journal · $1.4 trillion of speculative-grade credit through to 2014, continuing weakness in asset...

. perspective: TURNING THE TURNAROUND ON ITS HEAD . AlternAtive viewpoint: WHAT NEXT FOR PRIVATE EQUITY? . Fti roundtAble: HOW TO DRIVE DOWN HEALTHCARE COSTS . leAdership: HOW TO ENGAGE WITH EMPLOYEES DURING CHALLENGING TIMES . studY: WHY THE ADVERTISING INDUSTRY WILL NOT RECOVER UNTIL 2014 .

JournalFall 2009 . Launch issueQuarterly Insights from FTI Consulting

The Next WaveHow will companies ride out $900 billion of upcoming debt maturities?

Jack DunnPresiDent & ceO

ceo’s letter

Are we out of the woods? This seems to be the question on everyone’s mind today. According to United States Treasury Secretary Timothy Geithner, “A year on from the moment of crisis, it is clear that we have stepped back from the brink and that we are pointed in the right

direction.” By most indicators, his assessment is correct, but what exactly does this new direction look like? Has the global marketplace been fundamentally altered by the past two years of chaos? Will financial stability and economic prosperity look different in the future? Will a new understanding of risk change how we define and manage enterprise value?

The new rules are still being written. But one thing is certain: corporations, investors and governments will move forward with an acute awareness of what it feels like to be operating on the brink. And this awareness, at least for the next generation, will surely affect how these institutions set strategy, manage risk and achieve impact. Just as cities don’t recover from earthquakes overnight, markets don’t recover from systemic shocks in a matter of quarters, or even years.

As is evident in this inaugural issue of FTI Journal, these systemic aftershocks will come in many forms, including:

n Mountainous corporate debt obligations which risk undermining economic recovery (page 8)

n Bold proposals and counter-proposals for United States healthcare reform (page 36)

n Communications challenges facing business leaders in a downturn (page 25)

Given the nature of FTI’s client assignments, our professionals have lived and worked behind the scenes, or, as we like to call it, behind the headlines, for nearly three decades. We’ve been integral to our clients’ success but often invisible to much of the outside world. The recent economic crisis and its aftershocks have convinced us that now is the time to invite you, our reader, to share in our experiences and to benefit from our collective knowledge and lessons learned.

We have a bold vision for FTI Journal, and will strive to create a publication that is relevant, informative and insightful. Our professionals – and the occasional outside contributor – will dissect some of the most pressing and controversial subjects of the day while providing practical, actionable advice to help you protect and enhance your company’s – or client’s – enterprise value. I invite you to spend an hour or more exploring these pages, and welcome your feedback on this first edition and your ideas and suggestions for the future.

Thank you.

aftershOcks

Just as cities don’t recover from earthquakes overnight, markets don’t recover from systemic shocks in a matter of quarters, or even years.

DeLain Gray corporate finance/restructuring

neal hochberg forensic and Litigation consulting

John klick economic consulting

David remnitz fti technology

charles Watson strategic communications (fD)

sue Brownstrategic communications (fD)

adam cohenfti technology

randall eisenbergcorporate finance/restructuring

thomas fedorekforensic and Litigation consulting

Melissa kresse strategic communications (fD)

elizabeth kulikcorporate finance/restructuring (sMG)

edward reillystrategic communications (fD)

Bruce schonbrauncorporate finance/restructuring (sMG)

www.ftijournal.com

[email protected]

FTI EdITorIal Board

The views expressed in the following articles represent those of the authors and commentators and not necessarily the views of FTI Consulting, Inc.

W W W . F T I C O N S U L T I N G . C O M N Y S E : F C N

COMPLIANCE– Regulatory compliance– Antitrust disputes– Public policy– Foreign Corrupt Practices Act

FINANCE– Capital solutions– Transaction advisory services– Creditor advisory services– Valuation consulting

GOVERNANCE– Internal controls– Board advisory– SEC investigations– International due diligence– Corporate integrity

INFORMATION– Global electronic discovery– Financial and enterprise data analysis– Ringtail®– Strategic security

LIABILITY– Litigation consulting– Dispute consulting– Enterprise risk management– Electronic evidence discovery– Expert testimony

PERFORMANCE– Business economics– Interim management– Operational improvement– Turnaround and restructuring– Marketing consulting

REPUTATION– Corporate, financial and crisis

communications– Public affairs– Issues management– Corporate branding

The FTI service model provides a single source that addresses the interrelated issues that can affect enterprise value. Our goal is not just to solve problems, but to anticipate them, surround them and deliver solutions that are immediate and sustainable.

Protecting and Enhancing

Enterprise Value

ENTERPRISE VALUE

FTI Journal - Fall 2009 Downloaded from www.ftijournal.com

turninG $1 intO 33 cents How increasing digital substitution – advertising spending moving online from more traditional sources – will affect the recovery of the advertising industry.

alternative viewpoint: What next fOr Private equity?The FTI Journal asks six industry leaders to share their perspectives on the future of private equity.

roundtable: cuttinG u.s. heaLthcare cOstsThere are many ideas but few practical solutions. The FTI Journal gathers experts from a variety of backgrounds to share insights and provide some answers.

ManaGinG cOrPOrate chaOsFire, flood, biohazard and terrorism. How can firms prepare themselves for a potential crisis and what are the first steps that should be taken if disaster strikes?

the faLLOut Of PrOxy refOrMImpending reforms to proxy voting regulations will change the way shareholders have their say in how companies are run. But there are poten-tial pitfalls with the proposed new rules.

perspective: yOu can’t cut yOur Way tO a successfuL turnarOunDThere’s high demand for business turnaround experts. But from a long-term perspective a company cannot cut its way to an operational turnaround. What are the elements of turnaround strategies that work?

BrOaDBanD BenefitsWho will benefit most from consumers increasingly treating broadband as an essential household item? FTI does the math.

cover storY: riDinG the next Wave Of DeBt MaturitiesA spike in the maturity of corporate debt in the U.S. and almost all OECD countries will create huge challenges and opportunities. The cumulative need for refinancing more than $1.4 trillion of speculative-grade credit through to 2014, continuing weakness in asset prices and falling consumer demand are likely to claim victims for some time to come.

cOntents Fall 2009 . Launch issue

the neW LeaDershiP iMPerativeWhy business leaders should focus on motivating their employees during difficult times.


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media and entertainment

In a comprehensive look at advertising spending, new research by FTI says that the market will not recover to 2008 levels until 2014 and examines the disruptive influence of the Internet on more traditional forms of advertising.

In the vortex of the economic downturn, advertising-supported media companies are facing not only dramatic spending decreases, but the

massively disruptive effects of digital substitution. After an unprecedented three consecutive years of contraction in real advertising spending, advertising-supported media companies are asking when the turnaround will come, and wondering if advertising spending

patterns will be forever changed.Based on more than 1,000 hours

of research into advertising spending across 12 sectors, a recent study by FTI Consulting forecasts a 13% decline in advertising spending in 2009 and another 1% decline in 2010. This follows decreases of 2% and 5% in 2007 and 2008 respectively. While the report predicts a small upturn in 2011, real advertising spending will not climb back to 2008 levels of $284 billion until late 2014.

Looking at the trend in spending patterns, traditional print media (particularly newspapers) will continue to bear the brunt of the spending decline, and will regain prior years’ market shares only in rare cases. Internet substitution has permanently changed print media’s market share. Over the coming years, the Internet’s share of advertising spending is expected to grow at a steady pace, rising from current levels of roughly 9% of total advertising spending to 15% in 2015. Exacerbating the problem for traditional media companies is that one dollar of advertising spending on traditional media is replaced by just 33 cents on Internet sources. Thus, the fastest-growing segment of advertising spending substitutes digital cents for each previous dollar spent.

The Impact of Online Advertising on Traditional Media Our forecast research considered historical advertising spending patterns by medium to estimate the rate of growth of the Internet over the next five years, determined what percentage share will represent a steady state for the Internet and assessed its impact on traditional media.

The research indicated that television was the best analogy to the Internet in terms of its impact as a disruptive technology. The relationship between household penetration and advertising market share of TV is very similar to that of the Internet. After its introduction in 1949, television experienced rapid household penetration, reaching 50% of homes in four years and 90% in only 13 years. It captured about 15% of the advertising market during that time period, 20% after 25 years and eventually settled, 40 years later, at its current level of about 25%. Television put dramatic pressure on newspapers, which accounted for 37% of advertising spending in 1949 but only 29% of advertising spend by 1962. Radio’s share of advertising spending contracted by 50% over this time period.

The Internet also took approximately four years to reach 50% household penetration. In comparison

Truth in Advertising

Gregory AttiyehManaging DirectorCorporate Finance

With contributions from

Bruce Benson, Economic Consulting

Chris Nicholls, Corporate Finance/Restructuring

Roger Scadron, Corporate Finance/Restructuring

Luke Schaeffer, Corporate Finance/Restructuring

Carlyn Taylor, Corporate Finance/Restructuring

2014When advertising levels will recover to 2008 levels of $284 billion

media and entertainment

Historical and Projected Advertising Spending by Media

Source: FTI Consulting

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to TV’s 15% ad share in 13 years, Internet ad-spending share is expected to reach 10% by the end of 2009. This is 15 years after Internet usage debuted in the home and 11 years after broadband connections were introduced. FTI’s research suggests that the Internet will eventually peak and settle at approximately a 25% advertising market share. This forecast is based on a dynamic advertising-spend regression model, which uses the historical relationship between five variables to predict future ad spending: consumer spending, private investment, the unemployment rate, online market share and the incremental impact of either a U.S. presidential election or the Olympics.

Until 2000, real GDP growth and real advertising spending correlated quite directly. Advertising spending

represented about 2% of GDP. When the economy grew, advertising spending grew and when GDP contracted, advertising spending contracted disproportionately. Since GDP is comprised of roughly 70% consumer spending, 10% private investment spending and 20% government spending, FTI found a stronger relationship between advertising spending and consumer outlays and private investment.

But spending and investment alone did not predict the trends experienced since 2000 quite as well. Therefore, to improve the accuracy of the model, particularly as GDP contracted, we also factored into our analysis three other variables.

First was the impact on consumer spending of employment, which we captured with changes in the unemployment rate. And, because of the effect of online price performance on total advertising spending and the resulting pricing pressures on traditional advertising media, we added a variable to reflect the change in online advertising market share. Finally, we captured the average boost in advertising spend during a U.S. presidential election and Olympic Games years.

The result of these additional factors was significant. The historical correlation from using our five factors was high, and the post-2000 correlation held even better. zx

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Most companies that are meeting or exceeding earnings estimates in 2009 are doing so as a result of aggressive cost-cutting rather than generating top-line growth.

Dominic DiNapoli Chief Operating Officer FTI Consulting

As economic historians debate whether or not Lehman Brothers could have been saved, it’s clear that the global financial markets crisis of 2008 was entirely a self-inflicted wound, which had been years in the making. There were no external factors or shocks to blame. Quite simply, investors collectively lost confidence in the decision-making and risk-taking practices of large financial institutions, private investment capital and large swathes of Corporate America – arguably with good reason.

In the corporate sector, credit quality had never been so poor going into a recession. As we entered the maelstrom a little over a year ago, some 62% of rated U.S. non-financial corporate issuers were considered

since late 2008 and the challenges that remain firmly in place even as the global economy seems poised for recovery in 2010.

How are Financial Markets Faring?Following the near-death experience in capital markets last fall and the precipitous price declines that continued into early 2009, the recovery in global financial markets has been striking. Conversations have moved on from open-ended bailouts, the nationalization of troubled industries and other dire rescue plans to, ultimately, the realization that the collective commitments and bold actions of policymakers in the developed world appear to have prevented the Depression-like scenario that seemed plausible last December. Yet this is no guarantee of smooth sailing in the months and years ahead, and it is certainly not a harbinger of borrower-friendly credit markets. Capital markets have opened up again to investment-grade and near investment-grade corporate issuers, but global fixed-income investors remain highly selective (and demanding) for riskier issuers.

One striking feature of the environment today is the growing divide that has opened up between investment banks and their corporate and retail counterparts. Investment banks – particularly in more

speculative-grade by Standard & Poor’s (S&P), of which over two-thirds were considered “deeper junk” (B+ or worse) – a significant deterioration in the distribution of credit ratings compared to a decade earlier. The leveraged buyout (LBO) craze of mid-decade contributed greatly to this phenomenon, with some $400 billion of LBO-related loans made in the U.S. between 2005 and 2007, according to Reuters LPC. European borrowers got in on the act too, with the equivalent of some $580 billion of leveraged M&A loans made during this same period, over half of them earmarked for LBO transactions. Already that fallout has begun; S&P recently noted that 42 of 46 European debt defaults of credit-rated or credit-estimated issuers that occurred in the first half of 2009 were LBO deals gone sour.

Today, even after cleansing the pool of rated issuers of hundreds of defaults that have occurred since early 2008, corporate credit quality remains exceptionally weak. Operating and financial challenges for high-risk borrowers still abound. The damage inflicted on a fragile global financial system from the combination of excessive risk-taking, high leverage and sharp economic contraction cannot be repaired in haste, notwithstanding the impressive rally in global credit markets since March 2009. This article will explore how risky borrowers have responded to largely inaccessible credit markets

The Next Wave

“Debts are fun when you are acquiring them, but none are fun

when you set about retiring them.” So said Ogden Nash, the late American poet and humorist. What then for companies that racked up billions of dollars of cheap debt during the go-go years of the credit boom? How will they cope now, faced with rather more sober refinancing conditions as maturity dates move into view?

