Letter number 33 of June 2008


News : Being CEO of a company in crisis

A company can be considered financially stressed if it is not in a position to honour its short term liabilities. In simple terms, the stressed financial situation we will discuss here is a cash crisis.

The liquidity crisis is not the only crisis a company might face in its life, nor necessarily the worst. A long strike, an obsolete technology, a loss of confidence from clients, a durable inability to break-even are the types of crisis that can threaten the survival of a company when a liquidity crisis coming from a temporary increase in working capital  can be swiftly solved.

The cash crunch is nevertheless the acutest crisis in the sense that it can cause in a very short time the collapse of a firm; in comparison it can take months or years for an unprofitable company to get into distress.

When a liquidity crisis occurs, the CFO will need to master three management acts: to forecast, to decide a strategy and to communicate.

1. Forecasting
Time is a key factor when a company gets into financial stress. There is no way a CFO can expect to resolve successfully a liquidity crisis without mastering this factor.

The first signs of a foreseeable cash crunch should be detected as early as possible; then it is important to evaluate with precision the number of weeks before the liquidity disappears.

a) The detection of  a foreseeable stress situation

Check the right liquidity indicator. The profitability KPIs, part of most Balanced Score Cards, might give a first indication of trouble ahead but are not precise enough to give relevant information on the timing of the cash crunch. Too many firms, very well equipped in P&L indicators monitored by competent management accountants do not have the basic indicators to forecast their cash-flows, apart from daily bank balances and monthly Budget forecasts which are not always up to date.
A Cash Flow Statement comparing Actual v Budget/Latest Forecast must be part of all monthly reporting packages. This Statement splits the Cash Flow (CF) into three types of flows:
 Cash Flow from operations: Ebitda, W/C
• Non operating Cash flow: capex, disposals, exceptional items, corporate tax,…
• Cash Flow from Financing Activities: cash interest, debt repayments, new borrowing,…

Analysis made from the Cash Flow Statement provides the CFO with three major findings:
• The size of the cash head room: in case of an indebted company, this is the difference between CF before Debt Service (Operating CF + non Operating CF) and Debt Service; for a company without debt, the level of CF compared to its potential overdraft
• The sensitivity of the CF to the sales and profit fluctuations (very high in Retailing with negative W/C  and low capex , less in heavy industries)
• The key factors of the liquidity and the risk areas

A good command of the liquidity levers allows for quick actions when the company gets into stress.

b) Managing time

When a company knows that it will become financially stressed, the first step is to evaluate precisely how much time is available before it runs out of cash so that its management decides which levers to activate.
The most frequently used tool is the 13 weeks CF forecast, split by day or by week. Building such a forecast consists in a bottom-up exercise on estimating future inflows and outflows based on facts coming from the departments/services which generate these flows. This tool must be updated monthly or, even better, weekly.

Having a definite idea of the time available for action helps the management in planning the appropriate turnaround strategy.
II. Deciding a strategy

To overcome successfully a cash crisis, it requires from the CFO, first to optimize the cash generation across the whole cycle of operations and then to act on the financing of the company.

Priority should clearly be given to “unlock” the cash unnecessarily “frozen” in the company. It would not be realistic for the management to believe that solving the crisis is just a matter of asking for, or negotiating larger facilities, especially in the present banking context where liquidity is more restricted.

a) To improve the cash situation, the CFO has to play on two sets of levers: operating and non operating Cash Flow

i) The levers of the Operating Cash Flow are concentrated in two areas: maximization of the profit and optimization of the Working Capital

The priority given to the Cash Flow leads to some decisions which would not have been made in normal times: cash consuming development projects might have to be postponed, discretionary costs have to be reviewed to determine those who are not critical to the survival of the company and therefore can be cut, purchasing policies based on obtaining rebates in exchange of large orders have to be questioned and hiring has to wait.
Optimizing the Working Capital leads to three types of actions:
• reduce the lead time between the order of the goods/services and their payment: (cash deposit requested when placing an order, control of payment terms by clients,…)
• shorten the production cycle and in particular control the level of inventories (raw material, work in progress and finished goods)
• challenge the terms of payments to the suppliers (e.g. discount for early settlement,…)

ii) Non operating Cash Flow is mainly driven by Capex and Exceptional Items.

It is the CFO’s role to impose a strict discipline in the process of committing money and to only allow investments which are essential to the survival of the company (e.g. capex for productivity improvement or capacity increase might have to wait).

