Capital adapts to core industry characteristics: the domestic auto industry is searching for ways to revive--and even flourish. New money meets old, familiar problems as restructuring consultants bring two parties together for mutual benefit.

When it comes to the restructuring market, the automotive industry and its domestic-headquartered supplier chain, and to a certain extent the airlines industry, are hot. And, notably, the automotive industry has been through more frequent and intense cycles of restructuring than most other economic sectors. Long-standing structural issues like capacity, labor costs and legacy costs continue to be serious issues that must be confronted, while balance sheets are further stressed by shorter-term issues.

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These latter issues for automotive suppliers include contract conditions imposed by original equipment manufacturers (OEM) and Tier One customers, such as pricing give-backs, assignment of greater and greater responsibility for research and design, sharing in warranty costs or spikes in the prices of raw materials. Competitive targets keep moving faster and farther. The urgency of the challenges facing the domestic automotive industry and the overall level of activity make the domestic automotive supplier chain a cauldron for the lessons of restructuring.

The biggest change (discussed in more detail below) has been the attraction to the industry of new sources of funding, such as hedge funds, forms of "distressed" capital and other sources seeking greater returns. These sources comprise a market flush with capital from both traditional and non-traditional sources and the thick wallets of private-equity firms--padded with monies from pension funds, state retirement plans or high net-worth individuals, all seeking greater returns. In many cases, the growing array of capital providers are bypassing the safer, performing-company transactions and focusing on higher-risk "value" investments.

As new money meets old--or at least familiar--problems, restructuring consultants have worked at bringing these two parties together in a productive fashion. The goal: meshing a "meat and potatoes" manufacturing sector, still subject to traditional industrial economic dynamics, to an aggressive, high-yield-seeking form of capital that is less inclined to admire the old ways of doing business.

In bringing these two worlds together for mutual benefit, the domestic automotive industry is searching for new ways to survive and, perhaps, flourish, while capital finds new fields of exercise. Indeed, some of the most recent restructurings are showing signs of learning from the pitfalls of the past. The keys are in solving the real and definable problems of individual companies as they present themselves to the marketplace.

Two Basic Restructuring Scenarios

It may be a prelude to a merger, acquisition, leveraged buyout or a take-private transaction, but restructuring is not the same thing as a deal. It is a process that is undertaken to solve, as much as possible, fundamental imbalances among revenue, expenditures (costs), the availability of capital and the cost of capital.

Important factors in this complex mix with respect to a manufacturing operation include such areas as existing customer base, existing and prospective contracts, operational efficiency and quality of management. Still, most of the situations encountered fall into two broad categories.

The first is when a company has generally good assets and management, but an unfavorable balance sheet. A recent example was a privately held, leading global designer and manufacturer of highly-engineered aluminum die-cast automotive parts. Industry participants (including customers) had favorable opinions of the firm's operations, capabilities and management, but acquisitions had burdened it with debt. The firm entered Chapter 11 bankruptcy, its debt was restructured and it has emerged intact.

When there is sound footing, things can move quickly; the firm spent less than five months operating under Chapter 11 bankruptcy protection. The plan of reorganization approved by creditors allowed the firm to shed $465 million in first- and second-lien senior secured debt and $28.9 million in 11.5 percent senior subordinated unsecured notes. It acquired $130 million in new equity investment and $255 million in new financing, while adding commitments from major customers.

In examples like the former, it isn't uncommon that some material portion of existing debt will not survive the restructuring and thus must be "converted" into new equity. A basic quandary facing many firms in dynamic but sluggish or challenged industries is that it is hard to "grow oneself" out of debt.

In a second scenario, where fundamental operational and management issues exist, the question becomes whether the company has reason to exist in the marketplace from a customer standpoint. Typically, outside influences--such as raw material price increases or product volume decreases--become the last straw that exposes inadequacies. In almost every case, internal reporting is not up to standards, which has delayed what has become obvious from becoming apparent sooner.

If the customer base and related contracts are there, key components to a successful restructuring are in place, although it is now likely about making significant changes to operations or management, or both, not "just" recasting debt. Possible pathways, all designed to maximize enterprise value, include sales of non-core assets and business combinations that can bring the necessary talent, expertise and capital to the table.