With contributions from

Randall Eisenberg, Corporate Finance/Restructuring

Steven Kingsley, Economic Consulting

Kevin Lavin, Corporate Finance/Restructuring

A spike in maturities of corporate debt in the U.S. and other OECD countries threatens to capsize the nascent economic recovery. Falling assets prices, weak consumer demand and deleveraging by lenders means that many companies facing some $900 billion of speculative-grade debt maturities by 2014 will struggle to refinance. FTI Consulting counts the cost of going overboard during the boom years and examines the outlook for survivors.

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traditional business areas such as foreign exchange – are delivering exceptionally good results. This is because a lot of capacity and capital has been withdrawn from the wholesale markets. By contrast, retail and corporate banking continues to struggle with asset quality and a lack of attractive new business.

As might have been expected, the first beneficiaries of government intervention programs have been financial markets. Equities, in particular, have rallied globally, while corporate credit markets have returned to pre-Lehman levels.

What’s Happening on Main Street?The recession, which officially began in December 2007, is both a by-product of credit tightening and a contributor to its perpetuation; and this recession has been particularly brutal in terms of its impact on U.S. employment and economic activity and the destruction of personal wealth. Real U.S. gross domestic product (GDP) contracted by nearly 6% in the six-month period ended March 2009: its worst two-quarter slump since 1958. Real median household income declined 3.6% in 2008 – erasing gains of the past three years; and household net worth has fallen by 22% from its peak in mid-2007. Consequently, consumers and businesses alike have become exceedingly cautious in their spending

fed the leveraged loan market, have pulled back in a big way.

Traditional banks, many of which are either capital-challenged or propped up with federal assistance, are significantly more cautious lenders than previously. All told, new leveraged loan activity remains several hundred billion dollars below peak levels (see Chart A), and this decline dwarfs any buoyancy of new issuance activity in high-yield bond markets so far in 2009.

This much is clear. Big changes in the regulation of banks are coming. The effect of events over the past two years has prompted regulators in major countries to revisit rules and consider sweeping changes. The area of change most likely to affect corporate borrowers is that of capital requirements for banks.

Regulators are almost certain to introduce new rules to limit both the risks that many banks retain and the size of their asset base for any given level of capital. The message here is that banks will need to raise fresh capital just to stay where they are in terms of size. Meanwhile, loan underwriting standards are being raised, too. At best, all of this will make refinancing more challenging and expensive; at worst, over-zealous rule-making could lead to severe deleveraging and credit contraction.

Throw in the unfolding collapse of real asset values, and you have a heady cocktail likely to cause a lingering hangover. Declining residential property values, negative home equity and rising foreclosures have dominated business headlines for a while, but there is widespread belief that commercial real estate defaults are the next headline-makers.

Collateral values underlying commercial real estate debt are widely expected to drop by 35%-40% from peak 2007 levels during this down cycle. Transaction activity has plummeted and Commercial Mortgage-Backed Securities (CMBS) markets, previously a major source of real-estate finance, remain dormant, making the prospect of refinancing maturing debt without additional equity incredibly difficult.

A recent article in The New York Times (citing a widely read Deutsche Bank report) noted that “as many as 65% of commercial

the private sector is not just an American storyline. Consumer-driven demand in much of Continental Europe remains in contraction and massive government intervention has been required to prop up economies in most Western European nations. Despite recent indications that the recession may have ended in Germany and France, the outlook for private consumption in Europe remains poor in 2010.

Clouds are mostly gray in the corporate sector. Operating earnings for the S&P 500 Index have declined 53% from their peak in 2007, considerably worse than the 32% peak-to-trough decline in the 2001 recession and the 25% decline in the 1990-91 recession. Most companies that are meeting or exceeding earnings estimates in 2009 are doing so as a result of aggressive cost-cutting rather than generating top-line growth.

These tough measures are driving employers to shed staff in record numbers, blunting consumer confidence and reinforcing their reluctance to spend. Until there is discernible improvement in consumer sentiment, it is difficult to foresee any meaningful growth in their current timid spending patterns. Yes, a Depression-like scenario may have been avoided, but a period of prolonged economic weakness or anemic growth remains a distinct possibility.

We should remember that while equities are in recovery mode, the default and employment cycles are lagging indicators, which will continue to generate bad news for many months to come.

What are the Prospects for Corporate Borrowers?Over the past two years, we have also seen a dramatic change in the composition of the lender landscape. There are now fewer financial institutions, and those that remain are significantly more risk-averse. New paper issuance by collateralized loan obligations (CLOs), structured finance vehicles which provided so much cheap capital during the peak years, has largely dried up. Other non-bank lenders, such as hedge funds and pension funds, which also

and finance decisions of late – largely by choice, but also driven by market-imposed discipline.

Consumer spending, the main driver of U.S. economic activity, remains in deep doldrums. This is hardly surprising, given that three pillars of consumer confidence have crumbled: house prices (down nationally by nearly one-third), the unemployment rate (more than doubling to 9.8% – its highest level in 26 years) and the value of financial assets such as savings accounts and 401(k)s (down by more than 20% since the peak).

There are clear signs that many consumers have downshifted to survival mode. Monthly discretionary spending totals by U.S. consumers have been consistently lower by near double-digit rates or worse (year-on-year) in most product categories outside of consumables.

Despite talk of early recovery, there is virtually no evidence that consumers are willing to open their wallets without steep incentives, such as the ‘Cash for Clunkers’ program. Survey data consistently shows that about three-quarters of all Americans have cut back on personal spending. Credit-card debt outstanding has contracted at a record rate so far in 2009, while the personal savings rate has moved from nearly zero to its highest level in more than two decades – distinct signs that behavioral changes afoot may be more than just temporary adjustments.

This state of high anxiety within

mortgages maturing over the next few years are unlikely to qualify for refinancing because of the drop in property values and new stricter underwriting standards.” Deutsche Bank Securities expects loss rates from defaulting real estate loans to exceed 10% of outstanding CMBS loan balances, a loss rate that would exceed the real estate crash of the early 1990s.

Until there is some persuasive evidence that the economic recovery has traction and that businesses are finally starting to expand again, markets for commercial real estate are unlikely to improve. Generally speaking, commercial real-estate markets tend to lag behind the economic cycle by at least one year.

A dearth of deal activity and depressed values in the M&A market are also impeding corporate turnarounds. There is little appetite to do deals at what might have once been considered ‘fair value,’ limiting the options of distressed corporates looking to dispose of assets to provide liquidity or refinance debt. Companies that can afford to do so are biding their time until the deal-making environment improves.

It is against this backdrop that hundreds of billions of dollars worth of leveraged corporate debt and commercial property loans will be maturing over the next five years. The ability of borrowers to meet or otherwise satisfy these upcoming obligations will depend on market-place conditions and economic circumstances outside their control, thus prolonging uncertainty in credit markets and corporate turnaround prospects.

The A&E solution does nothing other than buy time.

Chart A: U.S. Leveraged Lending Quantifying the Potential Size of the Refinancing ProblemAn S&P study published in May showcases the scope of the future debt threat. The study analyzed nearly $4.4 trillion of U.S.-issued rated non-financial corporate debt, which included loans, notes and bonds. About $2 trillion (or 45%) was rated as speculative-grade debt, and $1.3 trillion of this total – or nearly two-thirds – was rated single-B or lower, a common threshold of ‘deep junk.’ Moreover, of the $1.4 trillion of speculative-grade debt scheduled to mature within the next five years, nearly $900 billion is rated single-B or worse. This is especially worrisome, given the ongoing difficulties of low-rated issuers in accessing credit markets despite the 2009 rally, and the materially higher default rates for issuers rated single-B or worse. The current skew of S&P’s ratings distribution of speculative-grade debt towards deep junk is one big reason why the rating agency is projecting an all-time high spec-grade default rate of 14% during this cycle, and a solidly double-digit default rate one year from now. Charts B and C show breakdowns of maturing debt by current rating and by debt type over the next five years.

For many leveraged loans, most maturities in the 2010-2014 time frame represent incredibly borrower-friendly deals originating from 2005-2007. Renewals at previous levels, terms and rates are most unlikely even for compliant, well-performing borrowers. Furthermore, a sizeable slug of these maturing loans represents LBO financings for deals that were aggressively structured and favorably priced.

In many cases, the new math simply won’t work come maturity time. Reuters LPC data indicates that some $230 billion of U.S. LBO-related term loans will mature within five years. This phenomenon is by no means endemic to the U.S.; Western European nations were also caught up in the leveraged buyout craze and the equivalent of $140 billion of LBO-related term loans will likewise be maturing by the end of 2014.

Access to revolving credit continues to be reined in as traditional lenders seek to cut the size of new facilities,

Source: Reuters

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Revolving Credit FacilitiesTerm LoansBonds and Notes

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increase pricing spreads, shorten maturities and enhance collateral packages – in short, reduce their exposure to high-risk corporate borrowers. In May, Sears Holdings agreed to a bifurcated extension of its existing $4 billion asset-based revolver that was scheduled to mature in March 2010. Sears could only manage to get its lending syndicate to extend $2.4 billion of the original first lien facility by two years, despite a generous pricing margin increase of over 300 bps, a LIBOR floor, upfront fees and a BB+ rating. Now that’s

borrowers that tended to call the shots. While large global companies often have access to alternative financing options or the ability to generate working capital spontaneously, those inhabiting the most precarious end of the borrowing spectrum typically have little choice but to accept more onerous terms and conditions offered by lenders.

Conservative lending practices and capital rationing by banks will disproportionately hurt small and middle-market companies, since the new emphasis on relationship banking and key accounts naturally favors the largest and most diverse clients that generate business volume and can be cross-sold an array of banking services. Middle-market borrowers are already feeling the neglect.

Patching Up the WoundedDespite the daunting parade of upcoming corporate-debt maturities, there are no outward signs of panic just yet. Scheduled maturities for 2010 are relatively light (Chart B) and most likely to be manageable under current market conditions. However, the refinancing burden will intensify in 2011 and beyond. Concerned senior executives of underperforming businesses may be working hard to create a meaningful earnings recovery by then, but few are banking on it to save the day, judging by their actions of late.

Compelling evidence of highly cautious attitudes about the corporate credit environment can be found by examining the flurry of amends and extends (A&Es) carried out in 2009, often pre-emptive and usually on very costly terms, for debt maturities that were one or two years away. A&Es are essentially short-term deals that allow a company to extend loan maturities.

For borrowers, A&Es can push out maturities that cannot be refinanced outright, or they can grant financial covenant relief or added headroom until operating results improve. Lenders typically get to re-price these loans closer to market spreads, insert tougher loan covenants and extract lucrative fees as well. A&Es account for much of the recent leveraged lending activity, with S&P reporting over 200 rated borrower requests for loan amendments in the first half of 2009.

The problem with the A&E solution, known as ‘forward-start agreements’ in Europe, is that often it just delays the

risk aversion! It’s hard to believe the original ABL revolver was priced at only 88 bps over LIBOR in 2005.

The withdrawal or restriction of a line of credit can drive trade creditors and other critical suppliers to reduce their own exposures, by changing credit terms or placing riskier accounts on limit. This can intensify the pressure on a struggling company’s working capital when they are most likely to need it. In today’s new credit environment, the negotiating advantage has undoubtedly shifted back in favor of lenders, following several years when it was the

Chart C: U.S. Speculative-Grade Debt Maturing by Type (2010-2014)

Chart B: U.S. Speculative-Grade Debt Maturing by Rating (2010-2014)

Source: S&P’s Global Fixed Income Research

inevitable day of reckoning. It is a leap of faith by borrowers and lenders that the lending environment and operating conditions will be substantially better in the not-too-distant future. It does nothing to remedy the fundamental problem: too much debt. And given the mountains of debt due for refinancing before 2014, there is no assurance that credit markets won’t be just as tight or selective as these revised maturity dates approach.

Similarly, on the bond side, debt-exchange offers – whereby companies offer bondholders the opportunity to exchange maturing bonds for new bonds with a later maturity date and/or equity positions – have figured prominently in restructuring activity this year. Through August, S&P tabulated 74 distressed debt exchanges of rated securities in 2009 – easily more than twice as many as in the whole of 2008. Like A&Es, these transactions are often viewed as short-term fixes that allow distressed borrowers to buy some time to repair their businesses while achieving some degree of near-term financial relief.

This option is only possible because junior creditors often recognize that they are unlikely to see any meaningful recovery under a bankruptcy scenario, given the present economic environment and marketplace conditions. Ironically, it is the distressed borrower that often has the upper hand in these colorful, if not contentious, negotiations with bondholders, by using the prospect of a Chapter 11 filing as a cudgel to get creditors on board with an exchange

proposal. Despite these fervent efforts to stave off payment defaults and bankruptcy, history tells us that many companies orchestrating distressed debt exchanges today will eventually file for Chapter 11 relief.

Both A&Es and distressed debt exchanges are practical responses to the scarcity of fresh capital for perceived high-risk borrowers in today’s new lending regime. But what other options are available, and what should companies facing significant maturities in 2011 and 2012 be doing now to prepare for the refinancing that’s just ahead?

The Potential FalloutFor the legions of companies that financed their growth with piles of cheap debt, the double-whammy of a recession and a stringent credit environment is likely to hasten a showdown with lenders or creditors. While A&Es and distressed debt exchanges might paper over the cracks in the short term, by allowing struggling companies to limp along in an uncompetitive fashion, the pain is merely prolonged, and recoveries for creditors may ultimately worsen.

This backdrop is likely to mean heightened levels of bankruptcies well beyond the end of this recession. Once upon a time, a failing business might still have had new money thrown at it. Nowadays investors or lenders are more likely to be throwing in the towel, or at least be looking at other ways to extract value and maximize recoveries – without necessarily saving the enterprise.

Turnaround professionals and interim managers will be utilized more extensively as key players lose patience with incumbent executives in floundering organizations.