The crisis CFO is not only someone who can impose discipline within the company but he should be also able to identify the areas where cash is trapped unnecessarily. He will have to use this capacity to challenge existing practice or organization when come the time to look for financing.

c) Before starting to negotiate with lenders, the CFO must review the assets of the company to identify potential opportunities to release cash

i) One of the first tasks of the senior management of a stressed company is to define the core business to get focused on. Any assets outside this core business can potentially be disposed.

Even those assets belonging to the main strategy of the company can be transformed into sources of cash: sell and lease back of real estate and factoring of receivables are two classic examples.

Having explored all the possibilities to release cash from the company and included in the cash forecasts the amounts which can be realistically transformed into liquidity, the CFO is at last in a position to demonstrate the extent of the cash required and the capacity to repay any additional borrowing.

ii) The negotiations on refinancing the company can then start on a solid and factual basis. These discussions might sometime require the assistance of an expert, appointed or not by the court. This is always a tensed period for the CFO as he has to arbitrate between resolving the liquidity crisis and preserving the future independence of the company.

In many countries the management of a distressed company can decide to ask the court to protect it against actions by its creditors (chapter 11 in the US, “Procédure de Sauvergarde” in France) for a limited time during which a turn around plan can be built and put forward to the creditors.

III. Communicating during the crisis

This is one of the most difficult tasks for CFOs who are very often not used to communicate outside the company.

The balance is often difficult to reach: on the one hand remaining silent over the difficulties will let rumours spread, on the other hand being naively too transparent might create a panic effect.
The communication has two types of targets: the actors within the company and the business partners outside.

a) Communication within the company

Besides the shareholders whose contribution might be requested during the refinancing negotiations, two groups inside the company are of a particular importance: the senior management and the employee representatives.

i) In a stressed situation, the CFO needs the active support of the senior management

Efficient actions to release cash from the business require the collaboration of all the operational managers who must understand that the survival of the company is at stake. Senior management must feel part of the rescue effort and must be asked to contribute to the improvement of the liquidity situation by suggesting solutions at the level of their departments.

Senior Management has to be kept informed on a regular basis of the evolution of the situation to be a step ahead of the unavoidable rumours.

When the company gets out successfully from a well managed crisis, the management has always gained in strength and solidarity.

ii) The Workers Committee requires some specific attention for two reasons: kept informed right from the start of the difficulties it can help fight the rumours and it can facilitate the understanding and the acceptance of some difficult cost cutting decisions.

b) Communicating outside the company

Among the various partners of a company (clients, suppliers, lenders, State, local authorities, press,..) it is worth mentioning the importance of the Credit Insurers.

More and more companies decide to insure their receivables. The insurers therefore keep a close check on the financial situation of the companies who owe money to their clients (the insurer’s clients).

There is no commercial relation between the Insurance Company and the stressed firm which finances its activity through credit granted by its suppliers (Payables) and guaranteed by the Insurance Company.

The CFO of the stressed management having no leverage to influence the opinion of the Insurer must communicate with him in a proper manner to prevent any reduction of the level of payables guaranteed by the Insurer.

When an Insurer decides to reduce its guarantee, the supplier has the choice between not changing his terms of payments and therefore self-insuring the payables not covered by its Insurer (unlikely) or asking for early payments to maintain the level a payables within the reduced guarantee limit.

A miscommunication with Credit Insurers can rapidly worsen the liquidity situation of the company by a sudden increase of its Working Capital. Any risks of reduction of guarantee by the Insurers must be simulated in the cash flow forecasts.

A cash crunch can be time consuming for the management to handle when the attention on the running of the operations is most needed. Many companies choose to be assisted by expert consultants on Financial Restructuring.
Despite the tensions and the uncertainties, the management of financial crisis, when successful, remains as probably one of the most enriching experiences in the career of a CFO.
Senior Director – Alvarez and Marsal
Alvarez and Marsal is a global professional services firm with 1200 employees in 13 countries, working on Restructuring, Turnaround and Performance Improvement

Statistics : ROCE and WACC

Value is created when a company is able to get a return on its assets higher than its WACC (1). If the economy were behaving as modelled in some simplified models this would be Mission Impossible.

Over the last 15 years, the largest European listed groups, registered spreads between 0.1% (1994) and 3.9% (2006). In a nutshell, this is not impossible but very hard, even for the most powerful groups, to achieve!

The correlation of the difference between ROCE and WACC on the one hand, and stock prices on the other, is striking but logical.

Analysts are still optimistic for 2008-2009. We hope they are right but we believe they are wrong! At least this what investors seem to be thinking at the moment (witness current stock market performances).
(1) For more on this, see chapter 32 of the Vernimmen.

