Is there a turnaround fund in your company's future?

Is there a turnaround fund in your company's future? Chief financial officers face a dilemman. Many love the returns produced by the early LBOs, but they question whether these profits can be sustained in an environment of high-priced deals and political problems. More and more, they are considering turnaround investment vehicles as a profitable alternative. And why not? Some turnaround investments can produce returns of more than 40 percent annually compounded.

But before a CFO, along with his or her pension manager, can confidently recommend to the company that it should participate in a turnaround vehicle, the chief financial officer should be able to answer these questions:

* Why should you consider investing in turnaround vehicles?

* Where does turnaround investing fit in the overall corporate investment strategy?

* How do you evaluate turnaround managers?

* What type of turnaround fund should you choose?

* How should you work with and direct a turnaround investment manager?

When and where

turnarounds work

There are three basic reasons for considering turnaround investing. First, properly structured and executed, turnarounds can produce excellent profits, thereby making a disproportionate contribution to financing corporate pension obligations. Some turnaround managers working with public companies in trouble have produced returns of more than 100 percent annually.

A second reason is that turnaround investing parallels a CFO's experience and skills more closely than many other forms of investment and is far less subject to exogenous factors, such as the stock market. CFOs understand the basic approach and tools used by turnaround managers and can actively comment on and judge what is being done to enhance the value of the investments.

Third, turnaround investments can provide important secondary benefits as they create jobs and stimulate new investment, thereby overcoming many of the objections to LBOs.

As for fitting turnarounds into the corporate strategy, most executives realize that investment vehicles cannot be considered in isolation. They need to fit into the overall asset allocation mix among domestic and international markets, classes of securities, vehicles, risks, and return expectations. Many CFOs have set aside a certain portion of their total pension fund assets for alternative investments. The popularity of these types of investment has ebbed and flowed over the years, as the choices have ranged from real estate to oil and gas, to international investments, to LBOs. But while the relative mix has changed, the principal has become well established that alternative investments are a valuable part of the overall asset mix.

There are two basic positions for turnarounds in this overall strategy. Given the normal risk profile of most pension funds, only a small portion of a fund's assets should be committed to turnaround investing. Strategically, turnarounds are a long-term, return-enhancement vehicle and a hedge against poor performance in other asset classes. Tactically, they are an attractive vehicle for putting to work any uncommitted funds scheduled for LBOs or venture capital investments.

How to evaluate a

turnaround manager

Because profitable participation in turnarounds traditionally has been the province of a small band of professionals, turnarounds are only just emerging as an institutional vehicle. Therefore, institutional investors have little experience in evaluating the abilities of turnaround managers.

The first step in the evaluation process is to look at the basics: people and track record. There is no substitute for fund managers having direct experience as operating managers of a series of turnarounds. The team must be seasoned, sound, and have been bloodied just a bit in the past. Successful turnaround managers will have a track record of a decade or more in generating profits for investors, not just themselves. This factor plays to one of a CFO's strengths: he or she evaluates operating managers virtually every day and feels confident in his or her ability to do this. The bottom line--trust your gut!

The second major element in evaluating turnaround managers also plays to a CFO's strengths--a disciplined and systematic approach to management. Turnaround managers must have a defined investment and management strategy, not just know their way around bankruptcy court or how to give creditors a haircut. Most turnaround professionals use a highly disciplined approach to creating profits for investors in turnarounds.

This approach can easily be converted into a checklist to gauge the savvy of the prospective team of turnaround managers. Further, a CFO should look for evidence that the results claimed by the turnaround managers did indeed result from the application of the discipline they espouse. In this respect, the evaluation process is conceptually similar to evaluating the discipline of an equity fixed income manager.

Here are the areas on which you should judge a turnaround manager. The first phase outlines several of the preinvestment actions an effective turnaround specialist could take.

* Investment selection--Not every company in distress is a candidate for a profitable turnaround. The turnaround manager must have a defined set of criteria to use in identifying opportunities.

* Opportunity assessment--Before a turnaround management team accepts a company for a turnaround program, it should be ready to make a rigorous assessment of the candidate's markets, technology, and people. This must be done rapidly and before the turnaround manager takes a control position within the target company.