While deal-making continues to be difficult, there has been a huge upturn in distressed M&A activity. The Deal recently reported that Section 363 sales – the equivalent of auctioning off a failed entity’s business or assets – have almost doubled in 2009. These days especially, it may take a while to get to a Chapter 11 filing, but once there, the timetable really accelerates for some debtors.

Vulnerable sectors going forward will include a raft of consumer-dependent businesses that are asset-intensive, and burdened with debt or other onerous financial obligations. This extends well beyond the retail sector itself and includes airlines, travel and lodging, gaming, consumer finance, media and entertainment and consumer product makers, among others. In the healthcare sector, retirement homes and assisted-living communities are also looking vulnerable as the falling value of residential real estate and retirement accounts is frustrating the ability of potential new customers to take on units in these communities.

Lastly, consider the state of the banking sector. While some Wall Street banks were considered too big to fail, smaller regional banks will end up being too small to rescue. The irony is that many regional banks were conventional lenders that mostly avoided material exposure to toxic paper, risky financial derivatives and other structured investments that embroiled Wall Street. However, sliding values for commercial real estate, a business mainstay of regional banks, will inevitably impair their collateral and erode capital levels. Many believe the knock-on effect on balance sheets could prompt smaller regionals to fall by the wayside. No doubt the best assets of these failed institutions will be snapped up at bargain prices by national money centers and large investment banks – some of which qualified for previous bailout assistance.

In all of this, antitrust authorities will likely seek to play a more active role, but their voices may ultimately favor measures that restore corporate profitability and the preservation of jobs. It follows that strong companies

The term ‘jobless recovery’ is already being bandied around with a casualness that belies the grim reality of the expression for many millions of Americans.

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WhEn DEAling WiTh DEbT, ConfiDEnCE is King

Credit rationing means there is, and will continue to be, a race to access funds. While market confidence remains fragile, a company’s ability to communicate how it is addressing the threats and opportunities created by the current climate has never been more important.

While credit is an absolute phenomenon in the sense that there is only a certain amount of it available at any one time, we should not underestimate the significance of confidence in credit markets. Lenders require two elements – both the money itself and the confidence to lend it to someone. Highly leveraged firms are facing a difficult confluence of negative supply-and-demand dynamics, where there is increased demand for capital from struggling borrowers at a time when credit is tighter, and lenders are being much more selective about who is able to borrow.

Recent research undertaken by FD, the strategic communications segment of FTI Consulting, gives an insight into global confidence levels. In a survey of 153 institutional investors from more than 15 countries, 64% of respondents said that they did not believe the financial crisis was over. Only 31% thought that it was, with 5% undecided. As the chart (right) shows, UK, U.S. and Australian investors were the most pessimistic. Continental European and Asian investors were slightly more optimistic. It’s worth noting that the interviewees, who between them have more than $2.8 trillion of equity funds under management, cited the amount of leverage that remains in the system as a major concern.

A heavy debt burden and floundering confidence creates a huge gulf between companies which need refinancing and those that are able to stand alone. Well-capitalized companies have an opportunity to differentiate themselves by emphasizing their financial strengths

and self-financing capability. They are in a strong position in the M&A market and should look at ways to communicate how the current environment will present opportunities for them.

Weaker companies are in a completely different situation, but effective communications are no less important. Financial markets fear uncertainty even more than difficult circumstances, especially when visibility is low and confidence is fragile. Key here is how management teams proactively communicate actions intended to improve operating performance and cash flow at the company. Ultimately, the challenges and travails of publicly traded companies are open to the world so credibility is best retained by acknowledging and addressing the challenges head on. By doing so, one is providing a degree of visibility into one’s problems and helping to mitigate the fear factor for creditors, partners and investors.

Where possible, public companies should try to use their normal ongoing investor events, such as earnings announcements, to articulate how they are contending with credit-related matters. The emphasis is to communicate to both the debt and equity communities in a unified fashion rather than in parallel, which is less alarming to the market than stand-alone announcements regarding

financing. Furthermore, as debt maturity approaches, there will be a number of parties involved in the refinancing negotiations, with an accompanying increase in risk of leaks from parties that have differing interests.

It is important to have ongoing control of one’s story in advance of that, rather than being put in a position of having to respond defensively to adverse leaks or disclosures by others. In addition, this may warrant concerted and heightened communications to the debt community, and one will want as much as possible to maintain credibility and stay in their good books in order to tap their capital.

As debt issues intensify, it becomes more important to ensure that all communications with stakeholders are managed effectively, and with nuance. This is not easy. There is a fine line one treads between being transparent and causing alarm – get it wrong, and the loss of confidence this creates could become a vortex that destroys the business.

Finally, it’s important to remember that good communications can only serve an organization that is doing the right things. Companies cannot use communications to paper over bad strategy and execution, nor bail out a flawed business.

Gordon McCoun is Vice Chairman, FD, the strategic communications segment of FTI Consulting.

U.S. UK Australia Asia Europe

Do You Believe the Crisis is Over?

Source: FTI Consulting

No Yes Don’t Know

Institutional Investors by Region

Gordon McCounVice Chairman, FD

should have a good opportunity to pursue in-market acquisitions successfully over the next year or two, particularly if the target would otherwise struggle financially, or go bankrupt.

There Are No Magic BulletsSo what can be done? Most important is for companies to address the appropriateness of their capital structure and debt layering long in advance of refinancing dates, bearing in mind both the new tolerances and valuation parameters of capital markets and the expected persistence of weaker operating earnings in light of the recession.

As previously mentioned, a distressed debt exchange, especially one involving a substantial debt-for-equity swap, is a means by which a troubled borrower can reconfigure an unsustainable balance sheet in the absence of new money, and possibly without the need for filing for bankruptcy. But it requires Herculean negotiating efforts with recalcitrant creditor groups which may end up on the courthouse stairs in any event.

Secondly, companies must focus ruthlessly on driving business efficiency. Many have done so admirably during this downturn, with the retail sector coming to mind first. Large U.S. retailers generally surpassed Wall Street’s low earnings expectations in the second quarter, despite slumping sales and gross margin compression. Such results can be achieved through a combination of cost-cutting, vendor and landlord negotiations, reduced capital investment and better inventory management. Senior executives should keep an eagle eye on subtle

changes in critical trends that impact their business, and should understand how key performance indicators can be utilized.

Companies with marketable assets might consider selling some of the family silver to pay down debt. While M&A markets are slow, the deal environment is gradually improving. Sometimes such measures are painful, but necessary. Struggling retailer The Talbots sold the J Jill Group – a business segment it could no longer support, given the distress at its namesake chain – in June to a private equity shop for $75 million. Talbot’s purchased the J Jill chain some three years earlier for $500 million in cash. Even if a sale is not possible straight away, companies can start positioning some dispensable businesses or assets for sale as soon as markets improve.

Which Way Now?We know that refinancing the dozens of billions of high-risk debt slated to mature over the next few years will be a challenge for most, and impossible for many. While there is a good chance that economic conditions may be showing signs of improvement as we move into a new decade, the consensus points to a slow, below average recovery. It is likely to take several years for corporate earnings to return to 2007 levels, for job prospects and personal wealth to recover enough to kick-start consumer spending and for lenders to shake themselves free of the noxious overhang of bad assets and bad practices that they acquired during the halcyon days of the credit boom.

However, some just can’t hold out that long; others will be unable to earn their way out of their financial predicaments. The term ‘jobless recovery’ is already being bandied around with a casualness that belies the grim reality of the expression for many millions of Americans. To make matters worse, federal budget deficits and borrowing needs will remain exorbitant. It’s not exactly a recipe for optimism.

2010 is certain to be a pivotal year for the U.S. and global economies – a ‘show me’ year in the minds of both equity and credit investors who now fully expect to see fresh, indisputable evidence of positive economic growth and solid earnings recovery, and who have already priced such expectations into capital markets. Many economists, though, are less sanguine about any rosy growth scenario as long as stricken consumers stay planted on the sidelines. The interplay between corporate operating performance and credit market conditions will likely be reinforcing: better than expected earnings may further embolden credit investors and ease access to capital, which will in turn bolster corporate results. But it could work the other way too, with vast pockets of economic weakness that persist into 2010 finally causing financial markets to doubt the adequacy or sustainability of a recovery. How the economy unfolds in 2010 may very well determine whether the debt maturity challenge eventually rises to the level of a crisis. We’ll be watching closely. zx

Dominic DiNapoli is Executive Vice President and Chief Operating Officer of FTI Consulting, responsible for the day-to-day operations of the company’s five business segments.

Canada 20082001

U.K. 20082001

France 20082001

Germany 20082001

U.S. 20082001

Japan 20082001

Italy 20082001

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0.6

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28

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1

Life in the Fast LaneBroadband adoption in G7 countries, subscribers per 100 inhabitants at year-end

Average monthly broadband subscription prices, US$ at purchasing power parity, October 2008

Source: OECD

Germany

Canada

United States

France

Italy

United Kingdom

Japan

$48.22

$45.65

$45.52

$35.60

$31.25

$30.63

$30.46

0%5%

-5%

-10%

-15%

-20%-25%

High-speed Internet

Mobilephone

Car Cable-TV Dishwasher MicrowaveHome airconditioning

Source: Pew Research Center

Nice to Have, Need to HavePercentage point change in share of consumers

considering item a necessity, 2009 vs 2006

0%

-4%

-8%

-12%

-16%2005 2006 2007 2008

Good BuyProjected decline in demand resulting from

a 10% increase in the price of broadband

Source: Compass Lexecon

consumer broadband study

considered high-speed Internet a necessity. And broadband was one of the few items to grow in importance in surveys over the past three years.

But just because something is desirable doesn’t necessarily make it useful. Thus, the researchers at Compass Lexecon sought to quantify the benefits of household broadband for consumers, deploying an array of econometric tools in the process. The goal was to identify the ‘consumer surplus’ associated with broadband access – that is, the value of the service to subscribers above what they actually paid for it. If the actual value of a service is less than its price, nobody will buy it. On the other hand, if the value surpasses its price, buyers receive benefits from the service that are not captured simply by how much is spent on a particular service.

To determine the actual surplus from broadband Internet access, Compass Lexecon’s researchers analyzed a sample of broadband purchasing data for 30,000 households from the

new study by Compass Lexecon’s Mark Dutz, Jonathan Orszag and Robert Willig, American consumers enjoy more than $30 billion of net benefits per year from access to broadband Internet connections.

As part of economic stimulus legislation passed earlier this year, the U.S. Federal Communications Commission is charged with developing a national broadband strategy “to ensure that all people of the United States have access to broadband capability.” Indeed, even though broadband adoption has increased more than sixfold since 2001, some 43% of U.S. households have yet to adopt high-speed access in their homes. The Compass Lexecon findings underline the potential benefits of accelerating broadband adoption.

Size of the PrizeIn a survey of American consumers in April, the Pew Research Center found that around one third of respondents

At current prices, the net consumer surplus for broadband is $31.9 billion per year.

Access to high-speed Internet service is fast becoming a necessity that consumers cannot live without. Nonetheless, a

sizeable minority remain unconnected. With policymakers working on efforts to make broadband more widely available and affordable, a recent report by Compass Lexecon, an FTI subsidiary, helps to inform the debate.

Broadband Internet can transmit billions of bytes over fiber-optic cables. The economic benefits of high-speed Internet can also be measured in the billions. According to a pioneering

The Need for Speed

Thus, growth in the value of broadband to consumers increasingly outstrips a rise in its price, implying that the size of the total consumer surplus is growing. At current prices, the net consumer surplus for broadband is $31.9 billion per year, Compass Lexecon estimates, up from $20.1 billion in 2005.

Onwards and UpwardsThere are strong reasons to believe that the true value of broadband is significantly larger than these estimates. The research looked only at fixed-line broadband use at home and estimated the aggregate consumer surplus. Outside of the scope of the study were mobile wireless broadband, consumer gains as the productivity gains from business users are passed on, and the producer surplus enjoyed by broadband providers, as well as firms whose services become more economical or feasible as the speed of Internet access increases.

Finally, broadband access can also be considered an ‘experiential good’ – once consumers experience high-speed Internet access, they tend to value it more highly than if

they had not experienced it before. The size of the consumer surplus would therefore grow if the current share of households with dial-up or no Internet access were to try broadband for the first time.

For companies, the case for greater broadband adoption is compelling. Compass Lexecon researchers found that 22% of workers with broadband regularly access their employer’s network from home versus only 8% of employees with dial-up access. Given the well-established benefits to employee productivity and retention that stem from flexible working practices, anything that can be done to make working away from the office easier should be encouraged. Broadband also allows firms to open new sales channels, develop new product markets and expand customer-service possibilities.

The steady expansion of Internet access over the past 15 years has revolutionized the workplace, not to mention the world. The next step is expanding access and affordability to broadband, which promises to deliver billions of new opportunities across all segments of American society. zx

largest 100 metropolitan areas in the U.S. between 2005 and 2008, and then extrapolated up their findings to the U.S. population. Based on pricing and adoption rates in the sample, the researchers could estimate consumers’ willingness to pay for broadband under a variety of conditions.

A 10% rise in the price of broadband would have led to a 15% decline in demand in 2005 whereas, in 2009, a 10% rise in price would result in only a 7% decrease.

Research


perspective

In a turnaround situation, too many businesses rush to apply short-term fixes rather than diagnosing the real problem. There is only one cure: identifying the competitive advantage and transforming the corporate culture, while keeping a laser-sharp focus on the end-game.

The problem is that many management teams focus primarily on access to capital.