Research : Hedge fund activism and corporate governance

An article published this year by four US academics (1)  provides valuable new insight into the workings of corporate governance. They looked at the specific role played by hedge funds (2), which over the last 10 years have become major players on the market. Their work, based on the US markets from 2001 to 2006, shows that activist hedge funds created lasting value for shareholders.  These results are of fundamental importance, for at least two reasons.  Firstly, they dispel the myth  that hedge funds are only interested in short-term results and they allocate a role to hedge funds that is distinct from that of other institutional investors.
Empirical studies carried out to date have not shown any significant impact of investment funds on the value creation. Unlike most UCITS, hedge funds are not forced to diversify or to ensure that their assets can be readily liquidated. Additionally, the remuneration of the managers of such funds consists of a share in the capital gains made, and is not a percentage of the assets under management. This makes them very performance oriented. Focusing on hedge fund activism, Brav et al note a large positive average abnormal return of around 7%, which is particularly high.

The activism measures analysed are those described by managers of hedge funds on forms filed.  These included maximisation of shareholder value (in half of the cases), modification of the capital structure or the firm’s strategy, or replacement of management. In total, targets set are met in two-thirds of cases, whether the activism is non-confrontational or imposed on a reluctant management team.

The abnormal return of the target firms at the time of the announcement of activism is not followed by a lower return the following year.
Brav et al explain that this performance should not be attributed solely to the types of firms that hedge funds invest in, but to a lasting improvement in the governance of these target firms, which again shows that hedge funds do not deserve their reputation for short-term thinking. The share prices of these firms is also given a boost by an improvement in opinions published by financial analysts after the activism.

The article also shows that target firms improve their financial performances (especially their operating margins) and increase the size of dividends paid to shareholders (by 0.5 point), in the years following the activism. The positive reaction on the part of the markets at the time of the announcement is thus justified.

Finally, this article appears to show that hedge funds improve the corporate governance of listed companies through their activism, whether the measures they introduce are non-confrontational or hostile.

This conclusion does not appear to have been missed by the venerable Rockefeller family, shareholder of Exxon Mobil, one of the off-shoots of the former Standard Oil, and which for the first time has stated publicly that that it would like to see an improvement in the governance of the oil group. 
Better late than never!
It should however be noted that the abnormal returns recorded over the period went from close to 16% in 2001 to 3.4% in 2006.  The authors attribute this drop to an effective improvement in the governance of firms, which reduces the opportunities of hedge funds, in the same way as an arbitrage profit that declines over time as it is implemented.
(1) A. Brav, W. Jiang, F. Partnoy et R. Thomas (2008), Hedge Fund Activism, Corporate Governance, and Firm Performance, Journal of Finance (to be published in August).
(2)  For more information, see chapter 21 of the Vernimmen.

Q&A : Customer’s advance payments and value accounting

Because of the very long operating cycles on the sectors on which they operate, some firms receive very large down payments from their customers, which results in negative working capital. Sectors in which this happens include the engineering, shipbuilding, nuclear power plant construction and public works sectors.
These down payments are sometimes very substantial. For example, on December 31, 2007, Technip posted down payments net of expenses incurred and end-losses on contracts of €1.58bn, to be compared with its book value of €2.2bn or its market capitalisation of €6bn. Customer down payments are volatile and ephemeral, as contracts come and go, depending on customer requirements. Bouygues was never able to secure a down payment as large as that paid on the famous University of Riyadh contract.

How should the portion of these down payments that is not yet used, be treated when carrying out a valuation? There are two possible methods for valuing these amounts:
• treat them as a normal element of working capital, the cash value of which should be deducted from net debt
• treat them as a normal element of working capital, but deduct them from cash in the bank, as these funds will definitely be allocated within a very short period of time to the payment of costs that are necessary for completing contracts to which the firm is committed

Using the second method, the advantage gained from this prepayment made by customers is factored in by including the financial income generated by these down payments in operating income, until such time as they are used. 
We think that this is a better reflection of economic reality given that the commercial negotiation of these contracts is often the result of an arbitrage between the sale price and the amount of the down payments. The sale price is generally lower if the advance payments are more generous.

Technip uses this method.  In 2007 it posted €91m in financial income related to down payments on contracts, that the group booked under sales and not under other income or financial income, confirming the economic reading of this phenomenon.

In our view, the first method should only be used if it can be shown that these down payments will be paid on a regular basis and that the amount thereof will remain constant over time. This is not what happens with long-term contracts which are subject to cycles, for example contracts for building nuclear power plants.
Accordingly, we would recommend that you use the second method which values the advantage secured only in the amount of the financial income that the firm is able to obtain by investing these advances until such time as they are used.