The past 12 months have proved that the business world is inherently volatile. For middle-market companies, navigating downturns can be particularly challenging. Limited access to capital and thin profit margins can make them especially vulnerable to economic headwinds, requiring a change in strategy.
However, in many cases, the true trajectory of a company can be masked if leadership is looking at the wrong indicators, leading to a company clinging to its current operating plan until it’s too late for course corrections to have the desired impact. To manage volatility successfully, companies must have a bias toward action and change strategy as early as possible.
A traditional approach to restructuring for middle-market businesses would be to wait for a crisis to hit before acting. This reactive stance can be disastrous, leaving businesses scrambling to salvage what they can in the face of mounting debt and declining revenue. There are sure warning signs that could signal the need for proactive action to preserve existing liquidity and engage in operational or debt restructuring:
- Increasing Accounts Payable: A lengthening accounts payable cycle can indicate cash flow constraints and potential liquidity issues.
- Declining Profitability: A sustained decline in profitability and shrinking gross margins require addressing.
- Stretched Working Capital: Working capital provides a snapshot of a company's short-term financial health, and a significant decline can indicate difficulty meeting short-term obligations.
- Inventory Issues (if applicable): Excessive inventory levels or slow inventory turnover can tie up valuable cash and indicate potential operational inefficiencies.
Why Proactive Restructuring Matters
There are two interrelated but distinct types of restructuring: operational and financial. Operational restructuring focuses on rationalizing the product portfolio, identifying which fixed costs must go, optimizing cash flow planning, and downsizing the business. Financial restructuring addresses debt service, equity sizing, and funding and asks whether the company is adequately capitalized given its challenges.
A proactive approach to restructuring emphasizes early intervention and strategic planning. Middle-market businesses can gain an advantage by anticipating potential challenges and taking steps to address them before they become critical. Proactive restructuring is often advantageous when a company anticipates future challenges, such as an economic downturn, customer/industry shifts, or significant capital expenditures.
Early intervention allows for a controlled and orderly process, maximizing flexibility and minimizing disruption to operations. Additionally, restructuring during periods of relative financial stability offers better leverage with lenders and creditors, potentially securing more favorable terms and interest rates.
For middle-market companies, navigating the complex world of debt can be a delicate dance. While leveraging debt can fuel growth and expansion, it can also become a burden if not managed strategically. Determining the optimal moment to restructure existing debt requires careful consideration of internal and external factors.
However, waiting for impending financial distress is usually not the correct answer. Signs like declining profitability, liquidity constraints, or more extreme missed debt payments indicate a need for immediate action. In such scenarios, restructuring is necessary to avoid/minimize potential defaults, creditor lawsuits, and bankruptcy.
Calling in the Experts
Recognizing the need for proactive operational and debt restructuring is the first step. However, navigating the complexities of the process often requires professional assistance. Financial advisors, restructuring specialists, and experienced attorneys can provide invaluable guidance, helping businesses develop and implement effective operations and debt restructuring strategies. These strategies, which need early intervention and time to take effect, will often include the following elements:
- Debt Reduction and Optimization: Lender forbearance delaying principal amort payments, converting a portion of the debt to equity, and resetting financial covenants to a revised operating budget with actions towards increased profitability are samples of debt restructuring, as well as negotiating with vendors for relaxed payment programs or outright partial write-downs reducing overall debt levels and optimizing debt structures to better align with cash flow capabilities can significantly improve a company's financial flexibility.
- Preserving Liquidity: Maintaining adequate liquidity is crucial for navigating economic uncertainty. This requires careful “weekly” budgeting and proactive measures to preserve cash. Companies should also consider alternative sources of liquidity, such as asset-based lending or factoring, to mitigate potential shortfalls.
- Cost Cutting and Operational Efficiency: Streamlining operations and identifying areas for cost reduction can free up valuable resources and improve profitability. This may involve implementing lean manufacturing practices, renegotiating supplier contracts, or right-sizing the workforce.
- Revenues: Prioritizing higher gross margin revenues.
- Scenario Planning and Risk Management: Preplanning and developing contingency plans for various economic scenarios allows businesses to react quickly and decisively when faced with adversity. This includes stress testing financial models, identifying potential risks, and formulating mitigation strategies.
- Building Strong Relationships with Stakeholders: Open and transparent communication with lenders, investors, critical suppliers, and other stakeholders is essential for building trust and securing support during challenging times. Regularly communicating financial performance, restructuring plans, and progress updates fosters collaboration and ensures everyone is on the same page.
In the ever-changing business landscape, proactive operational and debt restructuring is not a luxury but a necessity for struggling middle-market businesses. Early identification of the company’s challenges is crucial, so be sure processes are in place to regularly monitor your financial health, including debt-to-equity ratios, cash flow, and fixed charge (or debt service) coverage ratios. Furthermore, proactive communication with lenders builds trust and opens doors to flexible solutions before a crisis strikes.
Britt Terrell is managing director and head of capital markets at Palm Tree, which helps clients navigate corporate finance, leveraged acquisitions, and corporate debt restructuring.