed in Chapter 16. To execute the total acquisition of a target company, an LBO is realized with heavy debt fi nancing. The private equity investor sup- ports the deal with fi nancial resources and the technical skills and knowl- edge necessary for the construction and organization of the deal. 3. Merger and acquisition strategy — This occurs when a fi rm decides to grow quickly through acquisitions. The management team of the company or the entrepreneur needs to be supported by a professional intermediary with fi nancial resources and soft services such as an international network of relationships necessary to expand beyond the domestic market. Private equity investors usually subscribe risk capital to the target company so they can earn fees for their support services. 17.2 CHARACTERISTICS OF TURNAROUND OR REPLACEMENT FINANCING Turnaround fi nancing is risk related to target company downsizing, but the cen- tral concept that must be considered is connected leadership. During this type of deal, management skill and exceptional leadership profi les are the two most important elements for a successful outcome. Managing the replacement for a distressed company is fraught with diffi culties for the turnaround practitioner. First, the turnaround executive has to persuade the key stakeholders that this type of intervention is the best solution for the recovery of their company. Then a change of management is usually necessary, but it is not always easily realized, because the fi nancial intermediary has to negotiate with the previous chairman. Another consideration is the fi nancial and economic condition of a fi rm that needs this type of fi nancing. If it wants to avoid bankruptcy there must be a sense of urgency in the process. Usually, the turnaround practitioner decides to implement an effi cient and well-organized management and fi nan- cial controls to develop and communicate a new vision for the business. When this is done, he will obtain the support and collaboration of the entire group of employees. There are two types of turnaround executives: those who specialize in cri- sis stabilization and those who undertake the complete turnaround process and stay and work for the target company to manage growth and organizational transformation. In general, the fi rst group of executives stays in the company from 6 to 12 months, whereas the second group is likely to stay in a leadership role from 12 to 24 months. 255 17.3 THE MAIN REASON FOR TURNAROUND OR REPLACEMENT FINANCING In the fi nancial environment, technology, competitiveness, and the expectation of demand change quickly. This makes it necessary for companies to modify and adapt their strategies and organizational structures to survive and remain com- petitive. Underperforming companies have to fi ght to exist and deliver a service or product able to generate a return that exceeds the connected cost of capital. These rearranged strategies include a clear sense of purpose, direction, and realistic long-term rules that are viable because companies want to perform bet- ter and maintain a competitive edge. A company that is targeted for replacement fi nancing has already passed its embryonic stage and is headed into the development phase. Within this next stage there are problems connected with its organizational structure (manage- ment) that make it diffi cult to move into a mature phase. Consequently, when a venture capitalist decides to invest in a turnaround operation, he must know that a lot of energy will be spent solving issues related to management activity. Once these are solved, successful modifi cation of the competitive strategy and structure can begin. Strategic changes realized by companies are meant to move toward a future desired condition such as reinforcing competitive advantages. This process is very complex and only a few successfully manage it by launching new strate- gies and new structures to obtain an effective and renewed value proposition. It is important to recognize the sharp difference between strategic and organi- zational change. Strategic change refers to the realization of new strategies that lead to a substantial modifi cation of the normal business activity of the fi rm, whereas organizational change is the normal consequence of redefi ning the business strategy. In conclusion, a strategic change always includes an organi- zational change, especially when it is suddenly implemented without relevant resistance. As previously outlined, the typical company targeted for a turnaround deal is going through its mature phase and needs a renewal of the value proposition for its economic survival. Turnaround operations are part of strategic changes that include the reengineering, reorganization, and innovation processes: Reengineering — Sweeping change in the company’s costs, production cycle, services, and quality with the implementation of different techniques and tools that consider the fi rm as a complex system of customer-oriented processes instead of just a cluster of organizational functions. The emer- gence of aggressive new competitors in the market can force the company 17.3 The main reason for turnaround or replacement fi nancing 256 CHAPTER 17 Turnaround and distressed fi nancing to fi nd new strategies to recover their loss of competitiveness. The com- pany’s management team has to focus its attention fi rst on critical busi- ness processes such as product design, inventory, and order management and then on customer needs, constantly monitoring how to improve the quality of the value proposition with a lower price. Implementing quality methodologies such as total quality management to improve process effi - ciency should also be a focus of management. Reorganization — This is the second way management can launch a change, and it is