Reconstructive Surgery

Fixing troubled companies is a hard business. Nothing short of radical change may be required.
Hilary RosenbergAugust 1, 2001

PSINet, the Ashburn, Virginia-based Internetservice provider, is one of the most spectacular flameouts of the New Economy. In just six years, the company loaded up on $4 billion worth of junk-rated debt, made dozens of acquisitions around the globe, and saw its stock reach a giddy high of $60. But like so many other Internet ventures, PSINet never made a dime. Its stock collapsed, and today a share costs about 5 cents. The delisted company has defaulted on its pricey bonds and filed for protection under Chapter 11, becoming one of the largest high-tech bankruptcies ever.

Yet the outcome for PSINet could have been even worse, had CFO Larry Hyatt not prepared for the fall.

“It became obvious relatively early on that the capital markets were closed and we had to stop spending,” recalls Hyatt, who joined the company in May 2000. In September, PSINet announced it had a $600 million funding gap through the end of 2001. The company halted all capital spending, laid off hundreds of employees, cut a layer of management, and started selling assets. The cash burn rate dropped from a whopping $200 million a month in mid-2000 to around $15 million a month today. Sales of real estate and operating subsidiaries have raised about $300 million.

Still, with more than $3 billion in debt, mostly unsecured bonds, PSINet ultimately realized it was headed for bankruptcy. To prepare, the company examined its subsidiaries in 27 countries “to make sure those operations could stand on their own,” says Hyatt, and as a result transferred funds to subsidiaries located in major geographical markets. Then, armed with its cash hoard, it filed for bankruptcy in June. Its cash allowed it to reject offers of debtor-in-possession (DIP) loans, which carry high up-front fees. Today, the company is assessing the viability of a reorganization plan and talking to potential buyers.

Taking action early saved the company–at least so far. “Some CFOs and general counsels are the Cassandras,” observes Henry Miller, vice chairman and head of global restructuring at Dresdner Kleinwort Wasserstein, which is advising PSINet. “They help companies recognize that there is a serious problem.” These days, many companies besides PSINet are in dire need of such help. And acting quickly to avoid disaster is even more critical now, because restructuring is more difficult today than it was in the last workout wave.

“Turnarounds have always been complex, but today’s turnarounds are more complex than ever,” declares Bill Hass, CEO of TeamWork Technologies, a turnaround and strategy consultancy. A decade ago, most restructurings involved repairing companies overburdened by debt. Relatively straightforward deleveraging and cost reductions turned around the likes of Southland, News Corp., Goodyear Tire & Rubber, Holiday Corp., and Macy’s. But now, more companies are suffering from operational and management problems, have fewer sources of cash, and face complications posed by global operations.

“Ten years ago, drastic cost reduction alone was considered a silver bullet,” says Hass. “Today’s turnarounds take a variety of silver bullets in operations like cost reduction, quality improvement, innovation, and speed.”

Indeed, troubled companies often find they must engage in more fundamental change to head off the kind of downward trajectory that ends with bankruptcy and liquidation. That type of undertaking means anything from radical changes in strategy to trimming product lines, selling noncore assets or businesses, recapitalizing foreign subsidiaries, realigning management, or selling the entire company.

The good news is that if bankruptcy is necessary, it is an increasingly effective tool for restructuring. The well-developed secondary market in distressed securities has eased the way for many bankruptcy reorganizations, and an active acquisition market for distressed companies provides an ultimate way out for more businesses than ever before. Make no mistake, though: for companies that fail to take decisive action well before filing, Chapter 11 can be a slough of despond.


Like PSINet, the most visible casualties are Internet-related and telecommunications companies. They are trying to deal with the double whammy of huge overcapacity and the sudden loss of access to capital as a result of the stock market meltdown.

“When the high-yield market shut down and there was no liquidity, telecoms couldn’t build out their systems,” says David Resnick, managing director and head of restructuring at investment banking firm Rothschild Inc. Observes Bill Repko, managing director of the restructuring group at JP Morgan: “In telecoms the capacity is huge, and it will be a long time before demand equals supply.” In many cases, incomplete networks have so little value that, in a restructuring, bondholders would simply be wiped out. As a result, these companies have to find a strategic partner or buyer to survive.

But they’re hardly alone. Both young and well-established companies in a plethora of industries–including high tech, utilities, retail, steel, textiles, health care, movie theater chains, manufactured housing, automotive, and manufacturing–are also experiencing hardship.

Blame the strength and length of the economic boom. Capital availability and economic growth allowed many companies to ignore operating deficiencies. After all, “it’s relatively easy to run a company when growth is strong and the capital markets are open to everyone,” says Repko. “And Wall Street loved a growth story.” But the longer the recovery lasted, the more the problems festered.