Greg Rayburn Senior Managing Director

To paraphrase the opening line from Tolstoy’s Anna Karenina, all healthy companies resemble one another; every unhealthy

company is unhealthy in its own way. Indeed, there are many reasons

why companies end up in poor health: flawed business models, strategic gaffes, poor execution, emerging competitors and weak management, to name a few. When it comes to turning around an unhealthy company, however, there is a single formula that works. The field of turnaround management has attracted a wide range of practitioners and philosophies over the years. We believe that some approaches are not only ineffective, but actually serve to stifle recovery. This article will describe a proven framework for operational turnaround management that can help to ensure sustainable long-term profitability and market leadership.

The Balance Sheet is Not the Place to StartThousands of companies are in the midst of financial distress every day, even in the best of economic climates. But restructuring and operational turnarounds tend to attract the most attention during periods of economic contraction. Underlying problems in core business models are exacerbated

approach most notably in the retail sector, where there are repeated declarations of bankruptcy – known as ‘Chapter 22’ and ‘Chapter 33’ scenarios. Many retailers are prone to multiple bankruptcies because their turnarounds are often little more than feats of short-term financial re-engineering. From an operational standpoint, most distressed retailers overly focus on a ‘four wall’ cash flow analysis. The allure of such an analysis is its simplicity: keep stores that contribute positive cash to overhead and close cash-flow-negative stores. The result is often a slimmed-down operation and a smaller footprint that’s still riddled with shortcomings. Unless management addresses competitive advantages (or the lack thereof), the smaller chain continues to see declining operational performance. It’s akin to treating symptoms.

during these periods, and bankruptcies surge, as recent experience has demonstrated. Moreover, projections of corporate debt maturities and defaults over the next few years (see Debt Maturity: The Next Wave on page 8) suggest that we may see a record number of restructurings before this cycle ends.

The effects of the recent global credit crisis notwithstanding, the majority of distressed companies historically have faced challenges well beyond the balance sheet. The problem is that so many management teams in turnaround mode focus primarily on access to capital. This finance-first approach is short-sighted at best, fatal at worst. Recapitalization is helpful for shoring up finances quickly, but it does little to guarantee long-term cash flows and operational sustainability.

We have seen the failure of this

Turning the Turnaround on its Head


perspective

perspective

Sustainable Turnarounds Focus on the Income StatementMost failing companies have a fundamental problem in their core business, which is why the only way to execute a successful operational turnaround is to focus on the core, not, as we call it, the clouds. The first instinct of many managers when commencing a turnaround strategy is to cut costs. Costs should and will be scrutinized and there will always be areas of inefficiency and waste. However, from a long-term perspective, a company cannot cut its way to an operational turnaround. While cost-cutting can help to achieve a cash-neutral or cash-positive position in the short term, it won’t solve deeper structural problems facing the core business.

A more dangerous instinct is for managers to try to supplement the core business by launching new products and/or entering new markets. The theory is that the revenue and cash flow from successful new businesses will help to fund the turnaround of the core. This is illogical. Growth on top of a flawed business simply produces a larger flaw. For a struggling ice cream chain, introducing a new flavor will never repair the underlying business problem. Instead, managers must identify and capitalize on the company’s distinct competitive advantage. This advantage, if one exists, will serve as a life raft to strengthen core operations over time.

The initial phase of a turnaround is day-to-day implementation toward defining the end-game. It involves a combination of short-term and long-term decision-making, which must be executed quickly and communicated clearly. We’ve found that maximum interaction with staff

over many years. And when they are exacerbating the core business problem, the first job of the turnaround specialist is to identify them.

A real-world example will help to illustrate our recommended approach to operational turnarounds. In 2000, I was CEO of a leading company in the time-share market, with 89 resort properties in eight countries and $500 million in annual revenue. A key growth driver for the company was its mortgage origination business, which loaned customers 90% of the $10,000 unit purchase price. A majority of these subprime mortgages were securitized and sold to Wall Street, thus removing significant risk from the balance sheet. However, some of the mortgages remained on its books. When defaults on the mortgages held by the company accelerated, its ability to tap the secondary market dried up and this sudden lack of liquidity forced it into bankruptcy. When I became CEO of the company, I worked with management through four key stages of the turnaround process, forcing honest reflections and tough decisions. This process generally doesn’t make a lot of friends, but sticking to these phases will invariably optimize any company’s outcome.

Assess Existing BehaviorsNobody likes working for a weakened company. But it’s the entrenched behaviors of these same employees, often starting with the CEO, which usually have weakened the company in the first place. And they usually know it. That’s why employees often open up to the turnaround team, offering their own diagnoses and sometimes already knowing the solution. As implied in Figure 1, the turnaround team’s first priority is to understand the existing behaviors and their impact on performance decline. Then they must take a step back and evaluate the incentives that are in place to motivate and reward these behaviors. Is the culture driven too much by the sales function? Too little? Are employees rewarded for retaining or expanding customer relationships? Are they given the tools to do so? How are collaboration and cross-selling rewarded? How are acquisitions integrated culturally? Has management communicated a vision

Cultural Change is the Ultimate Factor in Turnaround SuccessAchieving the end-game will often take years and will depend on the wisdom of hundreds of decisions along the way. After nearly three decades in this field, I’ve learned that one element in the turnaround process is more important than any other: employee behavior. In fact, we’ve developed a Golden Rule of operational turnarounds (see below).

Culture is all-powerful in turnaround situations, and what fuels culture are the incentives for staff to behave in a certain way. What’s more, culture has little to do with the balance sheet, but has everything to do with the income statement. The key is to focus employee behavior – through proper incentives – on the activities that will most rapidly enhance the income statement, which of course will depend on the nature of your business problem. If done properly, these new behaviors can reduce or eliminate negative cash flow, which is a necessary precursor to long-term health.

Every unhealthy company struggles with counter-productive internal behaviors, even if these same behaviors at one time enabled the company’s growth. As shown in Figure 1, negative behaviors do not appear overnight. They typically become entrenched in the culture of the organization

Above all else, this stage is an exercise in market assessment. What distinct advantage or niche does the company own in the market? Why do customers choose the company over its peers? Most importantly, the results of the competitive advantage must be clearly reflected on the income statement; if historical sales patterns and/or cash flows can’t demonstrate that the advantage is real, then it isn’t.

Examples of competitive advantage may include:n A presence in more lucrative

geographies than any competitorn A reputation for customer service

and support unmatched in the industry

n Exclusive licensing deals with important partners or distributors

n An unrivaled R&D capability and reputation for innovation

n A respected brand that generates greater customer loyalty than that of competitors

Once the competitive advantage is defined, it will become the foundation of the company’s turnaround strategy. The competitive advantage will quickly come to define the company’s success, both today and in the future. This means that management’s end-game must be defined in competitive terms and then communicated aggressively both internally and externally.

during this phase leads to maximum performance outcomes. Ride along on repair calls. Have lunch with the admin pool. Go on sales calls. Such interactions help the turnaround team to frame the discussion about the competitive advantages.

Like many turnaround advisors, I learned my most important lesson early on in my career: many companies cannot be turned around. Despite natural optimism and good intentions, management teams cannot will an operational turnaround to happen. The most brilliant turnaround team cannot turn a market laggard into a market leader. The company’s assets and advantages must be evaluated with brutal candor; only then can management determine with confidence whether a turnaround is feasible or if the company’s best course of action is liquidation. If there is no clear competitive advantage on which to build a realistic plan, then an operational turnaround is not feasible. And if a turnaround is not feasible, recognizing this fact quickly is the most important strategic decision for preventing further losses.

If a competitive advantage does exist, then it must quickly become management’s platform for future profitability. The most effective way to harness this advantage is to make it the core of the end-game, which is management’s vision of the company’s future state once it has achieved sustainable long-term health. The end-game must be driven by the market opportunity inherent in the company’s competitive advantage. An end-game must be as specific as possible and must be driven by markets, not finances. A return to profitability is not an end-game; it is a tool required to achieve the end-game.

and strategy for the future? How does the company reward employees for helping to achieve that strategy?

At the time-share company, the corporate culture was driven entirely by sales. Built by acquisitions, these acquisitions were poorly integrated. Customer experience and retention were not a priority. An exclusive behavioral focus was on revenue growth. Sales representatives, who were paid entirely on commission, earned 20% of each $10,000 sale. At the same time, the time-share company provided most customers with mortgages for 90% of the purchase price, or $9,000. With no credit standards in place, these subprime mortgages came home to roost as high defaults (in the same way as we have seen over the past two years in the U.S. housing market). Without the ability to securitize the loan, even before taking into account overhead and marketing expenses, every sale immediately ate into the company’s cash flow, setting it up for a death spiral toward liquidation.

Define the Competitive AdvantageA turnaround lives or dies on the basis of a company’s ability to define its competitive advantage, which necessarily forms the core of the turnaround strategy. So, what is a competitive advantage exactly?

Golden rule

I (F+nF) = BB x T = CBoiled down to its essence, this Golden Rule is simple: incentives produce culture. Specifically, Incentives (Financial and Non-Financial) produce Behavior and Behavior over Time produces Culture.

Figure 1: Correcting Entrenched Behaviors Key to Effective Turnaround

Time

Perf

orm

ance

Turnaround team takes control

Counter-productive behaviors drive performance declines

Shift to behaviors with measurable impact on income statement

Employees don’t have to like your decisions, but they need to understand them.


This will help to avoid the panic that often accompanies uncertainty and, in particular, will tackle the appetite of the media for conflict and crisis. If an organization can demonstrate clarity and control though its communications as it undergoes change, then it stands a much better chance of preserving confidence in the business and, ultimately, protecting its value.

Giles Sanderson is a founder of the european restructuring & recapitalization Communications practice at Fd, the strategic communications segment of FTI.

perspective

perspective

Every decision throughout the turnaround process will be measured against its effect on the end-game, which is why it must be as specific and realistic as possible. Years ago, I asked a client to describe his end-game, to which he replied, ‘To get bigger.’ Such a response is not entirely uncommon. Unfortunately, such a vague notion is not only reckless, but can be extremely damaging to the turnaround process. On the contrary, end-games must be market-driven and specific, such as to become the number one or number two player in market A, or to be the largest provider to vertical market B, or to have physical presence in our 10 most important geographical markets. Such objectives are not only realistic and measurable, they are infinitely more inspiring to employees who know the company’s competitive position better than anyone.

In the case of the time-share company, rudimentary market analysis revealed that the company’s international footprint of properties was its key differentiator and unique advantage in the marketplace; not a single U.S.-based competitor offered customers such a breadth of international options. Moreover, the European operation was the only profitable part of the business at the time. Yet these were the assets that management was planning to sell to raise cash to continue funding the non-profitable part of the business. Such a transaction, which was ultimately canceled, would

n Securing new contract terms with customers and vendors

n Introducing new metrics for staff productivity and performance

Since these short-term fixes will change incentives and require new behaviors, there is likely to be an onset of employee fallout. Embrace these departures! They are a sign that the message and end-game are clear. Headcount reduction is usually inevitable during a restructuring process and the most successful form is natural attrition. As behavioral standards suddenly change, certain staff will come to realize that they will no longer thrive in the new environment. And this is good.

From our experience, sales talent falls into one of two orientations – and skill sets – within an organization. We call these hunters and herders. As shown in Figure 2, hunters are oriented toward customer acquisition and see their mission as helping the company maximize revenue growth, while herders are oriented toward customer retention and see their mission as helping the company maximize efficiency and profitability.

These categories apply not only to the sales team. Typically, one orientation is more likely to leave the company based on the end goal. It is management’s job to change the incentives in a way that ensures the wrong type of talent is departing and that the talent required is staying.

In the time-share company’s situation, its short-term survival required a dramatic shift in behavior from revenue-at-any-cost to profitability-at-any-cost. The first step was to centralize control of the sales and mortgage origination processes,

have all but guaranteed the infeasibility of a turnaround and the liquidation of all of the company’s remaining assets.

Define the Required BehaviorsThe next stage can cause a turnaround specialist to become extremely unpopular, as it’s during this period that changes are made and sacrifices are required. Compliant with our Golden Rule mentioned earlier, new standards and incentives are introduced to change human behavior – a daunting exercise even in the best of circumstances. The first priority is to fix the cash-negative problem through short-term strategies, which may include:n Centralizing operations to

maximize cost efficienciesn Decentralizing operations to

promote greater revenue growthn Closing certain business segments

that are beyond repair

Figure 2: Matching Talent Orientation to Turnaround Needs

HunTers Herders

Personal motivation Customer acquisition Customer retention

Operational goal Top-line revenue growth Profitability and efficiency

Scenarios when needed

Weak sales, new market entry, heightened

competition

Weak profits, consolidation, strong brand equity, high

existing market share

Don’T run bEforE you can Talk: a communicaTions pErspEcTivE

Realizing that you have a problem and need specialist turnaround help is the first step in seeking to re-establish your business. However, don’t overlook the impact that communications can have, both positively and negatively, on that process.

The solution is to adopt a multistakeholder approach to communications, with a different plan for each audience. This includes not just the media but all internal, commercial, financial, political and regulatory audiences. Failure to identify and address the communications issues on a multistakeholder basis can potentially cause immense damage to a business. Competitors and the media may wish to create drama, driving customers to take their orders elsewhere, suppliers to change their terms of business and nervous investors to dump their shares.

Whatever the exact situation, it is crucial to maintain confidence and trust in a business throughout the turnaround process. The challenge is for the communications strategy, working hand-in-hand with the turnaround work of the restructuring professionals, to negate the risks that arise from a corporate crisis – the communications agenda needs to be set, control demonstrated and change managed.

Early planning ahead of an anticipated problem helps significantly, although this is often not possible as the restructuring process may have already started. While all businesses need to understand the importance of effective communication in helping companies maintain ‘business as usual,’ the

process differs slightly based on a company’s market status.