composed of two main phases. In the fi rst phase the fi rm reduces, in terms of number and dimension, business units, divisions, departments, and the levels of hierarchy. The second phase begins downsizing to reduce the number of employees to decrease the operational costs. A company decides to implement a reorganization because of the external environ- ment; for example, a technology revolution that makes their product obso- lete, a recession that depresses demand, or a law deregulation that changes the rules. A fi rm usually reorganizes because it has not renewed its strategies and man- agement to align with the environmental changes. Reorganization repre- sents the only way to survive and regain the lost competitiveness. Innovation — A strategic change pushed by new technologies that impact the production process and lead to a new confi guration of the company ser- vice and product. To anticipate competitors, a company has to introduce a new production process or technology with a redefi nition of its strategy and follow the innovation wave of the industry. 17.4 VALUATION AND MANAGEMENT OF RISK The company targeted for a turnaround deal generally suffers from cash fl ow problems, insuffi cient future funding, or the inability to service their debt. It can also have an excessive debt equity ratio and inappropriate debt structure unbal- anced between short- and long-term debt, and balance sheet insolvency. The objectives of a fi nancial restructuring are to restore the solvency of the company, in terms of cash fl ow and balance sheet, align the capital structure with the planned cash fl ow, and ensure that enough funds will be collected to implement the turnaround plan. These objectives are reached by modifying the existing capital structure; for example, raising additional funds, renegotiat- ing the debt, or raising new equity capital from existing shareholders or outside investors (venture capitalists). 257 The private equity investor has to consider four fundamental risks when structuring a turnaround deal: 1. Social risk — When a fi rm is in crisis it strongly impacts both society in general and the fi rm’s stakeholders. During this time the fi rm has prob- lems with creditors, suppliers, employees, and customers. The community is affected by the loss of taxes paid by the fi rm and the costs to support employees who have lost their jobs. 2. Economic risk — The economic crisis of a company is analyzed by their return on investment (ROI); if it is lower than the average industrial ROI, the company is underperforming. This analysis can be problematic, and a better indicator of economic problems is the decline of the entire indus- try. A company is in crisis when its fi nancial performance is continually decreasing in terms of ROI and return on sales and when the net incomes are negative. 3. Legal risk — The bankruptcy of a company raises many legal issues. 4. Management risk — From a management point of view, a company is in crisis when the ROI starts to decrease. Managers are the fi rst to under- stand the situation and know if the crisis can be averted. There are fi ve different types of turnaround strategies in terms of operation impact, operations changes, and exiting the crisis: Management — The key factor is management change. The objective of this type of deal is to turnaround the weakness of the management and general culture of the company. This is the most frequent type of turnaround. Economic cycle — Turnaround is provoked by the economic cycle of the sec- tor. Management must maintain the stability of the company while exploit- ing the potential revival of the cycle. Product — The company is able to exit the crisis by launching a new product because of a new technological innovation. Competitive background — Firms come out of a crisis because general ele- ments in the competitive background change positively, such as decreasing the costs of raw materials. State and government — When the crisis is provoked by market conditions out of the fi rm’s control, the government provides help to solve their fi nan- cial problems; for example, the automotive industry. 17.4 Valuation and management of risk 258 CHAPTER 17 Turnaround and distressed fi nancing 17.5 MERGER AND ACQUISITION Acquisitions represent one part of the merger and acquisition (M & A) operation. To be more precise, acquisitions are composed of all the services that support the closing of operations that produce structural and defi nitive modifi cation on the corporate aspects of the involved company. M & A represent one of the technical solutions developed and supported by private equity investors during turnaround and replacement fi nancing. M & A operations include a set of hetero- geneous deals such as mergers, the acquisition of a business unit of a company, the acquisition of quotes that represent a minor participation of the capital risk of a company, and all deals that allow the transfer of the proprietary control. In this situation, the role of the venture capitalist is not only the soft support realized through advisory services but also the direct investment in companies with turnaround needs. When they act as advisory providers, economic returns are realized in the fees charged for this soft activity. When they invest directly, the economic return is higher and consists of gains they can realize on exit of the deal through an IPO or trade sale. Advisory support from the venture capital- ist is critical, because the M & A deal is composed of acquisition search and deal origination, due diligence, valuation of the company and deal design, fi nancial advisory and funding, and post closing advisory. This type of deal has a high rate of selection so there is little relation between deals closed and the cases ana- lyzed. This makes the presence of professionals who improve the effi ciency of the information and operative processes critical. 