Should you acquire a company in need of a turnaround?

by Global PMI Partners Partner, Eitan Grosbard

Are underperforming companies an attractive business opportunity?

In cases of corporate decline, stakeholders start contemplating their investment and their willingness to continue investing. Many times, they are fatigued and looking for an exit strategy.  The company’s decline may present an opportunity for a potential buyer, who is able to acquire at a deep discount.

Even when a company’s financial performance is subpar, valuating the company as a whole (including cash or other assets) may present an opportunity. Seasoned investors can quickly move in and take advantage.  Their position is, “We can manage your company better, increase its value, and ultimately sell it at a profit.” But are companies in decline really good investments? The answer is complex and depends on several factors. In this article we examine different factors to take into account when acquiring companies in need of a turnaround.

The stage of corporate decline – an important factor

Business results are only part of the picture

You should not only focus on the company’s financial results. Rather, a look at three central components can better predict decline before a company sees decrease in sales or revenues. The three predictors of decline (and therefore of a turnaround process) are the strategic component, the financial component, and the behavioral component. The first two are obvious, but the third is often overlooked.

Decline is a gradual process, which follows distinct stages that can be clearly identified, and may unfold over many years.

Stage 1 – Inability to take creative risk

In this first stage of decline the company’s ability to take creative risk takes a hit. The immense enthusiasm and energy previously dedicated to increasing sales and discovering new markets begins to dwindle. The company is less confident in its ability to continue to grow organically, and often turns to external sources of growth (acquisition of technology, knowledge, products, other companies, etc.). The confidence of managers begins to decline. Their willingness to commit to challenging goals and aggressive planning significantly decreases. Operational departments such as finance, oversight, and legal get a big boost, while marketing, sales, R&D, and business development are significantly weakened. Departments start to operate in silos and not cooperatively as part of a whole. The degree of formality within the company increases. Business results are still good (sales, orders, profitability, cash flow) because the company is using the momentum created by its earlier success, but the number of initiatives and the level of creativity are nothing like what they used to be. Employees experience deterioration, but do not discuss it openly. This stage can span a long time, and to the outside world may appear as “business as usual.”

Stage 2 – Decline in business results

In the second stage, decline manifests in business results. Initially, it can be seen as a decline in numbers. This is the stage when some companies will increase their prices in order to sustain their sales cycle, while others will lower prices in order to increase sales. This ultimately results in decreased sales and profitability. The tendency at this stage is to attribute the decrease to external forces such as market conditions, exchange rates, interest rates, the state of the economy, etc. At this point, companies tend to cut their expenses and speed up their development process so that new products hit the market faster. The attempt to cut costs and create stricter cost-control mechanisms bring a sense of cynicism among the ranks of the organization.  At this stage, managers tend to psychologically distance themselves from the organization, scale back their responsibilities, become more secretive about what is happening, and in general stay away from other managers. Denial and inability to cope with the situation are common responses at this stage. Financial symptoms begin to show at this stage. In particular, a reduction in market share, increase in company debt, decrease in working capital, operational and net revenues, and ultimately changes in the management team of the company.

Stage 3 – Inability to make and implement decisions

In the third stage, the organization’s ability to make significant decisions and implement them is dramatically decreased. Managers isolate themselves from colleagues (and often from their subordinates), meetings are postponed, and cross-organizational processes are practically eliminated. Managers are concerned with their personal survival, and with meeting their own goals, without taking into account the larger picture (which is long gone). The overwhelming feeling is, “Anything you can do alone, you just do.  Don’t wait on others or try to reach shared goals, because that’s simply not going to happen.” Battles over limited resources become an integral part of management, and a culture of blame becomes pervasive. Common phenomena during this stage of decline include individuals protecting their own interests, territorialism, indecision, blame, a mass exodus of key management, and inward-looking orientation, all while completely ignoring customers and their needs. This stage obviously includes further business decline.

Stage 4 – Lack of loyalty and responsibility

In the final stage, loyalty and responsibility are gone. Management and staff are only concerned with personal survival. Distrust, introversion, and isolation are common at this stage. Often times, the company maintains its sales due to previously signed contracts which create an artificial sense of vitality. The needs of customers have long ceased to be a concern for management, and the disconnection from the market’s needs is deepening daily, which ultimately escalates the company’s decline.

Factors to consider when acquiring a company in need of a turnaround

Based on the stages described above, it is paramount for a potential buyer to understand which stage the company is in. Are there early signs of decline that can be addressed? Are these signs of more advance decline, which present much greater risk for the buyer?

In the early stages, the common strategy of replacing the CEO, rearranging the board of directors, and deciding on a few new strategic directions can certainly turn the company around. Even ambivalent investors who are not deeply involved can still reasonably expect a handsome return on their investment.

In more advance stages, the turnaround process may be deeper and more painful. A new CEO would need to take more drastic, painful steps. Few CEOs have the personality and capability to lead such a process successfully. The risk level for a potential buyer is much higher at such stages, and he must therefore understand that further decline is expected and likely inevitable. The natural trend is toward escalation and intensification.

Investing in a company that is in more advanced stages of decline is nothing like investing in a company showing only early signs of decline.

A company considering the acquisition of a company in need of a turnaround should take into account that it will be called to support its acquisition in a number of areas:

Management team changes: In order to put the company back on track for growth and profitability, a personnel change is almost always necessary in the management ranks. You don’t have to replace all management. However, management is often unable to lead the needed change. If it were capable, it would have done so a long time ago. The critical question then becomes who can execute the change and lead the company on the complicated road to recovery? In most cases, the most pragmatic players stay on, because they are the ones who understand the political shifts and the new demands as they revitalize the company.

Strategic change in the acquired company: A new understanding of strategy is an integral component of a successful turnaround process. Often times, the company will have to abandon existing strategic directions in favor of new ones. To overcome barriers to entry into new strategic areas often requires significant financial and organizational investments.

Capital infusion into the acquired company: Often times, even if the acquired company has “tightened its belt,” implemented strict budget oversight, slashed expenses in non-essential areas,  clarified financial responsibilities, and did all of this well, the acquiring company might still find itself needing to infuse significant funds in order to keep its purchase ‘above water’. The acquiring organization should account for such additional investment when calculating its own cost/benefit matrix.

Further difficulty in integration: It is well known that integration processes are difficult and have low success rates. Integrating an organization in need of a turnaround is even more complex. It requires attentive management and is very seldom successful. If the acquiring organization does not have the management bandwidth to invest in integration, it is better to avoid the deal since it is likely doomed to fail.

In conclusion

Acquiring a business in need of a turnaround is a gamble for a company that is inexperienced with corporate revitalization.

In cases of inexperience, it is best to only acquire companies who are in the very early stages of decline (stage 1), not ones that are already experiencing negative cash flow, have seen dramatic drop in market share in recent years, or are losing money and sales are in free fall.

Companies that are inexperienced with these kinds of processes should be aware of the “impossible” difficulties they will face if they make the wrong decision.

I would love to hear comments from others with some of their thoughts on acquiring an underperforming company. Comment and “Like” this post on LinkedIn by clicking here.

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