Publicly-listed companies have to comply with the relevant rules of their respective stock exchanges regarding the disclosure of material information to the market. While there is usually little discretion over the timing and level of disclosure, it is necessary to consider the impact of public announcements on each stakeholder group and examine whether there is a particular need to reach out to each audience to provide additional clarity or stability. Examples might include calling a company’s significant trade creditors to explain the impact of the turnaround or presenting the challenges facing the business to the staff and giving them an opportunity to have their questions addressed by the company’s management.

In the case of private companies undergoing a restructuring, there is more flexibility to determine the exact level of disclosure and timings with each stakeholder. Even when a decision is made not to disclose an event or milestone, there is a still a need to prepare a contingency plan which will give the business a clear course of action should there be a leak.

Remember that in a vacuum people will draw their own conclusions. So companies in turnaround situations should strive to manage the messages and communicate where possible.

Giles SandersonManaging Director

rIsks needs

uncertainty and anxiety set the agenda

destabilized business stabilize the business

Loss of performance demonstrate control

Increased scrutiny Manage change

erosion of confidence/trust resolve disputes

destruction of value Maintain confidence

Failure to identify and address the communications issues on a multistakeholder basis can potentially cause immense damage to a business.

certain staff will come to realize that they will no longer thrive in the new environment. and this is good.


perspective

from a long-term perspective, a company cannot cut its way to an operational turnaround.

control for which previously was scattered across a variety of managers and locations. All contracts would require central approval. Credit standards would be dramatically tightened. The historical 10% down payment requirement was scrapped and we reset the goal of down payments to an average of 30%. These new standards proved highly disruptive to the company’s sales-driven culture, but were essential to guarantee at least a cash-neutral position in the immediate future. Using our formula, we changed sales compensation from being based on total contract value, to being based on total amount of the down payment. We achieved our target of 30% down payments and were cash neutral in just over a month.

ImplementationConsistent communication is critical throughout the turnaround. Management must make sure all decisions – even the ugly ones – are designed to leverage the company’s competitive advantage and achieve the end-game. A world-class communication infrastructure is essential here. The management team, particularly the CEO, should always be accessible for questions. (See sidebar on page 23.) Employees don’t have to like management’s decisions, but they need to understand them. During turnarounds, lack of information is always worse than having negative information. This is why management must be quick in disclosing bad news as well as good news. And if management doesn’t have the answer to a question, it shouldn’t be afraid to say so.

So when is the turnaround complete? There’s no magic formula for deciding when the company is on a path to long-term growth, but in our experience, the board and management team will know it when they see it. The results of improved performance will be evident on the income statement. Staff turnover will have subsided. New behaviors

liquidation, the time-share company was sold to its new owners for $700 million, a 35% premium to its stock price. In announcing the deal,

the new owner cited the time-share company’s international

properties as a strategic complement to its own U.S.-focused portfolio.

ConclusionSuccessful turnarounds have many elements. Financial engineering is often hailed as a cure-all, but in our experience, even the best-capitalized company will ultimately fail if its core business

model is flawed and its internal culture and

behaviors continue to support that model. The four phases

of turnaround management described here represent a proven

framework for any management team struggling to repair fundamental problems in its core business. Turning around any company is often difficult, disruptive and sometimes unpleasant. However, through proper strategic planning and consistent decision-making, even the sickest of companies can hope for a recovery and a long, prosperous life. zx

Greg Rayburn is Senior Managing Director at FTI Consulting in the Corporate Finance/Restructuring Segment and Head of FTI Palladium Partners, the firm’s interim management practice. He has 25 years of experience in operational turnaround management, serving as interim Chief Executive Officer at companies across a wide variety of sectors.

will have been institutionalized. And sustainability and growth will be the new words of the day.

At the time-share company, management made the long-term decision to kill bad revenue; in other words, it needed to reduce sales volume and revenue in favor of sustainable profitability. And that’s exactly what happened. Within two years, revenue fell from $500 million to $280 million, but the company was profitable again. Overhead expenses were shaved, but many costs – sales and marketing, for example – were appropriately right-sized for a leaner, smaller organization. In 2007, seven years after its brush with total

employee morale. During volatile economic times, organizations without trusted and credible employee communications are likely to see their reputations erode and underperform relative to those companies with more effective programs for engaging and aligning employees.

In a new report, A Question of Leadership: How Can Business Leaders Best Engage with their Employees in the Downturn?, FD, the strategic communications segment of FTI Consulting, critically examines the engagement gap leaders face in today’s business environment. FD commissioned the respected polling organization YouGov to conduct the United Kingdom survey in the spring of 2009. More than 500 respondents

Fewer than 30% of respondents put a lot of trust in messages from the CEO.

Companies are falling short in informing employees about

how they are overcoming the challenges thrown up by

the global downturn. New research commissioned by FD

demonstrates that strong direction, a clear plan of action

and straight talking will keep work forces on your side.Charles Watson Group CEO, FD

Leadership and clear communication are critical pre-conditions for success in a competitive corporate marketplace.

But during turbulent economic downturns, when the future of many companies is uncertain, employees have an especially acute desire for honest, straight talk and clear direction from their leaders.

The global financial crisis has heightened employee anxiety about job security. This underscores the need for effective engagement with employees, as this will help to build trust and morale. For example, customer service, business performance and the ability to attract and retain talent are all affected by

Leaders Must Narrow the Employee Engagement Gap

Leadership Focus

z No

14%

z Trust a lot

39%

z Trust a little

28%

19%

z Not sure

1. Do you trust messages from your CEO?


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guarantees on jobs in the current market. However, employees still need to be reassured of their continued value, and understand the need to realign their expectations, given new economic realities. Leaders who wish to build trust and credibility with their employees must balance the need for candid discussions about the economic challenges that their organizations face with the importance of communicating clearly the value and role of employees in responding to these challenges.

As shown in Chart 4, only a minority of respondents felt that their role in helping their organizations weather the recession was well explained or that they had the opportunity to voice their concerns.

Face-to-face contact with managers and team meetings are the most trusted forums for talking about their organization (see Chart 5). Time invested in direct communications with employees will enhance loyalty and motivation, and thus ultimately protect the value of the business. FD’s findings suggest that ‘official’ channels of communication often lack credibility, with the grapevine and rumor mill trusted in many cases

over the company newsletter or intranet. Company leaders should also pay close attention to how employees respond to internal communications.

Some 13% of respondents said their employer had never communicated to them about the challenges of tackling the recession. Email was the most common form of communication for those who did receive some information from their employer, closely followed by team meetings and face-to-face contact with a line manager (see Chart 6).

In turbulent economic times, when there is great uncertainty about the future viability of

business organizations, employees are naturally anxious and value frank dialog with bosses. With a high degree of cynicism for official company communications, direct face-to-face engagement is most effective at establishing trust. It’s clear that business leaders need to provide candid explanations of the challenges facing their respective companies, demonstrate that there is a plan to meet these challenges, and show what role employees can play. This will build employee trust and morale, which will help to retain talent and motivate employees to strive for the high performance needed to survive today and thrive tomorrow. zx

were polled, representing a broad cross-section of white-collar workers in the UK private sector.

The report’s authors concluded that business leaders should be intensifying efforts to realign how they communicate with their employees about overcoming challenges associated with the downturn. In one of the survey’s more important insights, many respondents felt that strong leadership and a clear sense of direction and trust were lacking in their organizations. This suggests significant and potentially negative responses when it comes to employee morale and business performance.

Most of those surveyed think their leaders are not being open enough about how their respective employer is performing. And many don’t trust what they are being told about how their employer is coping with the economic downturn. As indicated in Chart 1, fewer than 30% of the respondents put a lot of trust in the messages they receive from the CEO. Moreover, fewer than 45% of employees think their CEO or Managing Director has shown strong, decisive leadership.

The report makes it clear that business leaders who fail to address employees’ concerns do so at their peril: poor employee engagement could damage performance and customer service, and create problems in retaining talent when the economy – and the job market – improves.

The findings illustrate the real danger of erosion of goodwill in the workplace when employers fail to address employee concerns about the recession (see Chart 2). While goodwill can be lost quickly, winning it back generally takes much longer and can incur a significant outlay of resources.

Chart 3 shows that the overwhelming concerns of white-collar workers are for their immediate personal futures – job security, financial and career prospects, and having to work harder under more stress. Fears about personal financial and career development can create negative morale, and motivation problems that may ultimately have a serious and negative impact on company performance.

FD’s report acknowledges that it is difficult for employers to offer

Leadership Focus

Leadership Focus

4. How well has your employer communicated about your role in tackling the recession?

5. How much do you trust different sources of information?2. Reaction if employer fails to answer concerns about recession

Face-to-face with line manager

CEO messages

Company newsletter/magazine

External press/TV

%

6. Most common forms of communication on tackling recession

Email

Team meetings/briefings

Company meetings

Face-to-face with manager

Intranet/online

Company newsletter/magazine

Conference calls

Other

%Job security

Salary and bonus cuts

Ability to weather the downturn

Having to work harder/under more stress

Restricted promotion/career prospects

Keeping customers happy

Not being told the truth about how we are performing

Not being listened to about my contribution

%

Many don’t trust what they are being told about how their employer is coping.

z Don’t know

z Not at all

15%

z Very well

40%

z Acceptably

17%

6%

22%

z Poorly

Become de-motivated

Look for another job

Do not go the extra mile

Pay more attention to the grapevine

Take more time off sick/take longer breaks

Give customers less time and attention

%

Criticize my employer externally

3. Top worries at work


private equity

Following a turbulent 12 months for the industry, six experts from across the private equity spectrum explore the shape of things to come.

After seeming to achieve eye-popping returns year after year, the U.S. private equity

industry stumbled in 2008 (like almost every other sector of the financial services industry). Returns were nearly 30% lower than they had been in 2007. And the news in 2009 hasn’t been much better – in the first six months of the year, only $24 billion worth of private equity deals were completed (globally). In 2008, the equivalent figure was $131 billion. In 2007, it was an astonishing $528 billion.

These developments have been a catalyst for private equity firms to adopt new methods. They are taking on less leverage and

It is inevitable that the private equity industry will be successful. To understand its true potential, you need to put the buyout boom years and the

current market difficulties to one side and consider the bigger picture.

Look at the changes to the investment landscape over the last 150 years. The mid 19th century marked the beginning of the modern concept of the limited company. Whereas previously these needed to be created by an Act of Parliament, the UK’s system of incorporating a company through a simple registration procedure, introduced in 1844, was rapidly copied throughout the world. Despite this, ownership was limited to private wealthy individuals.

The creation of large aggregation vehicles such as pension funds in the 1950s and 1960s marked the beginning of institutions holding shares for the benefit of policyholders and investors. In the 1970s these

assuming less risk. That’s to be expected, given recent events. But peering further into the future, the largest private equity firms have $400 billion worth of debt maturing over the next five years. In an environment marked by less risk, less leverage, and thus the likelihood of lower returns, how difficult will it be for these firms, and their smaller brethren, to settle their accounts?

That is one of many unanswered questions about private equity. For an informed perspective on emerging trends that could be shaping the industry’s future, the FTI Journal asked six experts to offer up their thoughts about where private equity goes next. Edited excerpts of their responses follow.

The dynamics of private equity investing have changed enormously.

Alternative Viewpoint: What Next for Private Equity?

THE PRINCIPALJEREmy CoLLER institutions became the majority

owners of large public companies. Consider the amount of capital held by insurance companies, corporate pension plans and state-controlled pension funds, and the fact that until comparatively recently these entities could only invest in equity through the public markets.

The private equity industry started on a very small scale but in the mid 1990s there was a massive explosion of money chasing private equity. The industry will continue to grow over the coming decades before reaching equilibrium at a much higher level than it is today. Of course, the market for private equity is cyclical like any other, so there will be peaks and troughs like the ones we have experienced over the last few years. But over a longer period we will see growth.

The rise of private equity secondaries is also inevitable. It’s true that growth of the secondaries market is a natural consequence of the current liquidity shortage, but that is far from the whole story. For a long time, investing in private equity was a

game of buy and hold. The secondaries market provides a way out for investors that will become increasingly attractive.

The dynamics of private equity investing have changed enormously since the onset of the credit crunch, but the make-up of investors’ private equity portfolios largely reflects pre-credit crunch conditions. Many investors – even those not facing liquidity issues – will consider selling assets in the secondaries market simply to help them reshape their portfolios in the light of new economic realities.

Momentum in the secondaries market will pick up during 2010 as private equity valuations become more realistic and the volatility of financial markets reduces. In addition, the re-starting of investment in the primary market will result in a flurry of capital calls creating acute liquidity needs for many investors. We will also see some institutions come under pressure from CIOs or trustees to sell private equity assets in order to adhere to their funds’ asset allocation policies.

Finally, you will start to see a much bigger difference between the returns generated by the best- and worst-performing managers in industry. For many years, investors were able to throw money at the private equity industry almost indiscriminately and achieve incredible returns. Everyone made money. Now the skill a general partner brings to the table is incredibly important, and you will see more investors looking to switch horses before a fund is fully realized.

Jeremy Coller is the founder and CEO of Coller Capital, a leading secondaries firm with offices in New York, London and Singapore and $8 billion under management.

private equity


private equity

private equity

The marquee private equity firms – Apollo, Blackstone, Carlyle and KKR – have emerged from the credit crisis with some bruises, but

they will weather the storm. They have adapted by operating like diversified alternative investment funds; they are active in distressed debt, real estate, mezzanine financing and financial and capital advisory services in addition to traditional leveraged buyouts. They have also expanded geographically to adopt a worldwide focus. These moves position them to pursue attractive opportunities at reasonable prices. Not all private equity firms are as fortunate, especially with investment capital increasingly flowing to perceived winners.

