Due Diligence in the Distressed Organization

Due diligence may be thought of as a fact finding mission or investigative exercise. It is a process designed to provide information that is required to meet a specific goal or objective.

Typically it is used when a business is involved in purchase or sale, or requires financing. The distressed organization also requires due diligence to address a fundamental issue that exists for the stakeholders of all distressed organizations. This issue is the decision to attempt a turnaround or to liquidate the organization.

This decision is fundamental to the optimization of shareholder value. Executed correctly, due diligence will provide a solid platform that enables this process. It will also provide useful information concerning ancillary objectives such as divestiture or refinancing. Should a turnaround attempt be the option of choice, the due diligence process will also provide the basis for a viable plan.

Proper execution of due diligence in the distressed organization requires both depth and scope in the investigative process. Importantly the organization experiencing decline will possess inherent characteristics that both impede the process and reduce the time available to reach a conclusion.

This article will provide practical and useful information to the stakeholders of the distressed organization who must exercise due diligence. It will:

  • Provide insight concerning salient characteristics of the distressed organization
  • Describe the parameters necessary for turnaround success- the essence of the turnaround/liquidate decision.
  • Outline key issues relevant to due diligence in the distressed organization.
  • Provide actual examples or case studies to illustrate important points.

Characteristics of distress

Most organizations move along a continuum. The end points of this continuum are diametrical opposites that reflect a very different internal state of affairs.

At one end is the custodial environment reflecting a relatively healthy or robust organization. At the other is distress or even crisis. There are many points that lie in between. The positions that lie between health and distress are not static. They may vacillate , dramatically change direction or temporarily stall. While some movement is inevitable, an irreversible decline is not. Often there is an inflection point, a point where there can be a reversal of fortune.  Examining the organization in this light is the reason for due diligence in the distressed organization. Contrasting the custodial and distressed environment will illuminate the challenges to this process.

The custodial environment is relatively stable and resource rich. The organization is profitable with growing revenues. Other financial indicators such as margins and market share are likely growing. The organization is producing quality financial information that is timely, relevant, and reliable. There is particular emphasis on the application of management accounting and its integration into a culture of performance management. The information produced is used by a competent and stable management team. In these circumstances there are no threats from creditors. There are also no other threats that represent a clear and present danger.

The distressed environment is harsh, exigent and ambiguous. The organization is likely experiencing losses on operations with all or many financial indicators in decline. These may include margins, sales and market share. This decline will have likely impacted the balance sheet in the form of increased debt. The organization is also likely facing threats from numerous constituents.

In this environment the time available to act is very limited. Time is substantively determined by available cash. However poor financial performance has usually impaired financial resources. And if threats from any of numerous constituents become elevated, available time will be effectively reduced to zero with the onset of a full blown crisis.

Typically management information systems have been adversely affected by demands for all resources. The organizations ability to deliver useful financial information is further impaired by the human factor. Denial is often pervasive: the result is a paucity of critical thinking and reluctance by anyone to be the harbinger of bad news.

The extraordinary demands upon custodial management and lack of perspective are a powerful and negative force. As a result, information systems frequently produce data which is late, erroneous, insufficient or incomplete.

The following case describes an organization in distress in clear terms.

Distress - a Case Study

A few years ago the author served as CRO and CFO for a group of nursing homes. This group had been family owned for three generations and badly neglected for at least a decade. The last several years of operations had seen enormous operating losses and the deterioration continued.

Symptomatically:

  • At the time of appointment the company was experiencing a cash crisis. It was unable to meet payroll the next day.
  • Monthly billing had dropped by about 20% due entirely to sloppy billing practices and not occupancy issues.
  • There were over 40 lawsuits or pending law suits.
  • The secured lender had lost patience and a demand was imminent.
  • Quality of care was so substandard that the Department of Health was threatening to revoke the operating license. This impaired the ability to maintain occupancy.
  • Morale was poor and for some position categories turnover was 100%
  • Accounting and MIS was dysfunctional. Periodic financial reports were not prepared, historical financial information was in doubt and balance sheet information was inaccurate.
  • Emblematic of this lack of corporate discipline, the company lost over 1M simply due to a failure to provide requisite cost information to a payer

This company was truly at the far end of the continuum and in extreme distress. In fact as a late decline this situation was as bad as it gets. It certainly seemed that the end was near and liquidation was imminent.

