Maybe Dilbert is Right
By David M. Weinstein
Principal, Lakeside Advisors
Reprinted with permission from The Journal of Corporate Renewal,
copyright Turnaround Management Association.
Scott Adams, the creator of Dilbert and author of The Dilbert Principle, states that he doesn’t know why the economy works, but he is quite certain it isn’t because brilliant people are managing it. According to Adams, “if you sum up all the absurd activities of management, the idiocies somehow cancel out, thus producing cool things people want to buy. Add the laws of supply and demand and you have pretty much described the whole theory of economics.” Further, according to Adams, “ninety percent of all new business ventures fail. Apparently ten percent of the time you get lucky, and that’s enough to support a modern economy.” While this observation may not be statistically correct, it does illustrate a point. No discussion of the economy would be complete without mentioning Management. Again, according to Adams, “first there were some amoebas. Deviant amoebas adapted better to the environment, thus becoming monkeys. Then came Total Quality Management.”
In the past twenty years, the economy has gone through evolutionary changes (perhaps not to the extent of deviant amoebas, but none-the-less, meaningful changes). In the early nineties, I authored an article that tracked the highly leveraged transactions (HLT’s) of the eighties that became the headline making bankruptcies of the nineties. We saw industry after industry suffer, more as a result of leverage than due to poor operations, the troubled economy or even fraud. From the headline-capturing tales of conglomerates and mammoth companies such as Penn Square and Drysdale Securities, and the Allied, Federated and Revco retail cases, to virtually the entire steel, healthcare and telecom industries. From the original Johns Manville case to the recent W.R. Grace, USG and Owen-Corning asbestos-related bankruptcy filings; and all the way to today’s big dogs, Enron and K-Mart. Case after case has caused the lending community to re-evaluate what it is doing both before and after the bankruptcies.
With the dust finally settled from the stampede of these highly leveraged transactions, we are now faced with companies with increasing problems due to poor operating performance, not merely leverage. In part, or because of this, DIP financing remains a much sought after financing tool to help companies rationalize their operations, improve their capital structures and if necessary, restructure their debts with creditors. However, the lessons of the past twenty years are evident in today’s DIP financing structures.
The Bankruptcy Code is designed to permit the debtor to reorganize rather than liquidate. The 1978 revision of the Code fostered the belief that bankruptcy is “debtor friendly”, thus permitting the same management team who may have caused some of the problems that precipitated the filing to remain in control during the bankruptcy process. This begs the question that if management caused, or at the very least, contributed to the bankruptcy, why would any lender back them to get out of the bankruptcy? Well, just as in the jungle, only the strong (should) survive. Companies do have Boards that bear the responsibility for weeding out incompetent chief executives. And in many instances, DIP lenders will require some form of outside operational or financial oversight by a crisis management or financial advisory firm as a prerequisite to any DIP financing.
In today’s environment, lenders routinely collateralize their DIP loans with both tangible and intangible assets of the debtor, as compared to ten years ago when the lender might have relied only on the Court granting “super priority claim” status without even taking a filed lien. According to a survey conducted by the Turnaround Management Association, the preeminent professional organization dedicated to corporate renewal, only 25% of the respondents said they noticed a tightening in DIP and Confirmation financing terms. However, more than 80% in the same survey responded that they have seen stricter covenants.