* Option negotiation--The turnaround manager should show that the team is able to properly negotiate an investment option arrangement with a target company, under which the manager supplies funds to keep the target company in operation for 90 to 120 days. In return, the turnaround team gets the right to determine what must be done to turn the company around, as well as obtains an option to purchase control of the company at an agreed price if it concludes that a viable turnaround strategy exists.

The second phase of the evaluation looks at how the turnaround program is managed.

* Turnaround strategy development--After negotiating the option arrangements, the turnaround manager typically sends in a team of fully qualified professionals to determine what specific action is needed to turn the company around, reposition it in its markets, and rapidly develop it into a formidable competitor.

A fundamental part of this step should be to plan the managerial improvements necessary to return the company to profitability and to determine what the investment requirements will be over the next three to five years. The effective turnaround manager uses this strategy. Then, if the company meets the manager's investment goals, the manager proceeds to the next step and takes management control.

* Direct investment--The turnaround manager then should exercise its option to obtain an absolute control position in the company through direct investment. This investment will support the turnaround and repositioning program. Investors should not pay twice for the same asset (once for the stock and again for the needed capital investment), as they do in many LBO funds.

* Direct operating management--Normally, the turnaround manager takes direct operating control of the company and installs new management wherever needed. Over time, a free-standing management team should be created within the company.

In the third phase, turnaround managers concentrate on repositioning and development. A CFO interviewing prospective managers should screen out applicants that don't have carefully constructed repositioning and development strategies such as those that are listed below.

* Planned investment--Additional investment in the company should be made by the turnaround manager against a systematically developed strategic plan and against carefully developed performance targets. Investment is done in stages--not all at the front end, as in an LBO.

* Strategic repositioning--The keystone of really profitable turnaround investing is for a manager to reposition the company strategically in its markets and turn it into a strong competitor. This involves developing a unique position based on competitive advantage in the company's markets.

* Corporate development--As company performance begins to turn the corner, the turnaround manager should focus on growing the company rapidly during its period of competitive advantage. This requires not only investment but the development of a tough-minded team experienced in managing the challenges of rapid growth.

* Compatible acquisitions--A company may not have the full range of skills, capabilities, and products necessary for overall competitive success. Therefore, acquisitions may be needed. Or often these companies are themselves in trouble and can be restored to health by becoming part of a larger, integrated whole. A turnaround manager must be able to identify these needs and respond to them.

* Job creation--Turning around a company, repositioning it, and embarking on a comprehensive corporate development program necessarily generates jobs. Profitability is based on solid growth driven by superior management and products, not cutting jobs and reducing benefits. Thus, the level of job generation produced in previous turnarounds is another good indicator of a turnaround manager's effectiveness.

* The golden rule--Sell when the rate of gain begins to peak. This is one of the most critical of all of the turnaround manager's skills--knowing how long to hold on, typically for three to five years, and when to sell the company to maximize the return for investors. Hang on after the rate of gain peaks and annual returns will drop. Sell too quickly, and the return will not be maximized. However, in order to sell as a high multiple, the company will have to continue to grow and represent an attractive investment.

Clearly, this is a systematic portrayal of the process from soup to nuts. Not every turnaround manager or fund operates on this comprehensive basis, and there are a number of variations on the theme. Some turnaround managers specialize in only a part of the process. These different approaches can be roughly grouped into four categories. And an understanding of these categories can help a CFO choose the right type of turnaround fund.

Which turnaround

fund is for you?

Each of the four major types of turnaround funds has its own strengths and weaknesses. These need to be carefully considered before you narrow the universe to a few turnaround manager candidates. Of the four investment approaches, the final one--strategic repositioning--generally meets with the most favor from the investing corporation.

Vulture funds--This approach focuses on legal and credit research to identify which class of debt is the most junior of those likely to be redeemed when a creditor company emerges from bankruptcy. Profits stem from being able to buy debt at the greatest discount relative to its eventual redemption value. Additional profits can be made from determining which class of debt will strongly influence, or even dominate, the negotiations to remove a company from bankruptcy--thereby gaining negotiating leverages.