Parameters for Turnaround Success

As dismal as this situation appeared, ultimately it was determined that the group met the parameters required for turnaround success. These are: a viable core product or service, financial resources, and competent management.

The core is comprised of goods or services that have a positive margin or will in the near future. Ultimately the core is the platform expected to generate profitable sales. This platform can only be leveraged if sufficient financial resources exist as fuel to execute and implement recovery. Lastly competent management must exist to act as a driver of change. In this case massive operational restructuring was combined with debt rationalization via Chptr 11. The secured lender was convinced to provide additional working capital and a CRO was appointed. This completed a full turnaround.

Information gathering - key issues

Above all due diligence in the distressed organization should proceed with speed and extreme skepticism. In terms of a fact finding mission it is important to consider the following:

  • Time is everything. There is always less of it than it appears.
  • The information available may be very limited in nature.
  • Information that is available is almost always flawed, imperfect or downright deceptive.
  • This information will have a positive bias.
  • ¬∑Management will usually seek to preserve the status quo. This will reduce transparency and increase the positive bias.

It is worth considering these characteristics in light of an actual case.

Case - an embroiderer

A few years ago the author served as CEO for a company that did embroidery and some garment manufacturing. It had plants in the United States, Canada and India. The company had been family owned for three generations and had obvious signs of deterioration. A preliminary look at its affairs revealed the following:

  • Sales had been declining slowly and they had lost two significant accounts apparently without warning.
  • There had been little reinvestment in plant equipment or technology for several years
  • Capacity far exceeded production requirements
  • The President was a family member and was focused upon an inappropriate internet strategy
  • The balance sheet appeared to have some strength. Debt was not excessive relative to apparent asset value.
  • The CFO had been in place for several years. Periodic financial reporting included both P&L and other reports relative to sales margins and production
  • The company was operating at almost breakeven
  • The CFO stated that the different locations were stand alone in terms of legal obligations to creditors.

On the basis of this information the author felt that the three parameters required: core product, financing and management were present or nearly so. A preliminary view suggested that margins could be improved, assets could be sold or leveraged and that management would accept necessary support. 

The company also appeared to be an ideal candidate for rationalization or downsizing through plant closure. However a little more scrutiny revealed the following:

  • Operating losses were being hidden. Once revealed they confirmed that the company was generating losses on operations and that margins were very poor. For some product lines they were actually negative.
  • Asset values were overstated. There was considerable obsolete inventory and real estate values were inflated. This left little room for refinancing.
  • Given these issues it was obvious that management was seriously deficient
  • It was also revealed that different plant locations had cross guarantees outstanding to the secured lender precluding a simple rationalization by closing a plant.  In fact the company was unaware of such guarantees, the author was actually informed of the fact by the secured lender.

The company was actually seriously deficient with respect to all three parameters. It was downsized marginally improving performance, ultimately it was liquidated.  

Veritas Vitae - Due Diligence Methodology

The primary goal of due diligence is to provide information that supports the turnaround or liquidate decision. The framework for this determination is provided using three parameters: management, core product, and financial resources.

The process will also yield ancillary benefits such as:

  • Quickly outline opportunities for cost reduction and revenue enhancement
  • Yield insights into accounting and MIS deficiencies
  • Provide accurate historical data and assist with pro forma planning
  • Provide a breakdown of revenue /expense in detail by product/department/division
  • Enhance the capability for market planning
  • Yield information which is valuable in the preparation of other reports.
  • Provide useful information concerning the quality and capability of management.