17.5.1 M & A motivations The main reason for M & A operation is to realize a higher total value with the merger of two or more business units or companies than can be obtained if they stand alone as single units or companies. After the merger, production costs are reduced, and there is the possibility of increasing debt capacity and reducing the cost of debt because of the company’s improved rating. Finally, the company has a better market position that affects the estimated rate for the earnings growth. There are fi ve main macro categories that determine if an M & A deal is feasible: Strategic motivation — An M & A can impact a company’s competitive posi- tion; for example, it is possible to enlarge the market share if a dangerous competitor is acquired, activity on the core business can be refocused, entry in a new market or industry, internationalization, and expansion of activity downstream or upstream. It is also an opportunity to enter net- works of specifi c companies. [...]... desirable exit strategy for institutional investors and private equity funds because it allows: The placement of minority shares of the risk capital, obtaining a capital gain and continuing to hold the control of the company Private Equity and Venture Capital in Europe: Markets, Techniques, and Deals Copyright © 20xx by Elsevier, Inc All rights reserved 2010 267 268 CHAPTER 18 Listing a private company A return... then delisted following a takeover organized by two top managers and a venture capitalist, who, during 2006, subscribed a minority participation of the risk capital A17.1.2 Investment structure In 2006 a private equity investor was involved in a replacement capital transaction with a minority participation The deal was developed through a NewCo founded by the venture capitalist with an investment of €8... who followed strategies defined by the venture capitalist and the entrepreneur formalized in a business plan focusing on the reorganization of STUFFED and on the maximization of the brand through: New products Expansion in international markets with direct investments New licensing and franchising programs Renewal and improvement of the wood toys brand and products In three years, the reorganization process... was involved in a replacement capital transaction through a minority participation of 15% of the risk capital Two other venture capitalists who subscribed a minority participation of 15% were also involved The investment was realized through a NewCo with the participation of the three venture capitalists in its risk capital The NewCo acquired 30% of NDS The resources invested by the three private equity. .. comfort and privacy NDS is particularly concentrated on medical, technical, and administrative staff selection and training, while the equipment is continuously updated to ensure cutting edge services NDS’ diagnostic services cover nuclear medicine, radiology, ultrasounds, cardiology, physiopathology, and specialized clinic consultations A17.2.2 Investment structure During 2006, a private equity investor... OVERVIEW OF DISTRESSED FINANCING A distressed financing deal is an investment realized in a company that is facing a financial and economic crisis or is close to declaring bankruptcy When a venture capitalist decides to invest in a distressed financing deal he has to consider the pros and cons of bankruptcy, because it is negotiated with public authorities, under specific laws and rules, and without the freedom... quality and technologically advanced services A17.2.4 Exiting The investment is ongoing but, as per the criteria fixed in the shareholders agreement, private equity investor’s participations are estimated at €20 million Appendix 17.3 A business case: STUFFED A17.3.1 Target company STUFFED is a company operating in the high-quality staffed animal industry and is a leader in its domestic market and in the... toys industry It was founded in the 1950s and its business is based on a completely externalized production, executed by Far East supplier, and on distribution of the products through sales agents in the domestic market In the European market it operates with two owned companies, a joint venture and an agent network A17.3.2 Investment structure In 2002 a private equity investor realized a replacement capital. .. activity During the holding period of the investment, FORFREI developed its business further by becoming a worldwide corporate network in the logistics and supply chain management 17.7 Characteristics of distressed financing 263 The company is the leader in its domestic market, in particular in the North American market It has also expanded its activity to the Far East and South America, improving business... offering diversified services A17.1.5 Exiting The investment is ongoing, an IPO is planned in the first half of 2009 The private equity participation, estimated by the shareholders, is €25 million Appendix 17.2 A business case: NDS 17.2.1 Target company NDS is a nuclear medicine diagnostic institution founded in the 1970s The company is a leader in nuclear medicine and is also active in developing software . modifying the existing capital structure; for example, raising additional funds, renegotiat- ing the debt, or raising new equity capital from existing shareholders or outside investors (venture capitalists) reorganization plan during the holding period of the investment. 17.7 Characteristics of distressed fi nancing This page intentionally left blank 267 Private Equity and Venture Capital in Europe: Markets,. allows: The placement of minority shares of the risk capital, obtaining a capital gain and continuing to hold the control of the company CHAPTER 268 CHAPTER 18 Listing a private company A return