At the same time, the length of the recovery fostered a cavalier attitude. The thinking was that if a company had a big problem, willing buyers and cheap capital would be there to offer a way out. “CEOs and CFOs said, ‘I can borrow or sell out,’” says Gary Burns, national partner in charge of U.S. corporate recovery at KPMG LLP. “That made the tightening of the capital markets much more dramatic than it was 10 years ago. Then, as capital dried up, opportunities to borrow or sell out dried up.”

Because of the culture of overwhelming optimism, many companies viewed the market falloff and credit crunch as temporary, and that has had a clear impact on the restructuring process. “They’re waiting too long before recognizing that there is a serious problem,” says Dresdner Kleinwort Wasserstein’s Miller. “They’re waiting until the gas tank is empty.”


Restructuring debt to raise or preserve cash, meanwhile, is more difficult for companies that are suffering from operating problems. “You’re not going to be able to accomplish a restructuring unless you can prove true viability from a core business perspective,” points out Melanie Rovner Cohen, a partner at Chicago-based law firm Altheimer & Gray and chairman of the Turnaround Management Association. “The banks have to be confident.” According to KPMG’s Burns, some companies are trying to persuade their banks to lend against the company’s cash flow or intangibles, or convince them that their assets are worth more than originally valued. But “lenders don’t like to lend against cash-flow value,” he says.

Ten years ago, a cash-strapped company might have sold off assets. But today, troubled companies have fewer sources of cash. Blame the banks, which during the 1990s secured many more business loans to riskier borrowers with all of the company’s assets.

These days, even some investment-grade companies have to promise everything to the bank. Last February, Lucent Technologies (at the time still an investment-grade credit) obtained $6.5 billion in new bank credit lines, but only by agreeing to pledge all of its assets as collateral. A distressed company with debt secured by a so-called all- asset lien has no way of raising cash through asset sales, since the bank is technically entitled to all the proceeds. What’s more, adds David Weinstein, national manager of bankruptcy and restructuring at asset-based lender Congress Financial Corp., “if a company is fully leveraged, there are no new assets to provide liquidity to take out the existing lender and have cash for the business.”

Because of the terms of its bank loan, Rankin Automotive Group couldn’t even use the cash it already had to help it continue operating in bankruptcy. The auto-parts company filed for bankruptcy under Chapter 11 in April, intending to restructure its obligations to creditors. But in May, the bankruptcy court denied the company’s request to use its cash, because all of it was “subject to the lien of its lending syndicate.” As a result, Rankin was forced to liquidate.


Then there are troubled companies that, regardless of the terms of their debt, have no assets to sell. Many of these companies imbibed the wisdom of the reengineering era and restructured to focus on their core business, but were never able to build up enough cash to weather crises.

Other such restructurings were less voluntary. For example, over a period of 13 years, supermarket operator Pathmark Stores conducted a series of moves to reduce onerous debt from a huge stock buyback meant to deflect a buyout. “We were downsizing every other year,” says CFO Frank Vitrano. “We had layoffs, sold divisions, closed stores. We did a pretty damn good job.” The company also sharply reduced its capital spending, even though that lowered its competitive position.

In December 1999, a planned acquisition by Royal Ahold, the Dutch food retailing giant, fell through, leaving Pathmark with no time to refinance its debt before key payments were due. “I looked at the checkbook on December 16 and knew we were not going to be able to make the payments,” says Vitrano. “We’d clipped all the low-hanging fruit over the past 13 years.” Seven months later, in July 2000, Pathmark filed for a prepackaged bankruptcy (an abbreviated form of Chapter 11 in which all parties agree to the reorganization plan before the filing).

That kind of reengineering may also be responsible for the virtual disappearance of another last-ditch source of cash: rejecting suppliers’ contracts and other contracts such as leases on vacated buildings, thereby forcing the supplier or lessor to file a claim in the bankruptcy.

So what does this shortage of cash and cash sources imply for restructurings? “As an adviser, it forces you into a much more traumatic time frame to identify [the problems] and stabilize the company,” says KPMG’s Burns. Presumably, then, a distressed company will be at a great disadvantage in negotiating a restructuring, and it may not be possible to avoid bankruptcy or wholesale liquidation. Also, the cash shortage means that the restructured companies “are relatively fragile in their capital structure and their operations,” says Al Koch, vice chairman of Jay Alix & Associates, a turnaround management consultancy.


The message for CFOs is clear: Take action early. “Denial is not just a big river in Egypt,” says Repko. “You have to know you have a problem.”

If things get worse, bankruptcy is not such a bad option for raising liquidity (through DIP financing), and for recapitalizing. Indeed, the bankruptcy reorganization process is easier than it was 10 years ago. Then, the prepackaged bankruptcy was just beginning to be used. Today, it’s common.