THE FINANCIAL AND TRANSACTIoN ADVISoRANuJ BAHAL

The survival of smaller funds, which represent the majority of private equity funds in the United States, is less clear given the challenging business climate. The firms which survive and thrive will be those that recognize today’s LBO market is less about leverage and more about generating and implementing smart ideas and strategies and defending and creating value from operating decisions at portfolio companies.

In the near term, private equity firms of all sizes will continue to actively nurture portfolio investments in order to ensure preservation and future growth of equity value and to meet the challenges of refinancing maturing debt on workable terms over the next few years. But the real challenge for sponsors will be generating sustainable top-line growth and improved working capital at portfolio companies, because much of the easiest cost-cutting has already been carried out. Fund managers will also be looking to

For a window into the future of private equity, look at the recent activities of longtime market-leading firm, Kohlberg Kravis &

Roberts (KKR). The firm is close to completing

a public offering of its equity by constructing a complex reverse merger with a publicly-traded European affiliate. It is also busy taking public the few successful companies in which it invested during the private equity boom of 2006 and 2007.

Even more noteworthy, over the long term, KKR is building up an investment banking business – one that has started competing with Wall Street for fees in such traditional businesses as mergers and acquisitions (M&A) advisory and debt and equity underwriting. A case in point is the upcoming initial public offering (IPO) of Dollar General, a discount retailer that KKR and Goldman Sachs bought together in July 2007 for $7.2 billion. According to the IPO registration statement, Dollar General hopes to raise $750 million in new equity for the company. Assuming a typical 7% IPO underwriter’s fee, KKR could share in the honeypot of $52.5 million in fees, which once upon a time would have been Wall Street’s alone. KKR’s new role as an underwriter now ensures that it will get some of those fees while it competes with Wall Street.

If this move into investment banking succeeds, and helps to shave third-party fees along the way, expect some of the other large private equity firms, such as Blackstone and Apollo, to follow suit. After a generation in the private equity business, firms such as KKR, Blackstone and Apollo have started branching out into investment banking to try to capture more of the fees they have paid to third parties and to create fuller, less cyclical businesses. If there is collateral damage with the large banks – in the form of taking fees from them – these firms have decided they can live with it.

Another indicator of emerging private equity trends can be found by looking at Northrop Grumman’s

THE CommENTAToRWILLIAm CoHAN

sale of TASC, its Virginia-based information technology business. Banks are competing heavily to finance the deal at five times cash flow. While a far cry from the eight times leverage that buyout firms could get at the recent top of the market, the deal indicates that the market for leveraged deals has reopened. Private equity investors now expect the market for leveraged loans to tiptoe back to a form of normalcy where leverage remains modest with deal terms less flexible than the ridiculous levels that prevailed at the top of the recent bubble. Practitioners view this as healthy. For instance, bank covenants, which had been all but abandoned in a fit of competitive frenzy, are starting to return to traditional levels.

But not all is rosy in private equity land. A number of the big deals constructed during the boom have imploded (see the bankruptcy filing of Reader’s Digest Association, which was owned by a consortium of private equity firms led by Ripplewood Holdings). The consequences for the future? Private equity firms are

likely to see their coveted ‘2 and 20’ compensation system – and in the case of Bain Capital, 2 and 30 – die away. Institutional investors are also cutting way back on their fund commitments, which means the days of $10-billion plus funds could be over as well.

It is clear that the private equity industry won’t be returning any time soon to the excessive ‘golden era’ of yesteryear. But KKR’s move into underwriting is a reminder that volatility breeds creativity and opportunity.

While private equity may be suffering from a cyclical downturn, the few rays of light now starting to emerge mean there is good reason to believe the industry will continue to loom large across the corporate landscape as a force for restructuring companies – and making money for their investors – in the United States and throughout the world.

William Cohan worked in private equity at Lazard Frères and is the author of House of Cards: A Tale of Hubris and Wretched Excess on Wall Street.

make opportunistically priced tuck-in acquisitions to complement their existing operations and drive scale.

Given the vast amounts of capital at the disposal of private equity firms, look for them to invest in areas where capital is sorely needed: the banking, real estate and mortgage industries. One potential obstacle, though, will be formidable regulatory and execution hurdles.

Private equity firms are also likely to pursue more minority interest investments and private placements in public entities (so-called ‘PIPEs’) – more than 50 U.S. deals involving $14 billion of capital have already been done in the last 18 months. And there has already been an acceleration of private equity activity in distressed M&A. About $80 billion of distressed debt deals have been done in 2009, and more may be on the way, given the onerous debt maturities on the horizon. Regardless of what happens, traditional buyouts will eventually return, but initially they will be smaller deals with lower thresholds on internal rates of return, less reliant on leverage and heavily dependent on more conservative forecasting and financing than in prior years.

History reminds us that some of the best private equity fund vintages were created amid adverse conditions akin to what we are experiencing today. This asset class is here to stay – it will evolve and adapt as necessary to meet the challenges and seize the opportunities that cyclical industries inevitably encounter.

Anuj Bahal is a Senior Managing Director at FTI Consulting in the Corporate Finance/Restructuring Segment.

The survival of smaller funds is less clear.


private equity

Private equity has traditionally been a lightly regulated industry in the United States. That may be about to change, as

Washington looks to overhaul regulation of the financial sector. The implications could be far-reaching for private equity firms, their investors and the broader economy.

Three reforms are looming on the regulatory landscape. First, there is an effort underway to increase taxes on private equity firms. Under current law, investments made by private equity funds are treated as capital assets, and the general partner’s carried interest share of the net gains is taxed on a ‘pass-through’ basis as capital gain. That translates to a tax rate of 15%. But the Obama Administration is expected to support congressional efforts to strip carried interest of its status as a long-term capital gain, and thus treat it as ordinary income. And that translates to a federal tax closer to 40%. The impact? Less capital for private equity

THE IN-HouSE CouNSEL DAVID SPuRIA

firms to deploy and do what they do best: buy companies, restructure them and sell them – a process that has generated jobs and income.

The second regulatory reform proposal that’s looming would change the legal status of private equity firms in ways that would alter how they operate and what they disclose to the public. One proposal in particular would alter how private equity firms are treated by the Investment Advisors Act of 1940. This law requires all investment advisors to register with the U.S. Securities and Exchange Commission, which creates significant compliance obligations related to disclosure, bookkeeping and audits.

Today, advisors with fewer than 15 clients are exempt from the law – and many private equity firms have stayed below the 15-client threshold. But as part of the financial regulatory reform package, that exemption could be scrapped. The Obama Administration has also proposed legislation that would require any entity with at least $30 million under management to register with the SEC as an investment advisor (this would include virtually every private equity firm in existence). If enacted, these changes would bring higher compliance costs for private equity firms, as they would be required to disclose borrowing, off balance sheet exposures, counterparty

private equity

credit risk exposures, and trading and investment positions.

The third regulatory proposal that has private equity firms concerned is one that would place new restrictions on their contacts with their largest class of investors: state pension funds. The proposal has bubbled up in the aftermath of a controversy earlier this year involving Quadrangle, a leading private equity firm. News reports indicated that Quadrangle paid large sums to ‘placement agents’ to help the firm gain access to officials at state pension funds. The Carlyle Group was also ensnared, and in May it announced it would pay $20 million as part of its settlement with the State of New York.

The use of placement agents has been common throughout the industry. But now there are moves afoot to prohibit any payments to such agents, with the SEC proposing a rule to this effect in mid-September. This has private equity firms worried, given the outsized role that capital from pension funds plays in the private equity industry. Any interference with that pipeline would inject further instability into the industry, which is still reeling from the broader market turmoil of the past two years.

Intensifying the stress on private equity firms is one non-regulatory issue: heightened tension between fund managers and their limited partners. Many firms are seeing anemic returns, and because there’s so little deal activity underway, these firms are not making distributions to the LPs. Yet they are still collecting management fees – typically 2% of assets under management. This is leading some LPs to call for fund managers to reduce or suspend their fees. Some LPs are suing fund managers, and there are even instances of LPs suing each other, when capital calls aren’t being met.

Some of these issues will dissipate as the economy strengthens, and new business niches will emerge. And the private equity industry’s success in helping to create jobs, and wealth, will help to deflect some of the regulatory onslaught. But one thing is clear: the future is not looking as bright as the past.

David Spuria is a Partner and General Counsel at Southlake Equity Group, a private equity firm, and a former general counsel at Texas Pacific Group.

The private equity model has a huge amount to offer the future of the world’s economies. First, look at the industry’s relative size.

Private equity is less than 2% the size of public equity by most measures, and in Europe accounts for just 0.4% of GDP. This suggests there are many more opportunities across the economy that would benefit from private equity’s style of ownership.

Second, private equity has demonstrated its resilience and ability to withstand extreme market and financial conditions, and to steward businesses in a responsible and supportive way through thick and thin. This helpful stabilizing effect in the economy should be recognized as regulators around the world pay more attention to systemic risks. The collapse of the credit bubble destroyed many parts of the financial economy. It also eviscerated the private equity market and in some cases forced managers at the larger end to reassess tactics. Given that private equity invests in real businesses, there will inevitably be some failures. But the underlying value creation strategy of private equity investment was never reliant on abundant credit or rising markets. It is about focused and committed company ownership. This remains an enduring quality.

Third, we are entering an era when political and social emphasis will be put on long-term rewards based on building sustainable value. In this area, private equity is an exemplar. Its

THE INDuSTRy VoICEJAVIER ECHARRI

long-term remuneration structures and alignment of interest between investors, managers, company executives and, very often, the workforce, are a vital element of its success. The future of remuneration across the corporate and financial sector is destined to follow the lead set by private equity, as social, political and regulatory pressure is exerted on short-term profiteering.

Javier Echarri is Secretary General of the European Venture Capital Association. He has previously held positions as the International Banking Director of BBVA Benelux, a Spanish bank, and as Secretary General of the Spanish Chamber of Commerce.

The future of remuneration across the corporate and financial sector is destined to follow private equity’s lead.


private equity

Six months ago, everyone in the private equity marketplace was expecting the next year or two to be one of the busiest and

most attractive investment periods in our lifetimes. The financial market meltdown sparked by the Lehman bankruptcy last September left every company and bank scrambling for liquidity. The $400 billion of committed but undrawn private equity in funds looked like one of the few sources of long-term capital available outside of government intervention. Every company facing a covenant default or a maturing revolving credit, term loan or bond looked like it was going to either go bankrupt or need to turn to a private equity solution.

THE PRIVATE EQuITy CEoTED VIRTuE

To the surprise of many, the credit markets have had an unprecedented rally, opening up the primary market for over $100 billion of new high-yield bonds and over $1 trillion of high-grade corporate debt issuance this year to address companies’ liquidity concerns. Even companies in the depressed airline, home building and retail sectors have had access to long-term debt. The equity markets have rallied over 50% from their lows, enabling companies to issue equity to delever and recapitalize. And banks have been more accommodating in providing waivers and amendments to defaulting debt, pushing leveraged capital structures forward.

With panic-selling pressure alleviated for the time being and only modest amounts of credit available for new deals, I believe private equity firms will still have two significant investment opportunities in this market environment. First is to equitize the many balance sheets that remain overleveraged from the easy money period of 2004-2007 so they can ride through the cycle. Many of these capital structures have extended their maturing debt but not deleveraged. This will be a big opportunity, especially in the absence of an economic recovery in the next 12-18 months.

The second opportunity is the need for traditional growth capital to transform companies and sectors. This has been a core strategy of private equity firms until easy money led firms to focus more on financial engineering than operating strategies. As companies move from survival mode to growth, private equity capital should be a needed source of funding for many companies and sectors to grow organically, consolidate within their industry and expand their geographic markets. Many of these deleveraging and growth investments will come in the form of minority investments, structured securities and PIPEs similar to the deals Leonard Green did for Whole Foods, BC Partners did for Office Depot, and KKR recently did for Kodak. zx

Ted Virtue is the CEO of MidOcean Partners.

As companies move from survival mode to growth, private equity capital will help many companies grow organically.

FD is acknowledged as one of the world’s premier consultancies dedicated to helping companies protect and enhance their enterprise value by providing solutions for their most critical communications issues.

Around the world, we advise the senior management teams of more than 1,000 clients on how to better inform strategic decisions and communicate business imperatives to achieve desired results, mitigate risk, and manage their company’s brand, reputation and valuation.

As the strategic communications segment of FTI Consulting, we offer a unique combination of industry leading human capital, diverse specialist practices, a deep understanding of key industry sectors, broad global reach and access to the expertise of our colleagues across the other segments of FTI.

www.fd.comwww.fticonsulting.com

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As the world’s leading investor relations brand, we advise clients on all aspects of understanding and in�uencing the drivers of the valuation of both their equity and debt.

We enable clients to fully comprehend the business impact of legislation and regulation across the world’s principal political and regulatory hubs.

FD is on the front line in helping clients understand the threats and opportunities presented by the digital media revolution, deploying creative solutions to deliver messages to the right audiences and through a variety of channels.

Our specialist consultants apply insights from business analysis and stakeholder perceptions to enhance our clients’ ability to make informed business decisions.

Our teams are working constantly on a multitude of highly complex assignments to help our clients build their corporate brands and enhance their reputations in the context of ever more demanding and diverse stakeholder groups.

For many years, FD has been ranked as the number one M&A communications advisor and more recently, our crisis management experts have been working closely with clients to mitigate the impact of the global �nancial crisis.

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FTI Journal Roundtable U.S. HealthcareThe FTI Journal recently convened a group of FTI experts from varied yet connected backgrounds and disciplines – from performance improvement and restructuring, to economic consulting and strategic communications – for a discussion about the state of healthcare in the United States and around the world, with a focus on what’s driving increased spending, and how to slow its growth.

The extensive debate playing out in the United States on healthcare policy and reform has revolved around efforts to

address rising costs and expenditures, and to expand coverage to a large population of uninsured.

