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What's up in private equity turnarounds?

The current economic downturn is bad news for most people, but not for those who specialise in turning ailing companies around. With all that choice in the market, where are the most – and least – promising opportunities appearing? And what stumbling blocks do private equity turnaround professionals come up against? We asked a panel of specialists for their views.

Our panel of experts are:

	Jon Moulton, managing partner of Alchemy Partners, a specialist in turnarounds and public to privates in the UK
	Gary Klesch, chairman of Klesch & Co, which specialises in investing in European companies in need of restructuring
	Ollivier Lemal, directeur general of Plantagenet Capital, a US and European firm that makes early-stage venture, strategic buy-out and turnaround investments

Where are you seeing the most opportunities at the moment?

Moulton: ‘The private equity turnaround market is quite small - it's only a tiny sub-set of the general turnaround field. The deals that work for us as private equity players are those in which companies need liquidity to keep going, where there is a business worth saving and where we can get management control - turnarounds without management change are extremely difficult and very rare. So, by the time you have run these three criteria across troubled companies, the universe is actually pretty small. Some players would define a deal in which a company is making, say, two per cent pre-tax profit but that should be making six per cent as a turnaround. I'd call that a turn-up.

‘We are in the world of heavy loss-makers with sales of between £50m and £500m. We see about two or three of these a month and we do about two or three a year. Last year we did three; this year we haven't done any as yet. In sectoral terms, there is no great concentration of opportunity. Having said that, there are a lot of small and medium-sized manufacturing companies in distress and their problems are made that much more acute by their large pension liabilities.'

Klesch: ‘We are seeing a lot of deals in industries that are threatened by China. The automobile sector, for example, is in the process of moving all its production processes out to China. That means automotive suppliers in the US or Europe are in trouble - there will be no growth in their market. The same applies to white and brown goods manufacturers and to heavy manufacturers throughout Europe. These companies are really struggling. It doesn't mean that you can't make money from them; it's just that your model has to be entirely different. If you understand the rules of the game then you'll know how to play it. These companies need to start preparing themselves for decreasing turnover, decreasing market shares, decreasing markets. They need to cut themselves to the bone and come up with new ways of doing business. That creates huge opportunities for turnaround players.'

Lemal: ‘We are very busy on turnarounds at the moment. I wouldn't say that we are seeing one sector or type of business over another - we are seeing a high volume from all parts of the economy. But one thing has changed over recent years. The first question we ask ourselves when we look at a deal is whether this business in a sector that will still be in Europe in five years' time? The threat from Asia, and more particularly China, is very new and it's quite shocking how quickly it has become a major issue for European businesses. As a result, we are only interested in areas that have a real future in France - and very often that means the service industry.

‘The other thing we are doing is building a turnaround consultancy as a separate arm from the investment side. The turnaround business is not very developed in France. We believe that we can provide companies with the unique know-how we have built up over the years on a consultancy basis.'

What wouldn't you touch with a bargepole?

Moulton: ‘Very little. We wouldn't do a large contracting turnaround. We have had no success in those and neither has anyone else. They are fundamentally feeble businesses, you never know the depth of the hole you are puttying money into and then the money at the end is usually pretty slight. I am also very suspicious these days of manufacturing. These businesses are swimming against the tide and they often have large pension and environmental liabilities. We are looking at some turnarounds in which the key issue is a dramatic restructuring to get rid of pension liabilities. It's brutal territory and a very unattractive activity for anyone to be involved with.'

Lemal: ‘The threat from China means that we are not looking at heavy industries any more. We are also constrained by the state welfare system in France - it makes it very difficult and expensive for us to make redundancies unless the company is bankrupt. As a result, we are reluctant to intervene in companies that employ a large number of people.'

Klesch: ‘I wouldn't touch pharmaceuticals and other industries that are heavily reliant on research and development. I won't go into business that are reliant on the skills of particular people, services such as advertising agencies and consultancies. We are also staying away from the construction industry. But we are in negotiations with companies in all other areas that are quite sick.'

What are your main challenges?

Klesch: ‘The most obvious challenges relate to labour laws and the difficulty of downsizing companies in trouble. The not so obvious obstacle is trying to restructure when you have a sick banking system around you. It's very tough dealing with banks on a day-to-day basis - they are shell-shocked and can't make decisions. They are also now very risk-averse and the Basel II accord is not going to make things any better.

‘Another challenge we're facing is with the companies we have turned around over the last five or so years. We have worked extremely hard to build excellent businesses, but valuations have come down so much over the last two or so years, it makes it a nonsense to sell.'

