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Making an LBO work, by learning the signals.

Making an LBO work, by learning the signals

After a leveraged buyout, many executives find themselves sailing in uncharted waters. Preacquisition "operations-as-usual" plans do not track actual results, cash is tighter than projected, and the corporate vessels are just not as watertight as expected. Mayday calls to headquarters for short-term financing, legal assistance, and other help no longer are possible.

For the acquiring management to be successful in an LBO, it must learn to anticipate business changes in advance, adjust its management techniques to match new circumstances (without layers of staff support), act and react more quickly than its couterparts in large corporations, and consistently meet or exceed all projections. In short, the new management has to have and use all of the instincts of successful entrepreneurs. It has to achieve the same results, but operate without the same cash resources, if it wants to be successful.

An estimated 70 percent of LBOs will not achieve their original objectives. Of these companies, 50 percent will experience serious financial problems, including bankruptcy, divestiture, sale of assets, or other compromise.

In addition to managing heavy debt service, LBO companies must maintain unusually high performance standards to cover premiums paid to original owners and to satisfy investors for the high level of risk assumed. Moreover, occasional management mistakes have magnified consequences in their highly leveraged environments.

There is little, if any, margin for forecasting error in LBO companies. Refinancing success becomes a matter highly dependent on management credibility. And performance related to plan is a key consideration of lenders in assessing management strength--although once a plan doesn't jibe with the expected results, poor performance is assumed, as opposed to poor forecasts.

What are some of the main factors that determine the effectiveness of an LBO manager? Above all, his cash flow position, plan for the future, and establishment of good accounting controls.

A cash-flow orientation

Succeeding in a highly leveraged environment is based on managing for cash flow, coupled with a controlled risk-taking mentality.

More than any other shortcoming, LBO managers fail to "take home" the idea that cash is king. Any disbursement of cash for non-productive purposes causes expanding ripples throughout entire organizations. For instance, if the operations division of a company spends $300,000 of its $2-million annual production budget on unnecessary labor, then all other divisions, such as marketing, finance, and research, must curtail their activities to replace the cash. In the alternative, if production is reduced, the company will not be in a position to generate sufficient cash to meet its projected requirements.

A cash-flow orientation can begin the acquisition transaction itself. By astutely determining the real or convertible value of assets, a buyer can develop extra cash to help pay for the purchase even though realizing the cash may mean doing business a little differently. For example, one consultant assisted in a $500-million leveraged buyout in which management determined that the segments of the company were worth more separately than as a whole. Notably, a communications division that had been purchased for $120 million prior to going private was sold 14 months after the LBO for $185 million. Even though the division was operating profitably, it was sold ("assets redeployed") to meet the company's short-term cash commitments. The division was worth more converted to cash than as an operating division generating future returns.

In another case, a company obtained asset-based financing for the buyout of a $40-million distribution company and was able to reduce its loan by 40 percent within 10 months after the transaction by reducing inventory levels significantly below the historic precedent. This early success was accomplished by pinpointing the true worth and need for the assets prior to the transaction and acquiring the whole for substantially less than the value of the parts. The required fairness opinions on the transaction were obtained from outside investment bankers who opined on the value of the business as a going concern. Immediately after the purchase, management geared its operations toward creating positive cash flow. To support its effort, management structured employee incentives based on the achievement of cash-flow standards rather than profit objectives.

Redeploying assets to achieve the optimum cash flow after an LBO often calls for innovative and entrepreneurial marketing solutions. For instance, an underutilized mill that produces hobby and craft yarn for knitting may benefit more by converting its operation to the full production of finished consumer goods, such as sweaters or other knitwear. Or a maker of consumer microwave ovens might utilize its equipment, inventory, and labor force more effectively by turning to the manufacture of related products for the food service or scientific markets. In short, adherence to traditional business practices can result in severe problems in cash-flow-sensitive situations.

Planning and

forecasting are primary

Surprisingly, managers of many LBO companies have not taken the time to effectively address the future realities of their business opportunities or the economy of their respective business environments. Such planning is essential. Many managers produce impressive but traditionally forecasted material that helps secure initial lenders' participation but ultimately becomes management's undoing. When the actual results vary, the managers' credibility is destroyed and lender support erodes quickly.

Today, management has at its disposal a variety of resources, including sophisticated computer software programs, for creating planning models, forecasting operating performance, and evaluating the implications of alternative strategies and action plans. By taking into account the company's financial situation, structure, suppliers, and other factors, management can plug in different variables and project potential scenarios. This then will allow a manager to track his projections against real results. There is, however, no substitute for good management judgment and clear business perspective. Good management is still 90 percent of the formula.

Since most severe cash-flow problems occur within a year after a crunch first becomes evident, probabilities should be tested for 30 days, 60 days, six months, and a year. Healthy companies may want to do regular planning about every other month, whereas financially troubled firms should do such planning as often as every two weeks.

Put in place financial

and operating controls

Another dimension of increasing an LBO company's cash flow and assuring coverage of acquisition debt is to maintain strong accounting controls over expenses and operating costs.

To reduce expenses, management must carefully examine staff salaries as well as travel and entertainment budgets. Contracted services in such areas as law, accounting, information management systems, marketing, and advertising also should be scrutinized.

A cash-rich publicly held corporation may acquire small companies without extensive due diligence. It may carry receivables for 60 days instead of 30 days. Or inventories may historically have turned only three times a year when they could turn four times a year through better inventory control procedures. Management of an LBO company cannot afford the luxury of any of these or other practices that can result in unproductive cash deployment.

Overhead can be reduced by selling idle equipment, consolidating factory space, or moving to a less-expensive location. Leasing rather than purchasing new capital equipment may be another means of increasing liquidity to fund debt or pursue other necessary projects, even though it may be more expensive in the short run. If legally permissible, reorganizing an overfunded pension plan also has the potential of freeing significant operating cash.

Active balance sheet management is another important aspect of a leveraged firm's day-to-day operations. Depending on the company's particular circumstances, this may involve accessing the futures or capital markets to protect against interest rate risk by hedging fixed and floating rate liabilities.

Warning signals

The failure of many LBOs can be avoided or the companies brought back on track if management heeds the warning signals of impending problems at an early stage. Too often, however, management is reluctant to acknowledge that a problem might exist, is unwilling to acknowledge the need for help, or is unwilling to initiate necessary changes.

Two of the most common red flags are a decline in operating margins and a loss of working capital. In some cases, the company's volume may remain constant, or even increase. Look at the questions to the right to get an idea of where the first signs of trouble appear.

Warning signals of a financial downturn demand decisive action based on an objective appraisal of the situation. Frequently, the company's management has never been through a cash crunch or cash crisis and may for emotional reasons become unable to function effectively. Identifying the warning signals usually is the fastest and most efficient way to isolate the problems and help arrive at the most advantageous solutions. The best time to act is before the critical stage--when the first caution signs appear.
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Title Annotation:include related article on how to tell if an LBO is in trouble; leveraged buy-outs
Author:Morris, Daniel M.
Publication:Financial Executive
Date:May 1, 1989
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