Healthcare costs of approximately $2.4 trillion are substantial (about 17% of GDP in 2008/2009 up from about 15% in 2005 and a mere 5% in 1965) and are anticipated to increase to about 19.5% of GDP by 2017, without comprehensive reform. The growth rate of healthcare expenditures has exceeded that of GDP by more than double over the past four decades. During the same period, there have been dramatic improvements in technology, communications networks, electronic media, treatments for a vast array of illnesses, better understanding of preventive care, improved longevity, and substantial evolution in the organizational structures for delivering care in the U.S. across plans and providers.

Pending legislative proposals involve a wide array of alternatives for addressing costs, quality and

extension of care. The national discussion has been focused on cost reduction efforts, including widespread discussion of organizations that have accomplished substantial cost reduction while enhancing quality of service. For example, in his September speech to the U.S. Congress, President Obama mentioned two such organizations – InterMountain Health and Geisinger Health – as examples of healthcare organizations with success in both improved quality and cost reduction (other frequently touted studies include other examples). An open question, which is subject to both policy and empirical examination, is how these ‘localized’ examples can best be replicated in more localities or at the national level. What are their secrets to success and how can they be taken into consideration in forming national policy? The effort to replicate those experiences, and to identify how and why such gains were accomplished, has become a key part of the legislative agenda. The intense focus on cost-reduction solutions is also reflected in the proposals made by healthcare industry representatives – including pharmaceutical

roundtable


Improvements in overall healthcare will require a common method of measuring change.charles overstreet

roundtable

roundtable

manufacturers, insurers, hospitals and physicians.

The discussion focused around three key themes: n What are the common elements/reasons for the actual or perceived successes at cost reduction with improved quality?n What works to align incentives among market participants – insurers, hospitals, physicians, employers, and consumers – to accomplish greater cost savings while enhancing quality of care and of life?n What are the impediments or challenges to achieving greater gains at the local or national level?

Meg guerin-Calvert: The most frequently cited examples of institutions that have achieved success in cost reduction and improvement of quality of care include some of the nation’s largest and most highly integrated private healthcare organizations. Some of these organizations provide the full spectrum of inpatient and outpatient care and others are more specialized. Kaiser, for example, may be the most fully integrated of the examples mentioned – within this single organization there are physicians,

Roundtable Participants

Edward rEillyCEO (Americas)FD, the Strategic

Communications Segment

of FTI Consulting

Edward Reilly is CEO Americas of FD, FTI’s strategic communications segment. With an extensive background in attitudinal and market research, Mr. Reilly has led a myriad of innovative communications programs that have advanced the business objectives of his clients across a spectrum of industries.

Martin CohEn Senior Managing Director, Corporate Finance/Restructuring-

Segment, Leader of FTI

Healthcare Practice

Martin Cohen is a Senior Managing Director in FTI Healthcare and is based in Washington, D.C. Mr. Cohen has 25 years of experience in senior financial, operating, development and restructuring roles. He has extensive experience in the healthcare industry and is the leader of FTI’s dedicated healthcare industry practice.

Charles Overstreet is a Senior Managing Director in the FTI Forensic and Litigation Consulting segment and is based in Nashville. Mr. Overstreet specializes in the development and implementation of improvement strategies for healthcare organizations and brings a strong background in managing organizational transition.

CharlEs d. ovErstrEEt Senior Managing Director, Forensic and Litigation

Consulting Segment, Leader of

FLC Healthcare Services

MargarEt guErin-CalvErt Vice Chairman and Senior Managing DirectorCompass Lexecon, an FTI

Consulting Company

Margaret ‘Meg’ Guerin-Calvert is a Founding Director of Compass Lexecon (formerly Competition Policy Associates), one of the top competition economics consulting firms in the world. Ms. Guerin-Calvert has an active practice before federal and international antitrust agencies and in litigation, including class certification, healthcare and pharmaceuticals, and network industries.

CElia hallSenior Vice PresidentFD, the Strategic

Communications Segment

of FTI Consulting

Based in London, Celia Hall is an award-winning journalist and media relations expert who specializes in the European healthcare industry. Most recently, Ms. Hall was with The Daily Telegraph, where she was the medical editor for 11 years. While at the Telegraph, Ms. Hall was twice awarded the BMA medical journalist of the year award for her coverage of the European healthcare industry.

Fourth, these are largely examples of private organizations, not public or government-funded ones, which have relied on market mechanisms to accomplish their goals. These include a variety of contractual arrangements with many different healthcare market participants.

Charles Overstreet: The most common element in achieving cost reductions is how readily any cost reduction can be measured. Cost reduction success stories are often best illustrated by how the reductions were tallied up. That is to say, whether the reduction or improvement is large or small and how easy it is to track. Many reductions have to do with the overall change in the actual outlay of cash. Supplies, hourly wage, medicines, devices, etc. all have a cost. If we can identify these costs, reduce these costs and then track the reduction, we have a success story.

But cost reduction is often illustrated in more complex scenarios where there may be many variables or components that are being improved (or are perceived to have been improved). The key to success in these more complex scenarios is not

clinics, hospitals and insurance, with fully managed inpatient and outpatient care. It’s also noteworthy that these entities coexist and compete with other organizational forms in the provision of physician services, insurance and hospital care, demonstrating that the healthcare marketplace supports a variety of entities.

There are several common themes from these examples. First, most of these organizations are very large for their locality or region. This

suggests that even as a single firm these organizations are able to get relatively complete information on the local population, its healthcare needs and characteristics, as well as on providers.

Second, these highly integrated organizations can use this access to develop and implement solutions to identify higher costs, to reward improved quality and cost reduction, and to induce providers and patients to take preventive care steps so as to reduce more costly inpatient or outpatient care. A common element of cost reduction successes are organizations that have made use of their own data and information on procedures, outcomes and costs, and then developed systematic and comprehensive analyses both internally, and relative to external standards, to identify the sources of variation and to develop solutions. They have developed metrics, and can track and implement them.

Third, the gains from improvements and cost reductions can be internalized by the organization, and thereby create greater incentives to invest in activities such as improved IT and electronic records.

in just tracking individual component improvements, but in developing and tracking simple overall statistics of improvement. One classic example is the great strides in improving cost and quality in cardiac surgery. Over the past several years we have seen many improvements in this area of medicine. Why? Yes, medical science has advanced and we have improved medicines, techniques and other factors. But I would argue that one of the major reasons for the improvement in quality and cost in this area is the ease with which one can actually gauge and track improvements.

Some simple statistics that are easily tracked are the real contributing factors of the improvement in this area – Length of Stay (LOS) and Cost per Case. These two statistics are easily calculated and they complement each other. Moreover, most would agree that a reduction in the LOS of a hospital stay is an improvement in clinical quality, and agree that a reduction in Cost per Case is also a success. Both metrics do not allow for much argument or difference of interpretation – ‘they are what they are.’

Martin COhen: Historically, hospitals and physicians have addressed cost reduction through enhanced management of labor and non-labor (i.e. medical supplies, cost of implants, cost of contract services, etc) costs. Also, in the early ’80s (with the introduction of DRG’s) and the late ’80s and early ’90s (with the expansion of HMOs) significant improvement was achieved in reducing clinical costs, through better management of the clinical care process. However, much is left to accomplish in this area.

Although hospitals and physicians must (and will) continue to look for ways to reduce labor and non-labor costs, in order to reduce the cost of care in a meaningful way it is essential to continue enhancing clinical care processes through better coordination and management of care delivery. On a day-to-day basis that would call for better coordination of preventive, diagnostic or therapeutic modalities provided by patients’ primary care and specialty physicians. In an acute inpatient setting, this would entail not only coordination of care among the physicians but also the nursing, diagnostic and other professional staff providing care in the hospital.

There are several key elements required to bring about improved coordination and management of the clinical care processes including (1) improved access and transparency of patient medical information (electronic medical records), (2) the development and implementation of best practices with respect to clinical treatment protocols, (3) the need to better track and monitor clinical quality outcome measures and finally (4) the need to align the economic incentives for hospitals and physicians. Each of these is an essential component necessary to improve the effectiveness and efficiency of clinical care processes and all must be addressed.

Charles Overstreet: One of the reasons why reductions/improvements on a broader and deeper scale get bogged down, or do not reach their full potential, is that we get sidetracked in arguing over the metrics of reduction/


improvement, or we cannot develop sound and systematic metrics of measurement. In my example of the cardiac surgery improvements, we can quickly get into a debate over measuring other factors of reduction/improvement when we get into more complex measures such as outcomes, readmission rates, volume of diagnostic procedures, etc. These types of factors are important and need to be measured, but we do not have a recognized commonality of ‘how to keep score.’ Thus I would assert that greater reductions/improvements in overall healthcare will require a common (and agreed-upon) method for measuring the change.

Martin COhen: Although there have been attempts to address the essential elements I described earlier, they have not been addressed in a comprehensive way and accordingly have met with varying degrees of success. For example, the establishment and growth of HMOs have provided a significant reduction in the cost of care. However, these reductions in cost have been primarily driven from the economic incentives provided to providers and reduced access to services. Absenting the transparency of medical information, development of clinical pathways and better tracking and monitoring of meaningful clinical quality measures, this method of reducing costs has a limited upside and is certainly not grounded in clinical effectiveness.

On the other hand, substantial work has been done in the development of electronic medical records, development and tracking of quality measures and establishment of enhanced clinical protocols/pathways. But until providers, both physicians and hospitals, are reimbursed for services in a manner that provides aligned economic incentives, and until quality becomes a component of how providers are paid, history has proven that behaviors are not likely to change and significant cost reduction impact will not likely be achieved.

In order to achieve the real efficiencies available through

critical role to play in communicating with employees what can be done to better manage costs to the business, and what individuals can do to change their behavior in ways that will help to reduce healthcare costs. The human resources departments in particular are playing valuable roles when employees interact with an insurance company – educator, explainer and advocate.

Our research shows that people are willing to make sacrifices to keep their employer-provided health insurance. Indeed, a recent FTI survey found that 70% of all respondents are willing to take a pay cut to keep the healthcare insurance currently provided by their employer. The same survey found that while 29% of those surveyed blame employers for rising health insurance premiums, five other groups were identified more frequently as the source of such increases (health insurance companies, hospitals/medical facilities, lawyers, government, and consumers/employees).

Charles Overstreet: In continuing my theme on the need for common measurement, I think that measurement and tracking are essential for aligning incentives for all those participating in the healthcare marketplace. Reduction in the costs to consumers must be balanced with the real or perceived loss of revenue from the perspective of the provider.

The promise of truly managed care allowed for some of this balance. Payments for care were to be placed in a pool and used as needed by a patient population. Through responsible management of that care and a focus on ‘health maintenance,’ the total outlays from the pool were to be reduced. When the year was over, whatever was left in the pool was shared between payer, provider and beneficiary, and thus, all of those involved had aligned incentives. This is the simplest way to initiate and sustain real reductions and improvements.

Meg guerin-Calvert: Even where there is sound measurement and metrics, there still needs to be sufficiently broad data (both cross-sectional and time-series) to be able to conduct a sound empirical assessment

public but are able to raise their own capital and save and invest

any savings they generate. They work to nationally agreed standards,

in order to provide consistent standards of care across the country. Hospitals can only obtain and maintain foundation trust status if they are able to prove and show good financial control and governance.

The foundation trusts are similar to medium-sized businesses, and there is a belief that it will be easier for these locally focused organizations to contain costs and cut waste. According to the independent regulator of NHS foundation trusts, the trusts spent £22.7 billion in 2008/09 and generated a retained surplus of £269 million. While this is a tiny amount compared to total spending, each of the 122 trusts in England is under an obligation to make efficiency savings every year or face loss of their foundation trust status.

edward reilly: We can also look to employers as innovators in developing ways to reduce healthcare costs while improving quality of life for their employees and families. For example, Coca-Cola has taken very innovative steps to control costs, by focusing on behavioral changes, and incentivizing people to live a healthy lifestyle. By next year, it is going to cover 100% of the cost of preventive screening for its employees. The program is projected to save an average of $300 in healthcare costs per employee per year, and reduce the company’s healthcare costs by 8%, annually.

Another example is the tremendous transformation we have observed at Walmart. It is counseling employees on how to take advantage of government healthcare options. And it is very active in promoting wellness programs, taking a more progressive approach, while putting more responsibility on employees.

Some may be surprised by the fact that one of the elements we’re seeing in our ongoing public opinion research is that employees perceive employers to be a primary steward of their interests.

So employers have an even more

of the variation in costs and quality, while controlling for the wealth of factors that can affect both. As Charles notes, there are often many factors that explain a given result, meaning that empirical analyses must be sufficiently sophisticated to deal with the complexity.

A hallmark of the FTI professionals working in the healthcare area is knowledge of healthcare data, extensive experience with empirical analyses at the most disaggregated and detailed level, and a thorough understanding of the approaches and mechanisms used to improve costs and quality – whether for firms in financial distress, those seeking process improvement, others via merger, or in the development of new ventures.

Celia hall: There are similar challenges in the United Kingdom, which is battling the problems of an insatiable demand for healthcare, little incentive to use the service responsibly and an ageing demographic. In the UK, two generations have got used to the idea of free healthcare and the NHS is very much seen as a sacred cow. There is little incentive for politicians to tackle the cost issues head-on so any changes will be a case of evolution rather than revolution.

Similarly, small hospitals in medium-sized towns are very inefficient. It is impractical for these hospitals to provide every single service or expertise that can be provided by larger regional hospitals. But there are huge political constraints, particularly for local representatives, in addressing this.

Another issue in the UK is that in trying to reduce costs, implementing comprehensive reforms can prove to

enhanced coordination and management of care, the Federal Government, through modifications to the Medicare system of reimbursing physicians and hospitals, will have to lead the way.