Lemal: ‘The social expenses we have to bear in a restructuring are a big challenge for us. Another is finding the right people. When we turn around a company, we set the strategy but we don't get involved in the day-to-day management of the business; we find other people to implement that strategy. It is very difficult to get these people. As you can imagine, turnarounds are a lot of work and there is a lot of pressure involved - it's not always an easy sell to managers.'

What occupies you in better economic conditions?

Moulton: ‘I don't think we're in particularly bad times at the moment and we're busy enough. Low interest rates provide a lot of cover for businesses and banks are not applying severe pressure at the moment. Outside of hotels and leisure, there is no particular industry in great distress at the moment. The UK economy has been the strongest in the West by per capita growth over the last decade or so. It doesn't feel like it, but it is not doing too badly.'

Lemal: ‘In better economic conditions there is less opportunity to invest, but it's easier to turn a company around. So we spend more time on sourcing deals than restructuring during better times and vice versa in difficult times such as now.'

Klesch: ‘It depends on what you mean by better conditions. I don't see the macro environment picking up in the near or even medium term. If that's true, we, as turnaround guys, have to adjust our expectations. Whereas previously we might have been able to achieve 30 to 40 times our money, the future will see much lower returns. That means we have to work hard on entry prices.'

What is a typical holding period for you?

Lemal: ‘A good holding period for us is between two and three years. After that time, the needs of a successfully restructured company change. Once you have managed to effect a U-turn, the business should be managed less by a turnaround mentality and more by a development mindset.'

Klesch: ‘It is in the five-year range. This is not your typical private equity play. You can't get these companies out the door within 18 months.'

Moulton: ‘Holding periods in turnarounds are shorter than those for traditional buy-outs. If they are going to turn around, they will do so in about a year. You then have a couple of years to get them into a more interesting state - tidy up the balance sheet, get some growth, develop new products, etc - to make them saleable. They are mostly in low or no-growth industries and so after you have managed that, you should be selling them on. Up until 2000, I had done around 30 turnarounds and the average holding period was three and a half years. I can't really say beyond that because last year there simply were no exits.'

Many people think of turnaround players as asset strippers. What is your response to that?

Klesch: ‘This is an American concept - it is feasible in the US. Asset stripping doesn't translate into a European context because it is impossible to do over here. In the US, you can go into a company, fire the people, sell the assets and walk away with the money. If you look at France, Germany or Italy, all the employees in a company come ahead of secured lenders. If you tried to do it in Europe, you would end up with nothing. You just can't do it here.'

Moulton: ‘Sadly, we see very few asset-stripping opportunities. We are not philosophically or morally opposed to it as a concept, but it is just extremely rare to find instance in which it will work. Out of all the turnarounds I've done, there have probably only been two in which we were able to strip out the assets - and of these, I think people would fairly characterise the deals as buying a set of assets rather than a business. Usually the assets are irresistibly trapped in the business.'

How do you see the future for the private equity turnaround markets?

Klesch: ‘The future looks good for us. We are going to have an extremely active few years. We're looking at so many deals right now that we are going to be very busy.'

Lemal: ‘In Europe, larger and larger companies are facing problems. As a result, private equity turnaround players will have to deal with issues on a global rather than an international basis. I would really like to help a large company that is struggling with its strategy and take a very European view on it. We would need to work in partnership with our network of contacts across Europe. In these types of deals you have to think globally, but you have to implement the measures locally.'

Moulton: ‘The Enterprise Act will have an effect on turnarounds - although it may not be so great for private equity as whole. It will become much less attractive for banks to put companies into bankruptcy and so there will be a lot more effort put into turning companies around. I'm not sure that it's good news. It will result in banks lending less to companies because it will be harder for them to get it back if things go wrong. And it's also sometimes far better for the economy in general for a company to be closed down and its assets and people redistributed to something more productive.

‘Having said all that, it should be favourable to us as turnaround players, on balance. There will be situations in which banks are neither willing to inject more money nor wishing to contemplate the pain or grief of a receivership - at that stage of the proceedings they will come way down the pecking order. So we will see more deals. The future may not be glowingly bright, but it looks as though the lights are pointing in the right direction.

‘I don't think we'll see growth in terms of competition. This is a very tough business. You have to do it in a rush on the basis of very poor information. You can find that, three months down the line, the business is in a much worse state than you originally thought. Desperate people often do desperate things. So you have to have a tolerance for losing some money rapidly. You can make a lot of money, but you can also lose a lot.'

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