Pathmark’s prepack “clearly saved us,” says Vitrano, because its brevity convinced vendors to stick by the company. After realizing its dilemma, the retailer moved quickly to persuade its banks, bondholders, vendors, and employees to agree on a strategy for preserving cash through a quick bankruptcy and then investing in store improvements and promotion. Aided by DIP financing, Pathmark was in and out of bankruptcy in 68 days.

Equally significant is the development of a deep, liquid secondary market in distressed securities. There are many more distressed-fund managers today, and they are more sophisticated than ever. In part because of the market’s liquidity, senior lenders are more willing to sell out their positions. Although the musical chairs of creditors can make the reorganization process more complex, most professionals agree that it usually helps.

What’s more, since buyers of distressed securities take out unwilling participants in a restructuring, they make the process easier. “And [they] improve the quality of restructurings,” adds Repko. “When creditors who got in at 100 cents on the dollar hold out for something bigger, the postrestructuring company is overleveraged.”

Finally, while merger-and-acquisition fever may have cooled overall, it’s still hot in the distressed zone. Traditional buyout firms as well as healthy corporations are buying distressed concerns, where several years ago they would have shied away.

Certainly, in many cases selling a company can offer creditors more value more quickly than a drawn-out reorganization process can. Secured bank lenders, for one, have less patience these days for a lengthy restructuring than they used to. In general, their perspective has shifted away from maintaining a debt claim and toward value preservation. So they would much rather sell their loans to vulture investors–who often want to sell the company–or, barring that, resolve the reorganization as quickly as possible in a prepackaged bankruptcy or sale. And as secured lenders, with all-asset liens in many cases, banks have more power than ever to demand a sale.

Of course, the complete story of this restructuring wave has yet to be written. Business historians are fond of reminding us that the introduction of a significant new technology–whether railroads, or automobiles, or the Internet–leaves plenty of creative destruction in its wake. What’s more, defaults are occurring in an unusually broad range of businesses. Many more bankruptcies and restructurings are on the horizon, predict experts.

But don’t tell that to CFOs fighting to keep their companies out of Chapter 11. To them, history, as Henry Ford said, is more or less bunk. 

— Hilary Rosenberg is a contributing editor of CFO.


In the 1990 recession, a workout consultant may have found that a troubled company’s senior debt was either unsecured or secured by some assets, including inventory, accounts receivable, and maybe some equipment. “But that was it,” says Al Koch, vice chairman of Jay Alix & Associates, a turnaround management consultancy.

Big bankrupt retailers such as Macy’s and Federated didn’t even have to pledge inventory, adds David Weinstein, national manager of bankruptcy and restructuring at asset-based lender Congress Financial Corp. “Today, I haven’t seen a single situation where a retailer had assets that were not pledged,” he says. The banks, says Bill Repko, a managing director at JP Morgan, have learned from experience. “We know that recoveries on secured loans are a lot better than those on unsecured loans,” he says. What’s more, bankruptcy law requires that borrowers in Chapter 11 continue to pay interest on secured loans, unlike unsecured loans. –H.R.


Amid today’s corporate carnage, it is easy to miss those companies that are staving off disaster by restructuring before they are distressed. One recent example is $28 billion International Paper. “We knew if we weren’t earning good returns in an economy growing 5 to 6 percent a year, we needed to do things differently,” says CFO John Faraci.

In 1999 and 2000, the paper giant acquired two others–Union Camp and Champion International–that strapped it with $9 billion in new debt, for a total of $17 billion. At the same time, it became clear that the company had gone far afield of its core business. A decade ago, International Paper acquired many unrelated businesses. And the two recent acquisitions brought more businesses into the fold that were either tangential to its core businesses of paper, packaging, and forest products, or not delivering acceptable returns.

So, in the summer of 2000–before the paper business was hit by the economic slowdown–the company made a commitment to sell off 14 businesses worth about $3 billion, plus $2 billion in timberland. As of June 2001, it had sold nearly $2 billion worth of businesses and $500 million in timberland. The proceeds, plus cost savings from a cutback in capital spending to about half the 1995 level, have slashed debt to $15 billion. “We’ll continue to reduce it until debt-to-capital is in the 40 percent range, down from the current 47 percent,” says Faraci.

Meanwhile, in an effort to boost long-term returns, the company has made radical changes in how it conducts business. For example, it is managing capacity better, idling and closing plants. In addition, management is making a better effort to engage employees by linking their personal goals to its mission. Finally, it has become less focused on how much it can produce and more focused on what customers need it to produce.

Those customers, says Faraci, are “stronger, smarter, and more demanding, with higher expectations.” –H.R.