Balance-sheet artist funds--This approach combines a heavy emphasis on negotiation with short-term management intervention in the company. This can take place whether or not the target company is in bankruptcy. The balance-sheet artist takes control of the company and forces creditors and stockholders to settle for cents on the dollar.

At this point, the balance-sheet artist typically hires operating management and moves on. Profits are largely obtained by creating a "spread" through forcing creditors and investors to discount what is owed to them in return for a more reliable payment stream, either immediately or in the future.

Discounted assets funds--This approach buys operating assets, almost regardless of the business, where the discounts are greatest. Profitability stems from the theory that any business is good if one can buy it cheaply enough and then put it back into operation. Profits are made by operating an otherwise marginal business with a very low cost of capital--i.e., assets bought at fire-sale prices.

The hallmark of these three classic approaches to turnarounds is that profits are made without strong emphasis on the strategic repositioning of the company in question. The company is treated as simply a property to be turned, rather than a company to be nurtured and grown. Cynics say that the profits are to some extent derived from the misfortunes of others. Optimists say that there must be a better way to do turnarounds. The optimists seem to be right and can point to the "strategic repositioning fund" as an example.

Strategic repositioning funds--This type of turnaround fund is relatively rare and just emerging as an institutional investment vehicle. Its similarity to the other types of funds is only that the starting position is with a company in trouble and that an attempt will be made to buy control as economically as is possible.

From that point on there is a great difference in approach, objectives, and how profits are created. Profits from strategic repositioning come from identifying companies with valuable products, technologies, or processes that, with stronger management, strategic and operational changes, and new investment, can be made to flourish. In addition to significant profits for investors, this approach typically creates jobs, strengthens competitiveness, and has a number of other corollary effects.

Working with a

turnaround manager

For a CFO, working with a turnaround manager is similar to working with the operating managers within his or her own company. The key questions are virtually the same: Does the turnaround manager have clear objectives for each of the investments in the fund? Do the strategies adopted for each of the companies square with the objectives and market realities? Is a reasonable operating track set for each of the companies? Does it appear that adequate managerial and financial resources have been provided to get the job done? Does the upside square with the perceived risk involved in accomplishing the program? And there are literally hundreds of others, all familiar to a CFO.

Obviously, there are certain constraints on the relationship between the CFO and the turnaround manager. First of all, the turnaround manager is managing companies as well as a fund. The fund will be made up of from 10 to 50 investors. If the CFO of every investor set as a standard the degree of diligence applied to his own company's operations and applied the same to the turnaround manager's plans, budgets, and results for each of the companies in the turnaround portfolio, chaos would result.

Turnarounds require prompt action and decisive moves. If every major action were to be subject to the advance review of every investor CFO, the program would crater. A happy balance needs to be struck between detail-oriented control and a thorough annual review of the portfolio. This probably should be done in an annual general meeting of all of the limited partners in the fund.

In short, alternative investments are complex and, within the sub-category of turnaround investing, there are a number of different ways to begin the selection process. While this complexity makes deciding whether and how to participate difficult, there generally is a variant of turnaround investing that can suit the requirements of any institution seriously interested in the general asset category. This decision process can be made relatively straightforward:

* Decide whether the overall category of turnaround investing is of interest, and decide which one or more of the general approaches match your institution's objectives and risk profile.

* Select the steps in the process described above that match the management requirements of the approach to turnaround investing that you have selected. Use this as a set of evaluation criteria by which to judge the suitability of prospective managers and investment vehicles.

* Based on your screening of potential vehicles, determine if the most attractive one, based on interviews and references, actually conforms to your expectations and objectives.

Turnaround investing can be a very attractive way of improving the overall performance of your institution's alternative portfolio--and one that can create a significant and profitable diversification of risk. But it is a specialized form of investing that requires careful review before you can select the turnaround management team that most closely parallels the investment objectives of your company's pension funds.

Peter von Braun Managing General Partner Phoenix Technology Turnaround Fund