Thomas W. Buck MBA, CIRA, CTP
Director, EisnerAmper Bankruptcy & Restructuring Group

The current economic climate has seen corporate bankruptcy filings increase 40% over the prior year. During the second quarter of '09, high yield default rates increased to 10.1% and were anticipated to approach 13% by year end. While these figures do not directly correlate to conditions for middle market companies, they are indicative of the current lending environment.

Many middle market companies rely on asset based lending (ABL) facilities. Such loans are generally fully secured by inventories and receivables and often have personal guarantees attached. These loans advance funds to the company on a formulaic basis (as an example 85% of eligible receivables and 50% of eligible inventories). The gross collateral value available to borrow against is often reduced by "ineligibles" such as receivables over 90 days, WIP inventories, and other deduction factors.

Generally companies move to ABL facilities when cash flow lending is no longer an available option. The conversion from a cash flow to an ABL loan requires additional processes and procedures for reporting but generally results in a higher level of discipline with regards to managing one's working capital. Because of the ineligible function, the company has less flexibility with regards to customer credit policies and slow moving inventories. Those that do not apply discipline to their working capital management will quickly find themselves out of liquidity. Companies that embrace the required discipline and build processes around it will find improved efficiencies.

Liquidity is the available cash that the company can draw at any given time. Because the working capital is pledged to the lender, the liquidity is the only source of funds to operate the business short of an equity infusion. All too often companies do not operate with sufficient liquidity to handle shifts in seasonality, macro-economic shifts, or bad customer debts. As a restructuring advisor for over 10 years, I often get called when the company realizes that it won't be able to make its current payroll. In the current economic environment I have seen viable businesses liquidated that could have avoided this result if they had identified and addressed their cash flow issues sooner. Out of liquidity can easily become "out of business."

Often the management has become "comfortable" operating with limited availability stretching the trade, utilizing float and drawing down their inventories. Over the course of months or even years, management style becomes reaction oriented, "firefighting" daily operational and financial issues whose root cause stems from insufficient liquidity. Over time this culture pervades all levels and functions of the business from accounting and production to shipping and customer relations. Everyone is working hard all day but in reality the company is paralyzed unable to make decisions related to any planning or strategic aspects.

A "liquidity trap" arises under the condition of falling sales and falling inventories. In the short-term the liquidity can be managed as the receivable "discount" is collected and working capital inventories are freed. However, an inflection point occurs as ineligibles increase (become a greater percentage of shrinking pool of collateral) and tighter inventories negatively impact revenues. At this juncture sales can plummet from supply chain constraints while non-material expenses remain unchanged. At this moment the company no longer needs "incremental" cash but a significant cash infusion to restore normal operations. I often find that this liquidity trap can catch both the company and the lender off-guard.

From a purely treasury aspect, liquidity should be managed daily, however from business management perspective, liquidity should be managed over the horizon. One of the primary tools restructuring advisors employ is a liquidity projection of three or more months. This projection (weekly or daily) is a direct cash flow of projected receipts and disbursements based on conservative revenue projections, cost inputs and working capital assumptions. Such projections should be a baseline and not include improvement initiatives. The purpose is to identify periods of liquidity shortfalls with sufficient time to put action plans in place to bridge the "funding gap" through efficiency measures and/or external financing.

Over the 10 years being in the restructuring industry, I can count on one hand the number of clients that had sufficient liquidity management practices in place. As a restructuring practitioner, I welcome the opportunity to engage a client early in the process before a crisis is at hand. Generally, however, the likely sequence is that a company has defaulted on certain loan covenants which may trigger a requirement to retain a financial/restructuring advisor.

It is often desirable and sometimes required that the lender have an existing relationship with the retained restructuring firm. In the eyes of the lender, the company has lost credibility by not achieving budgets and forecasts. The advisor represents the client company's interests, however, the lender who is in a damage control/asset recovery mode has comfort that the advisor is competent and will act in a timely basis navigating the client through the workout process. My recommendation to any company hiring a restructuring advisor is to hire the "person" not the "firm." Too frequently the advisory firms' senior management "sell" the work yet staff the project with junior associates. Furthermore, the potential advisor's crisis management experience is more important than relevant industry experience. The best advisors leverage the existing management's industry knowledge with their own turnaround/crisis management experience.

A good advisor will be a partner in the process, being both collaborative and combative, while at all times managing expectations of the stakeholders. The advisor should provide leadership and decision making in an environment with imperfect information, to help the troubled company embrace change and create opportunities to survive and prosper. Critical steps in the process include:

• Rapidly assessing the short term liquidity picture to determine the window of opportunity for a turnaround.
• Assessing the strategic alternatives in light of the time frame.
• Pursuing a parallel path of stabilizing the company through the design and implementation of practical solutions while considering alternative liquidity events in order to maximize/preserve the value of the enterprise.

One of the perverse aspects of the current market conditions is that companies with over-collateralized loans (companies whose secured assets are worth more than their bank debt) are just as likely to be forced into liquidation when facing a liquidity shortfall as those companies whose lenders are "underwater" relative to the loan to recovery value. This is because it is so difficult to refinance in the current market while the lenders are often looking to bolster their balance sheets by shrinking their book of loans using a heavy hand on credits with covenant defaults. There is often more negotiating opportunity on the "underwater" loans with respect to negotiating over-advances, modification of terms and debt forgiveness because the lender's alternative under a liquidation may likely be worse. From the bank's point of view, the over-collateralized loan can be recovered 100% while the "underwater" loan requires a write-off.

Refinancing during a time of distress takes time. Prospective borrowers need to be realistic with regard to the terms that will be offered. In many cases the interested parties are "lenders of last resort." Such loans require significant upfront commitment fees and closing fees. Although the commitment fee is non-refundable, I highly recommend pursuing a dual lender due diligence process. A distressed company likely has one opportunity (time frame) to refinance with the support of the existing lender. Pursuing a single lender process allows the prospective lender to take a "second bite of the apple" at closing, increasing the terms/costs from the initial proposal. Without an alternative lending prospect the company has no choice but to acquiesce to the revised terms.

Bankruptcy should be the last resort. For the majority of middle market businesses the end result of a bankruptcy filing is a "363 sale" of the operating assets (free of liens and encumbrances) to a strategic buyer or an outright liquidation. While a "363 sale" is an efficient method to maximize the value of the estate, the consequence is that equity is "out of the money." Rarely can a middle market company emerge from the bankruptcy process unless the equity sponsors have external capital to provide "new money" to a re-organization.

As a business operator, if you have concerns regarding liquidity, consider speaking to a restructuring advisor before your lender requires you. The additional time will result in more options and a greater potential for a successful outcome.

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