According to Chris MacDonald, a senior vice president with Foothill Capital, “ten years ago, Debtor-in-Possession financing was underwriting so-called insurance policies to Debtors which were overleveraged with unsecured debt and had moderate operating problems. With an occasional exception, DIP financing today is done defensively to cover operating missteps.” Barry Kastner, an executive vice president at Congress Financial, agrees. “DIP lending today versus DIP lending when it was so popular a decade ago poses a different set of issues for the lender. Whereas ten years ago, the big question was if the debtor would actually borrow; today’s DIP borrowers need money as part of the day-one funding. Today, the lender has little or no room to lend more aggressively against collateral since the debtor’s assets are usually fully leveraged when they file. ”
Ten years ago, many of the large retail bankruptcies were characterized by over-leverage due to the substantial amount of junk bond financing these debtors had put on their balance sheets to affect a buyout. By virtue of the automatic stay provision of the Bankruptcy Code, this class of unsecured creditors would not be entitled to current interest payments let alone any scheduled principal payments on their debt. By filing, the debtor effectively improved its cash flow by an amount at least equal to the debt service required on this debt, plus any net pick-up in trade payables which were similarly subject to the automatic stay. This “improvement in internally generated cash” was in many cases more than sufficient to provide the much needed liquidity, therefore resulting in little or no borrowings under the DIP financing line. This was the underlying basis for the credit decision to provide DIP financing. The biggest issue a lender faced in the early nineties was how to price the financing if the borrower never borrowed! Quite a conundrum for any lender!
Now fast forward ten years to the current lending environment. While leverage remains an issue, it is not the overwhelming juggernought or albatross it was then. Now we see companies (in some cases, entire industries), failing as a result of global economic conditions (e.g., the steel industry), or by over expansion (the telecom industry), or through mismanagement (like the healthcare sector). It could be argued that the current low interest rate environment masks some over leverage. Many more companies would be faced with the prospect of filing if interest rates jump just a fraction. Many companies today are just barely covering their interest expense. Any up-tick in interest rates could cause these marginal performers to fall into default and potentially file for bankruptcy protection.
The test of management in this environment is their ability to manage their operations, not just their balance sheets. Despite record low interest rates, companies are not generating sufficient cash flow to adequately fund their interest expense, let alone their capital expenditure requirements, their working capital needs, or even worse, their payroll. Trade creditors, historically a source of post-filing cash, have increasingly cut back their willingness to ship based solely on the administrative priority granted to them by the Bankruptcy Code. They are now asking for, if not outright requiring, COD (cash on delivery), or worse yet, CBD (cash before delivery) terms. The lack of post-filing trade credit has further burdened DIP lenders asked to supply liquidity needed to run the business. This was not the problem ten years ago when many debtors’ prepetition bank debt was unsecured. Today, it is more difficult, since many debtors enter bankruptcy with all of their assets already pledged to prepetition lenders. This does not provide the DIP lender with a pool of unencumbered assets with which to prime the liquidity pump to hopefully jump start the cash flow.
So where does this leave us? Is everything old new again? Have the rules changed but the players stayed the same? Does the rule of “what goes up must come down” still universally apply? We have concluded that leverage, while still a burden, is not the cause celeb it was ten years ago. This may be a function of the low interest rate environment, but nonetheless, leverage is not the sole cause of the current wave of bankruptcies. Certain industries, we have noted, are victims of general economic conditions (steel), and global events (telecom). That leaves management and poor operational performance as the ripple in today’s current wave.
Management should, by definition, be synonymous with leadership, and leadership is a subject that brings us back to Dilbert. According to Scott Adams, leadership is an intangible quality with no clear definition. The most important skill a leader must have is the ability to take credit for things that happen on their own. For example, according to Adams, “a tribal chieftain would claim credit for the change of the seasons and the fact that wood floats. They had the great advantage of the ignorance of the masses working for them. Television has largely filled this knowledge gap so the modern leader must take credit in more subtle ways.” In today’s environment, Adams suggests that if the company’s “accountants predict that profits are going up because of a change in international currency rates, then a good leader will create a company wide Quality Initiative, thus having a program in place to take credit for the profit increase.” (It should be noted that Adams wrote this over six years ago, well before the current “concerns” over accounting issues, hence proving that these issues are not ephemeral.)
It would be hard and certainly unfair to blame all of today’s business problems on management, or as we have defined, leadership. However, it also cannot be ignored that management missteps have caused many of the significant operational problems in today’s small and large companies, the large ones simply making more headlines. So, yes, in many ways the rules have indeed changed, but the players have remained the same.
|