In the automotive supplier network, contracts--and the need for OEMs and Tier One entities to ensure production of on-time, on-budget, quality component parts and vehicles--fuel what could be called a "restructuring imperative." Should a sale become necessary, it is the future revenue held within contracts that is the core asset being sold, as much as the productive capacity residing in people, systems and machines.

Bankruptcy or Out-of-Court Settlement?

Sometimes, there is no choice. While out-of-court restructurings are less costly and potentially speedier, a variety of situations compels firms to reorganize under Chapter 11 protection--and not just the most highly publicized situations, such as Delphi Corp.

Practically, when vendors get wind of troubles, firms are often confronted with "pay me first, and in cash" demands that they can't meet. Multiply this by all the entities one does business with, and a free-fall isn't far behind. With respect to debt, a negotiated setting helps when creditor interests are divergent. A secured creditor may balk at letting a "failing" company burn more cash on a weekly basis, while unsecured creditors may have different motivations.

On the other hand, no one--creditors, customers or community--is well served when firms try to reorganize "a step at a time." Getting out of debt isn't like a smoking cessation program; one auto supplier has been at it with six or seven plans by now.

Bankruptcy is generally prohibitive for smaller entities, due to the costs, but sometimes it's the only way to achieve a recapitalization of a business in a way that will allow it to continue as a viable entity. A recent example is a Midwest engine components manufacturer. This well-regarded company, in business since the 1800s, had enormous pension issues relative to its size. It was a viable company, but its cost structure no longer made sense. The only path to survival was cleansing itself of these obligations under formal bankruptcy proceedings. Regrettably, people lost their pensions, but jobs were preserved and a company important to its small town is on solid footing.

After an industry like the automotive-supplier sector works through a number of restructurings, common themes tend to reveal themselves. In recent years, prices for steel have spiked well outside the normal fluctuations for an extended period of time, leading many otherwise stable operations towards the ER. As a result, pass-throughs for these costs are demanding more of customers and impacting negotiated contracts.

Distressed or Not

Outside of millionaire yachts or personal submarines, the automobile is likely the world's most complex manufactured consumer product. Its success in the marketplace is impacted by everything from international balance of payments, consistent pressure from foreign competitors and environmental regulation to fuel prices and consumer whims. Even with all the modern statistical process controls, computer-aided design, robotics or lean principles, we are dealing with a traditional manufacturing environment.

Within this picture, the restructuring environment has been invigorated by the enormous growth of distressed buyers in the form of equity firms and hedge funds. The appeal was understandable, with firms trading at low multiples or historically low asset values. The two parties have gone though a familiarity period. In particular, these new investors have learned that enterprise value lies in contracts and business continuity, as opposed to being able to quickly re-sell companies at favorable multiples.

Automotive--while a cyclical industry--is more of a long-term play and unlikely to ever have the "jump" that's occurred in telecommunications, the Internet, biogenetics or similar industries. Technology plays by the automakers themselves, for the most part, have not been successful. At the same time, when the industry is hurting, even high-performing companies tend to get dragged down to lower multiples.

In the most recent restructuring window, we've witnessed a number of suppliers facing large debt redemptions resorting to the second-lien markets, as in the example cited earlier. But the overriding lesson of the last two to three years is that surviving to live another day by trading a near-term problem for a longer-term one often doesn't work. Debt must be converted to equity, and these new sources of capital, tempered by better understanding of auto industry dynamics and greater up-front investigation of proposed investments, are helping this process take place.

With reasonable expectations and terms, restructuring can work as intended--to let these important businesses go forward with their essential task of increasing North American and global market share. Therein will lie investment value.

Thomas H. Gordy, Managing Director for CM & D Capital Advisors, has provided financial advisory, capital-raising and restructuring services to clients with aggregate debt outstanding of over $3 billion. He can be reached at [e-mail] or 248.433.3694, extension 236.

RELATED ARTICLE: takeaways

* The urgency of challenges facing the domestic automotive industry and the overall level of activity make the domestic supplier chain a cauldron for the lessons of restructuring.

* A big change has been the attraction to the industry of new sources of funding, such as hedge funds, forms of "distressed" capital and other sources seeking greater returns.

* The new investors in automotive industries have learned that enterprise value lies in contracts and business continuity, not in being able to quickly re-sell companies at favorable multiples.