Given the nature of the environment it is necessary to optimize the time required and to have a procedure to evaluate information and ensure its veracity. Time and money are equated. The first step is to establish reliable cash reports and projections ( See Cash Management in Distressed Organizations- The Journal of Corporate Renewal Sept/Oct 2009)

Secondly it is necessary to establish an independent test center that establishes autonomous verification that the data is reliable. The use of incremental testing, contingent upon the perceived risk of the center, optimizes the use of time. Thus the parameters of speed and accuracy are accommodated. Operationally, the center also assists in the correction of MIS or accounting deficiencies on an opportunistic basis . This may seem counterintuitive but information gathering is an evolutionary and recursive process. During this process some information is used, some evaluated, and some rejected and corrected. Simultaneously action will be taken to improve the organization as it can be. In the distressed organization concurrence of activities is essential, a linear process of execution will fail given time constraints. Even though the goal is the completion of due diligence, it cannot be assumed that a turnaround will not be the option of choice. Evaluation,planning and action are not mutually exclusive.

Testing includes proof of revenue and expense tests, but also includes some balance sheet items such as hidden collateral, nonperforming assets and past due liabilities. Testing is incremental both in depth and breadth. Tests begin with a basic or cursory evaluation and can be increased to a forensic level as needed. They include:

  • Financial Statement Analysis
  • Comparison and analysis of the Trial Balance
  • A review of the General Ledger
  • Books of original entry ,such as purchases and sales
  • Source documents

The balance sheet must be re constructed with a critical eye. The data collected must be verified independently. The following steps will result in an accurate view of assets and liabilities:

  • The visual inspection of all tangible assets at all locations. This includes: plant, equipment, vehicles, real estate and inventory
  • An inventory of all tangible assets including A/R, patents, trademarks, leases and interests in other entities
  • A professional evaluation of all assets
  • Verification from source of current balances for all loans, mortgages and financial liabilities. Particular attention must be paid to those that are less obvious such as third party liabilities and contingent liabilities.
  • Through the use of competent legal counsel, the verification of all encumbrances, liens or ,mortgages on company assets.

At the conclusion of this process the viability of the firm will have become obvious. A core product possessing a positive margin will have been revealed if present. A reconstituted balance sheet with realistic values and true liability balances will provide a path for financing or raising cash from divestiture. It will also be necessary to support either statutory or non statutory restructuring of debt. In aggregate the exercise in due diligence will provide a comprehensive and accurate notion about how the company will perform in a new paradigm. Lastly the quality and competence of management will be verified confirming whatever changes are necessary.

Summary

Due diligence is a fact finding mission or investigative process. The distressed organization requires this process to address an issue of fundamental importance to all stakeholders. This is the decision to liquidate the organization or to attempt a turnaround. The parameters necessary for turnaround success are: core product,financial resources and competent management.

The organization in decline represents a special challenge to the process of due diligence .It is a harsh, extreme, ambiguous and exigent environment. In this setting time is short and information systems are likely impaired. This creates difficulties in gathering and assessing data. It is crucial that all data be viewed with significant skepticism.

The process should begin with a reliable cash budget. Cash is the lifeblood of any organization. This exercise provides threat management and starts the process of developing other financial reports and projections. Information is tested for accuracy keeping time constraints in mind.  Testing will include proof of revenue and expense tests. The balance sheet should be reconstructed with realistic asset values and proven balances for liabilities. Information provided will:

  • Establish a meaningful notion of potential performance in a new paradigm
  • Using real asset values it will provide a path for financing or divestiture
  • It will provide information necessary for statutory or non statutory restructuring
  • Provide a wealth of information concerning the organization that will give a boost to any recovery effort.

In aggregate this information will answer the fundamental turnaround or liquidate decision. It will also facilitate execution of the chosen strategy.

By: Tom M Onich CTP
Published in the Secured Lender

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