Annals Of Venture Capital

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"Here," one turnaround practitioner frequently says, dropping a key on the desk of yet another major -- and undersecured -- creditor. "You can have the key, and my newly acquired and deeply troubled company is yours.

"Or," he then will continue, "we can sit down and work something out." In the brave new world of turnaround venture capitalism, they usually do.

The Lazarus Syndrome

In venture capital, as the saying goes, lemons ripen early -- and, we might add, rot fast. While it can take a while to see whether a good investment turns great, not so the bad fruit; venture firms usually know after just a few quarters if an enterprise has grown sour and should be abandoned. Indeed, it is an industry tenet that at least 15% of capital disbursed to portfolio companies is destined to be lost forever. As the saying also goes: that's risk biz.

But there's an additional 15% of the venture-capitalized crop that doesn't wither so definitively on the tree: three-year-old-or-so companies with several million dollars already in them whose sales have stalled far short of initial public offering eligibility. The VC community dutifully puts in another round of funding, but with these companies it turns out that promised products are still months away, or that markets have shrunk, or that technology has shifted in other directions, or that there are fiscal storms that nobody foresaw, but that require yet more money to weather. Now what? With ever more stunted fruit piling up as a result of the venture capital industry's five-year seeding frenzy, nongrowing and nearly dead businesses constitute a sizable dilemma today -- and (this being America) a sizable market for even riskier biz.

And thus: turnaround venture capitalism. Like bag ladies of free enterprise, an assortment of capital pools dedicated exclusively to picking through the business garden's shriveled fruit have rushed onto the scene. Gambling on turnarounds isn't a novel concept by any means, but never before has it been so focused. And until now, turnaround investment was mainly passive, putting up the bridge financing and leaving it to existing management to pull itself together and execute the recovery. Today's pools are not so beneficent. To protect their fund's commitment -- often leveraged into yet higher degrees of peril -- hard-nosed general partners (or their hired guns) are now likely to move in bodily, sweep out old management and even old founders, and run the business themselves.

For better or worse, the new funds will have ample opportunity to practice such ruthless weeding. "Ten years ago, there were very few turnaround situations," observes E. Locke Walsh, who founded a crisis- and turnaround-management firm in 1977 to fix whatever few there were. "Now, with $10 billion [of venture capital] put out in the past three years, you've got a whole platter."

And, Walsh adds, there will only be more. "Venture firms aren't structured to deal with their own failures. They'd rather place $10 million in new capital than spend a year fixing an old $2-million investment," he says. And besides, "look past that to future fallout from current LBOs, and you see there'll be a whole other market." Given such abundant pickings, turnaround partnerships are popping up not only in such major money centers as Boston and New York City, but in major laid-back centers like Phoenix, where, for one, Sunbelt Holdings Inc. recently cashed in real estate to start a $40-million turnaround fund. And such hefty players as Chicago's Allstate Venture Capital, a $260-million division of Allstate Insurance Co. devoted mostly to conventional start-ups, are beginning to stir through the lemon orchards as well.

These hapless enterprises are not rescued out of mere charity, of course. For accepting supreme risk -- the possibility of losing everything within a couple of months, not just failing to achieve a decent five-year yield -- turnaround pools aim for rewards that, as one fund manager describes them, "dwarf" those of traditional venture investing. In conventional start-ups, a venture capital firm expects to own perhaps 80% of a portfolio company. But that's peanuts compared with what clever financiers can extract from some turnaround situations: 100% of available equity. Not to be piggish about it, says Dan Morris, president of Glenview, Ill.-based Morris-Anderson & Associates, but "to take any less would make it impossible to get your return."

Here's how one high-return tactic works. The turnaround fund approaches the owner of a business that has, say, $10 million in assets, against as much or more in liabilities. "Look," the owner is advised, "you have no net worth and your business has no market value. But we'll give you $200,000 for it. And we'll write you an earn-out formula, because we want you to stay and help us for a while." Naturally, the owner goes along with so irresistible a proposal. The fund then offers the business's creditors $5 million in cash for the $10 million in payables and debt on the books, explaining that 50? on the dollar is better than they would receive if the company were liquidated.

