| Summer 2008 - Monitoring Problem Companies During Down Markets |
|
Minding the Store in a Down Market Keeping an eye on Portfolio companies in downturns Well my phone has started to ring again – but it’s not because deal flow is picking up. In the last two months I’ve fielded not less than six Private Equity client calls asking me to review underperforming portfolio companies. Alarmingly, I’m even hearing from Senior Lenders on this issue. I thought there might be some value in putting together a newsletter on things to look for in your files during economic downturns. The problem is that the conditions that put a damper on deal flow can also put a damper on the financial performance of the files you already have in your portfolios. Sales volumes might be suffering, and prices for raw materials might be increasing. We already know that energy costs are higher. Inevitably costs to produce must increase. Do your portfolio companies have a plan to mitigate down market conditions? Are they flexing work force size and purchases to match the market? Are they doing it proactively or reactively? This is a time for increased vigilance. This Newsletter covers monitoring your Portfolio Files during downturns including:
If you visit www.charliereid.com you will find that Charlie Reid & Associates provides not just pre deal operational due diligence but also post deal evaluation of underperforming portfolio companies. We can generally establish very quickly whether or not management understands what they have to do in a down market and whether their plans are sound. If they don’t have a plan we can help develop one – again -- quickly. Happily this is not the majority of my work but from time to time it is necessary to help a client decide how to fix (or sometimes whether to fix) underperforming companies in their portfolios. The Most Common Mistake… … Waiting too long to act. In many cases your portfolio companies are well managed and while nobody likes to see less cash coming out of a company they own, most investors believe that – well – this too shall pass. Of course it doesn’t always pass as quickly as we thought it would – like now for instance. There is no right or wrong answer when establishing how patient you should be as you watch the monthly indicators moving in unfavourable directions. It’s a real dilemma. Sometimes a knee jerk reaction can be worse than no reaction, but to be honest I hardly ever see an overreaction to a downturn – mostly I see no reaction or very late reactions. Companies always seem to have a reason to avoid changing anything and let’s face it, it’s the path of least resistance. Most often companies simply don’t have a plan on how they will react to various changes in performance. The plan seems to come only after three to six months of decline. Sometimes it’s even later and sometimes it’s too late. As investors and owners it’s a good idea to have your own intervention plan in advance of a crisis or steady deterioration. Decide in advance what measures you will watch and how much rope you will give before stepping in or offering guidance. What to Look For The two most important operational indicators to watch are % Labour (including % direct, % indirect, and % salaried) and % Material. Take care to normalize these ratios for currency fluctuations. There should be very little variation in these ratios in most operations. When they begin to climb it’s almost always related to a decrease in volume. % Direct labour increases mean that the workforce is not being managed downward to match the volume changes. % Material increases often mean that purchasing practices have not changed to reflect volume reductions and/or that material price increases are being absorbed not passed on or resisted. But also watch inventories. Sometimes unadjusted purchasing practices show up in inventory increases. % Indirect labour is often at least partially variable so while it should increase with volume reduction be careful not to simply accept this increase as unavoidable. % Salaried labour is the same as Indirect. Highly variable mix can complicate this analysis but it should be manageable. (this is particular area of expertise for me so call me if in doubt). When to Look If you already watch these measures, watch them with higher frequency. Watch these indicators weekly in troubled times, and in no case should you be waiting for two weeks after month end for a proper “close”. Getting labour and material costs should be easy and fast. Getting sales should be easiest. What to do if performance is sliding The most important thing to do is ensure that your portfolio companies have a plan. It would be better if the company had a disaster recovery plan in place before the disaster occurs but I seldom see this – strike that – I’ve never seen this. Recovery plans seem to be developed after the performance slides not before. Keep in mind sliding performance is usually the result of decreasing revenue and increasing prices, NOT, actual negative changes in how the companies are operating. As such most companies experiencing difficulties in a down market often feel powerless as the pressure is external. You still need a plan. The plan should be clear on what impact it’s going to have on the operations and how this will be manifested in the operating statements (in other words – how will you know the plan is working). The plan should be simple. Back to basics is almost always the best approach. Homerun strategic solutions are seldom the answer in these situations. The plan should articulate what the next step is if there’s even more turbulence. What’s a Simple Plan? Examples: Cut back an operating shift, for example; Increase prices by 5%; Stop making that one part number with the high scrap rate and low selling price; Sell this asset. Etc. These may sound simplistic, obvious or even patronizing but you’d be surprised how few companies consider let alone take these actions without prodding from external agents such as Boards of Directors or influential Shareholders. As a Board member in several companies I speak from experience. A simple plan is one that can be implemented with a bit of planning and executed over a very short time frame. It will have clear measures that cannot be easily misstated. And remember … “Simple” is not the same as “easy”. Priorities Managing the workforce should be a priority. Cutting back shifts and staff is difficult but it is often the quickest solution to mitigate declining revenues. Make a labour cut back be as specific as possible. I always ask for a list of names of people who will no longer be paid and what things will no longer be done once the cut takes place. Capital projects are almost never the appropriate solution in these situations but there are exceptions. If your portfolio company is asking for more money I’d be suspicious that they’re looking for a homerun instead of fixing the blocking and tackling. Ongoing Monitoring Monitoring operating performance in more detail on an ongoing basis is always a good idea. Charlie Reid & Associates offers a course on interpreting operational measures that helps you identify the indicators that could be right for your operating companies. Charlie Reid & Associates Can Help Charlie Reid & Associates can assess the quality of the plan your portfolio companies put together; or we can help develop one for them. This is a generally a rapid deployment project requiring 3 to 5 days. Call us at 416-580-9573. Cheers Charlie |