EUROPEAN MID-MARKET II: TURNAROUNDS

Not surprisingly, many fail to appreciate the aesthetic quality of the credit market fallout which added to more general economic fears and which potentially threatens numerous companies with the prospect of default. Yet turnaround professionals' mouths are watering at the prospect of overleveraged companies running into trouble.

Take Alchemy Partners' Jon Moulton's Christmas message on sister website PrivateEquityOnline.com, for example: “Many people will enjoy the difficulties the mega funds will have both funding new deals and keeping their highly leveraged progeny afloat. Integrity and real due diligence will return to the system. Bubble burst!” The excitement is palpable and Moulton's taste buds are clearly tingling at the prospect of some under-performing companies to feast on.

For all this, turnaround professionals have not seen a dramatic uptick in deal flow as yet, but their mood of expectation has been buoyed by endless gloomy headlines. They can see the right patterns emerging. Paul Cartwright, a managing director of UK turnaround specialist Rutland Partners, says: “I wouldn't say we've seen more deals but we expect that to change.”

Matt Prest, who undertakes restructuring consultancy work as a managing director at Close Brothers Corporate Finance, has already started to see an increase in clients with problems, although these haven't manifested in a distressed sale yet: “We have seen an increase in the number of companies facing covenant pressure in the past three to four months, but I don't expect an avalanche of defaults in the next few months.” But he adds that leveraged loan default rates are likely to rise to around 10 percent in the next two years.

It is safe to say turnaround professionals are confident there will be more work soon.

FINE-TUNING
The business of turnarounds is more about fine-tuning ailing businesses than attempting to give the kiss of life to those in a near-terminal condition. Those who have pulled off successful recent restructurings in the private equity arena such as Swiss buyout firm Argos Soditic or global private equity investor Advent International refuse to take on turnarounds where the business has negative cash flows. But both have had significant successes at businesses that were cash-neutral at the time of acquisition due to various problems.

Argos Soditic exited Swiss cable machinery producer Maileffer Extrusion with a ten times return on its investment from the CHF250 million (€156 million; $229 million) sale last month to trade buyer Alpha Groupe. Its seven-year turnaround began after it bought the unprofitable business from Nokia just as the telecoms boom was coming to an end. The business' EBITDA rose to CHF30 million during the firm's ownership and is forecast to increase next year to CHF45 million.

Guy Semmens, the partner at Argos Soditic who led the transaction, said: “Nokia were focussing on fibre optics and they wanted to dispose of what they saw as a mature business.” Argos Soditic began spinning off aspects of the manufacturing function to refocus Maileffer as a more design-focussed business. He says that, after the turnaround, the business brought the number of parts it manufactured down to almost zero. This refocussing of the business allowed the firm to make profits in a mature industry, which had been unprofitable before.

Advent International pulled off an equally tough turnaround at German electronic components manufacturer Moeller, which sources in the market cite as a classic example of the rewards astute turnaround investing can bring. Advent bought the business in 2003 when it was on the verge of insolvency, according to general manager Ralf Huep. It sold the business two years later to Doughty Hanson for €1.1 billion, while retaining a 15 percent stake.

The business was cash-neutral because while the business' components division was performing well, with around €60 million in EBITDA, the systems division was “eating up all the money”. Huep says: “We felt this division was not in a position to survive but it had some 4,000 employees, and if we shut it all down it would cost ‘x amount of euros’. We felt we were better off to go into a much more painstaking process [of selling off parts of the division to trade buyers].”

The company had been in disarray for five or six years largely because of this loss-making division, Huep says. When Advent took over, around 80 percent of the shares were no longer in the hands of the founding Moeller family but rather in the hands of the business's banks, he says.

Contrary to Advent's expectations, sales at the components division went up around 10 to 11 percent once people understood there was a new investor putting money into the business. This led to EBITDA growing from €60 million to more than €100 million, while Advent simultaneously managed to dispose of the systems division.

Moeller was sold to trade buyer Eaton Corporation two months ago for €1.5 billion with Advent exiting its 15 percent stake alongside Doughty Hanson, leading to a three times return for the latter, while Advent's overall return was undisclosed. Due to the way Advent disposed of the loss-making division, only 400 people lost their jobs as a result, Huep says – and they were able to find jobs at the strategic buyers which acquired the separate parts of the division.

CAUTION
Due to the complex nature of turnarounds, success stories are of course only one part of the story. Many ‘turnaround’ candidates never do end up being turned around and it's a strategy therefore at the riskier end of the private equity spectrum. Limited partners acknowledge that the opportunity for turnaround specialists is promising in today's environment, but still express caution.

Wim Borgdorff, managing partner at Dutch LP AlpInvest Partners, which has around €40 billion under management, says: “The number of pure-play turnaround managers is very few although there is a lot of leak-through from managers which have a somewhat broader mandate. We do have a distressed component in our allocation which is consistently somewhere around 5 to 7 percent of the overall allocation and we've had that for five to six years.” Borgdorff says this segment is reserved for firms that buy debt for control as well as the equity turnarounds which are the focus of this article. “To give you a feel for magnitude, our allocation could go up to 10 percent and that's it. This is not a huge universe of manager opportunity.”

He adds: “For the last few years many people have been talking about the next wave of distressed that was to come and there has been a lot of money earmarked to invest in the distressed marketplace. But people shouldn't look at this segment as the sort of area where you can play the allocation game. It is a hairy market where performance has been spotty and cyclical.”

Nonetheless, if you identify the best managers, there is potential for a high risk-adjusted return from the space. Plus, in a diversified portfolio, it can provide returns to compensate for strategies impacted adversely by an economic downturn.

Turnaround professionals able to detect the hidden charms of faltering companies may well have the opportunity to prove themselves in the coming period as worthy recipients of LP capital. Many expect this to be a time when the idiosyncratic talents of the turnaround gurus will provide investors with something to smile about as many of their other investments undergo a severe examination.