However, the $5 million in cash the creditors get doesn't come from the fund's pockets; it is supported mostly by the assets used as collateral. The fund puts up $1 million of its own, then goes to a lender for the remaining $4 million, pledging the now-unencumbered assets as collateral. Thus for $1.2 million or so, the fund owns the entire business, and has just acquired twice as much in assets as in a conventional deal. "That's how you generate the returns -- good buying on the front end," Morris teaches.

Coaxing major creditors into going along with deals like this is the hard part, claims Walsh, whose godfatherish flourish of dropping a key on the desk of the worried loan maker is, he finds, particularly effective. "You can have the company's key and the business is yours," Walsh reminds the undersecured lender. "Or we can sit down and work something out." Once, an officer of a major bank sat eyeball-to-eyeball with him for seven minutes and 38 seconds -- a record -- before reluctantly voicing agreement. "When you talk to banks, you have to be tough," Walsh says. Also persuasive. To win over creditors, he submits cash-flow pro formas suggesting how they might get paid in the future. Often the chanciness of the deal is made painfully apparent by Walsh's sweetening it with warrants for high-priced stock that don't expire until the year 2020.

However hard-nosed turnaround practitioners must be, their deals often have the trappings of charity, particularly if they take place in public. In two investments of a recently organized $25-million pool managed by Reprise Capital Corp., in Garden City, N.Y., 5,000 jobs were retained. Unfortunately, the two companies' apparently inept managers didn't get to retain theirs -- but then they're the ones who engineered the debacle. Reprise replaced the officers of Mangood Corp. and PCA International Inc. (both publicly listed) with Reprise's own set of hand-picked executives. "If you don't change the culture within a company that is in serious difficulty, you're not going to turn it around," preaches Reprise chairman Stanley Tulchin, who, after a 33-year stint as a collection agency operator, decided to go for a more direct piece of the cut-rate action. Last September Reprise invested $4 million in Mangood -- a $70-million-a-year weighing-instrument systems manufacturer -- after it had lost money three straight years. For the first quarter of '87, the Company eked out earnings of a nickel a share. "We worked very hard. There aren't many people who know how to tidy up a mess," concedes Tulchin, whose willingness to part with new capital obviously helps. When Reprise restructures the company, it puts in sufficient investment to create a positive net worth. When payables are settled, cash flow turns positive -- and the immediate survival of the company is ensured.

In return for its generosity, Reprise wound up owning 55% of Mangood. Into $150-million PCA, a national portrait photographer whose misguided marketing was resulting in losses exceeding $1 million a month, Reprise poured $5 million last January, cropping out old management and taking a 47% interest through proxy offerings to stockholders that met with virtually total acceptance. Reprise expects to enter four such deals a year, not all of them public. To get its money back when an enterprise is private, Reprise will likely bring the revivified company public or arrange a management LBO. "There are plenty of ways to exit an investment," Tulchin figures, "but first you have to make it a good investment."

Predictably, each of the turnaround funds has its own special interests and style. Walsh, for example, is president of Locke Venture Management Inc., the general partner of a new Lake Forest, Ill., fund that targets smallish emerging companies, usually under $20 million in annual sales. The typical capital requirement is about $2 million. A crisis-management team takes over, paying itself salaries commensurate with those of the positions they fill during the day-to-day turnaround stint. The effort runs about six quarters, after which, if all goes well, the recapitalized business -- its original investors severely diluted -- is fixed and growing again. The crisis team then replaces itself.

"What makes you good at a turnaround," says Walsh, "makes you fatal as a chief executive of a stable company. They're mutually exclusive capabilities. People think turnarounds are simple: you go in there and close all field offices. That's the simple part. It's the restart that is the value-added, and why turnaround people have to be entrepreneurs. You have to come up with a new strategic plan, you need innovative tactical solutions, and you have to lead, not talk. Decisions have to be made fast.

"You have to know how to do the surgery," he says, "without killing the patient."

Last updated: Sep 1, 1987




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