Meg guerin-Calvert: The examples of individual organizations are the most dramatic and perhaps most informative, but may obscure other sources of gains in the management and reduction of costs. During the 1990s and early 2000s, there was substantial consolidation of hospitals, the vast majority of which raised no antitrust concerns and which resulted in substantial and well-documented efficiencies. In addition, efforts on the health insurance and provider sides have focused on mechanisms to create incentives for improved preventive care, pay for performance, and metrics.

Celia hall: The United Kingdom’s National Health Service (NHS), which oversees the delivery of healthcare to all UK citizens, has pursued some noteworthy reforms that deserve more attention as the United States looks for opportunities to control costs and preserve quality.

One initiative has been to break up the organization into smaller, more flexible and more autonomous units such as NHS foundation trusts covering both hospital and primary care. These are self-governing organizations that run hospitals and provide healthcare to the general

Until providers are reimbursed in a way that provides aligned economic incentives, behaviors are not likely to change. martin cohen

70% of employees are willing to take a pay cut to keep the health insurance currently provided by their employer.

roundtable

roundtable

FTI research


roundtable

be quite costly. There have been well-publicized delays and cost overruns on a central IT operation for the National Health System. The IT was designed to link 30,000 GPs and 300 hospitals to a central system and contain information on 50 million patients. It was projected to save more than £1 billion a year. But it is now four years behind schedule and it may also end up costing four or five times the original £6.2 billion budget.

edward reilly: As a result of the healthcare reform debate, irrespective of the final resolution, there will be greater scrutiny on healthcare providers and the cost and effectiveness of what is being delivered. Although not directly included in health reform, the Government has set aside billions of dollars for comparative effectiveness trials to look at the relative benefits of various treatments for the same indication or diagnosis. For example, a trial would look to compare rehab therapy to surgery for a specific orthopedic procedure, review the outcomes and assess the relative benefits. The tools are available

today to design and implement patient registries, studies and technologies for evaluating real world outcomes for safety, effectiveness, quality and value.

Meg guerin-Calvert: As my colleagues in this roundtable have indicated, achieving clear gains in costs and quality depends on developing and assessing sound empirical evidence, which must then be connected to effect changes in

performance, whether by physicians, hospitals, insurers, employers or patients or some combination of them. That involves organizational structures, including some internal to firms, and others that require coordination across otherwise independent players. I can envision that such extensive empirical analyses could be conducted by individual health systems, by insurers, by physician groups, as well as by combinations of such entities. While there are opportunities for substantial cost savings at the individual provider or insurer level, there are likely to be even greater potential gains from finding the means to develop sufficient data to conduct sound studies by multiple entities in an area and to implement the results across firms and markets. That is a challenge because it requires development of contractual arrangements to accomplish data-gathering, development of the empirical analyses, and then implementing solutions for cost reduction and alignment of incentives.

The experience of successful healthcare organizations shows that in a market-oriented healthcare system, the market can function to achieve substantial cost savings, where it can replicate by contractual arrangements what integrated firms have been able to develop internally. However, increased coordination can lead to a reduction in competition. And so antitrust authorities will need to provide greater guidance about the standards by which any new types of arrangements between and among participants will be evaluated, because existing guidelines suggest that many of these arrangements fall outside of recognized safety zones. For example, would antitrust issues arise if hospitals and physicians, hospitals and plans, or smaller independent plans within a region, pool data and information on claims or procedures, collectively fund empirical research on the sources of cost increases, and then implement initiatives to change behaviors so as to reduce costs? zx

The tools are available today ... for evaluating real world outcomes for safety, effectiveness, quality and value.edward reilly

Dealing with the Unforeseen

Great companies might not be able to predict the future, but they are ready for whatever fate throws their way. The FTI Journal examines best practices from a region familiar with crises.

Anyone who predicted in the beginning of 2008 that some of the world’s leading financial institutions would be wiped out, that others would require rescuing via massive govern-ment bailouts or that the global

economy would teeter on the brink of a new Great Depression would have been laughed at.

The size and speed of the financial tsunami last fall illustrated how ill-prepared the corporate world was for such a meltdown.

international risk

Steve VickersPresident & CEO FTI-International Risk


international risk

international risk

While there are now some early encouraging signs that the worst may be over, uncertainties still abound. This is precisely when organizations should assess their ability to handle the unforeseen and to make wise decisions in crisis environments.

From a corporate perspective, the most common crises are generally found in three key areas:

n Natural disasters – including floods, fires, typhoons and earthquakes;

n Environmental and health-related problems – including epidemics, accidental spills, hazardous material issues, nuclear or chemical scares, sudden reversal of government policy or the intervention of NGO environmental groups;

n Man-made events – including arson, sabotage, terrorism, aggravated labor issues and the public exposure of substantial

In the experience of FTI-International Risk, the first 48 hours from the onset of any crisis or emergency is the most critical period. The key to success is to support senior management in mobilizing resources, focusing them on resolving the core issue while also minimizing the impact to personnel or disruption to day-to-day operations. It is important, therefore, that the crisis containment team is activated at the earliest possible opportunity.

Where it is evident that manage-ment does not have the necessary knowledge or experience ‘in-house,’ organizations should seek the support of an independent risk mitigation consultant. For the first few days of the crisis, there is a need for some-one, often an external firm, to act as the ‘aggregate’ to hold together the various disparate elements involved in the corporate response to a crisis situation. Organisations with matrix management structures are often ill-suited to deal with sudden and unpre-dictable events, which to be correctly addressed require a defined leader, and a clear chain of command with no room for equivocation, internal politics or finger-pointing.

While the size and composition of crisis containment teams in corpora-tions varies according to their size and geographic disposition, they are usually comprised of elements of senior management, finance, opera-tions and legal. Externally, specialist consultants in both crisis containment and crisis communications are often retained. Many public relations firms are not specialists in crisis communi-

corporate fraud or corruption, resulting in threats to the enterprise.

In Asia, we are routinely exposed to all of these risks. Natural disasters have occurred and continue to occur in South Asia and elsewhere in the region, and there is always a threat that Tokyo or Osaka will experience a major earthquake.

China is particularly vulnerable to health-related problems, given its explosive growth and attendant environmental problems. Over the past year, China has experienced widespread chemical-related problems and issues involving tainted milk and other food products. These incidents have had a global impact since China is increasingly the workshop of the world. Within China, it was recognized that these issues could potentially pose a threat to the legitimacy of the ruling party, and possibly impact internal stability.

From a corporate point of view, these crises issues require careful planning, execution and sensitivity.

In Asia, one of the most common ‘man-made’ crises is in the area of significant and sudden corporate fraud. In the coming months, we are likely to see further disclosures and significant failures, particularly related to corporate malfeasance. Companies need to be able to react swiftly and effectively in order to preserve their brand, reputation or market valuation.

Many companies have developed plans to deal with business interruption and continuity plans, perhaps following the occurrence

of a ‘set piece’ event (e.g. a natural disaster or environmental crisis). Unfortunately, most organizations are ill-prepared to deal with the practical implications of substantial corporate fraud, terrorism or other man-made crises. Our experience is that the larger the company, the less likely it will be able to respond effectively and in a timely fashion to avert the fallout of a major crisis.

Larger companies frequently seek to identify risks and combat them by utilizing risk registers and other mechanical measures. These are helpful but not sufficient. The key after having conducted this process/exercise is to develop practical and realistic plans to actually deal with the problem in a hands-on manner.

How Prepared is Your Company to Handle a Crisis? Company directors should be asking a number of questions: n Do we have systems and protocols

in place now? n Have they been tested? n Can we respond quickly and

efficiently to a crisis? n Do we have an effective

infrastructure in place? n Can we find the designated

people who are part of our crisis containment team?

Directors need to know that in times like these, the company has sufficient resources, both internal and external, to respond to any major corporate emergency or challenge.

The size and speed of the financial tsunami last fall illustrated how ill-prepared the corporate world was for such a meltdown.

CEOs are unlikely to be able to manage a significant corporate crisis and their normal business for more than five days, without failing at both.

Crisis COnTainmEnT and rEsOluTiOn

Throughout the handling of any significant crisis, the designated crisis containment team should be regularly addressing and readdressing the following issues:

n Is this an enterprise-threatening issue?

n Do we have sufficient resources in-house to deal with it?

n What is the likely long-term financial impact on the bottom line?

n Have we plugged all immediate and identifiable gaps to prevent further losses?

n Can the losses be recovered, or are they covered by insurance – fidelity policies, bankers’ blanket bonds or a directors’ and officers’ policy?

n Which controls failed and are we still exposed?

n Who was involved / what damage has been done / what are we doing about it?

n Should an immediate report be made to the police or to other local authorities?

n Is there a requirement to report to regulators?

n Crisis communications – are we prepared to deal with the media even if we have not yet had time to plan?

Crises are, by their very nature, unpredictable, but with a well-designed and tested structure in place, companies can mitigate the damage to their reputations and their share value, while also preserving the loyalty of their customers and staff.

cations, and it is important to make this distinction.

The collective goal of the team should be to facilitate well-informed decisions that are implemented in a consistent and timely fashion. While crises come in all shapes and sizes, the response tends to follow a classic pattern: the initial step is to comprehensively assess ‘Ground Zero’ and to realistically estimate the damage or likely future or continuing damage to the entity. For example, in the event of a catastrophic fraud or corruption issue, this is often

determined via the swift examination of relevant documents, including phone records, emails and other computer files, meeting schedules, travel patterns, and so forth.

Ninety-five percent of the world’s business records are estimated to be in some form of electronic medium. Therefore, electronic evidence recovery and e-discovery protocols are vital in the support of almost any corporate crisis.

Once the team has a better understanding of the situation, efforts can be made to identify possible options, and the relative merits and disadvantages of various courses of action can be discussed.

CEOs are unlikely to be able to manage a significant corporate crisis as well as normal business operations for more than five consecutive days, without failing at both. Therefore, it is imperative that senior management be presented with sufficient information and recommendations to make the best strategic decisions. It is equally important that they be kept sufficiently above the fray so as not to be over-involved in the minutiae to the detriment of the ultimate objective of ‘seeing through the crisis and visualizing its resolution.’ zx



capital markets

Critics of the SEC proposal argue more time is needed to ensure the technology is in place to support this new style of proxy voting, and to ensure that corporate issuers aren’t hampered with excessive costs of materials printing, mailing and proxy solicitation firm engagement to get out the retail vote.

The real issue behind the proxy access rules is that it has the potential to simplify shareholder activism and reduce the costs associated with it. Lower turnout and support for board members this proxy season paves the way for bad press, hostile shareholders and heightened activism levels at target companies. The SEC’s proposed rules put few limits on shareholder activists who will find it easier to advance their narrow interests at the expense of the broader shareholder goals.

The New York Stock Exchange’s Rule 452, approved in July, provides a preview of how the proxy reform would work in practice, were it to be enacted. It is likely to cause short-term problems since it eliminates ‘Broker Discretionary Voting’ without providing an easy way for retail shareholders to vote. While the intention of removing brokers’ ability to cast votes for shareholders who don’t return voting material unless instructed to do so may be fine, the consequences could have major adverse impacts in practice. Without new technology to lower the cost for retail shareholders to vote, the rule will likely translate into lower voter participation rates. Board members may appear to get much less support than in the past, making them appear to have lost shareholder confidence when, in reality, there were simply fewer voters. This may have the unforeseen consequence of exacerbating the voting impact of the better coordinated activist or opposition group.

It remains an open question as to whether the SEC will approve changes to the proxy process. If it does, it could lead to a shake-up in corporate boardrooms. What’s not clear is whether the shake-up will be for better, or for worse. zx

accountable to company owners.’ The essence of the proxy reform

proposal is to allow shareholders who own at least 1% of a company’s shares to have their board nominees included in corporate proxy materials. This would apply to companies with a market capitalization exceeding $700 million. A 3% stake would be required for shareholders of midsize companies and a 5% stake for shareholders of smaller companies.

After releasing a detailed proposal in early June, the SEC received more than 500 sets of comments. The intensity of the response is not a surprise. As one attorney told The Wall Street Journal, ‘It’s the biggest change relating to corporate governance ever proposed by the SEC. Period. It gives activists the ultimate vehicle to express dissatisfaction with a board, the ability to replace board members at the company’s expense.’

The all-out lobbying battle in Washington has pitted the Business Roundtable, U.S. Chamber of Commerce and National Investor Relations Institute against investor groups such as the Council of Institutional Investors and institutional-investing giant Capital Research & Management Co., as well as some large unions. All agree the present proxy system is too complex, but some argue the SEC isn’t attacking the root of the problem, and instead is approaching reform in a piecemeal fashion that doesn’t take into account how the interrelated parts need to work together.

It’s the biggest change relating to corporate governance ever proposed by the SEC. Period.

Elizabeth Saunders Managing Director, FD

Early next year, the five members of the U.S. Securities and Exchange Commission are

expected to vote on an issue that for years has sparked fierce debate between companies and shareholder activists. The issue revolves around whether to make it easier for shareholders to nominate directors for corporate boards.

Policymakers, investors and industry leaders have long recognized the importance of modernizing U.S. proxy voting and communications. Momentum is gaining to help retail shareholders do just that. The proxy reform movement, which has been debated for years, received new life in the aftermath of the global financial crisis, which highlighted the need for boards to be more accountable. In a speech earlier this year, the Chairman of the Securities and Exchange Commission, Mary Schapiro, said, ‘This crisis has led many to raise serious questions and concerns about the accountability and responsiveness of some companies and boards of directors to the interests of shareholders.’ She believes that if a proxy access rule is adopted, it has a ‘real chance of holding boards of directors

Proxy Reform– Be Careful What You Wish For

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