Dr. Tamir Agmon is the Associate Dean for Research and Development at the School of Management and Economics, Academic College Tel Aviv Yaffo in Israel. He is also a Professor of Financial Economics at the School of Business, Economics and Law at Gothenburg University in Sweden.
The economic ocean is comprised of a large number of small drops of water: a micro approach to the crisis
The efforts of the Treasury and the Federal Reserve Board to deal with the current financial and economic crisis are focused on the “large picture”. Hundreds of billions of dollars are given to major financial institutions and to major manufacturers. This is clearly necessary and important. Yet, thousands of firms find themselves in financial and economic distress as a result of the crisis and as a result of their business policy in the boom period preceding the crisis. Firms that based their business policy on the assumption that American and other consumers will continue to buy more every year and financed this policy by borrowing ever increasing sums of money find themselves today in financial distress. Many of these firms have good business foundations. They have the capabilities to design, produce and sell good products and useful services. They do have problems today in selling a particular product or a service to a particular industry, and they do have problems servicing the accumulated debt from the boom period. If they fail and disappear the cost to their employees, their suppliers, and to society as a whole is high. These small and medium size firms, often unknown to the public and below the radar of the media contribute substantially to the general welfare. It is impossible to address the needs and the potential of these firms at the macro, federal level. Fortunately, there is a private sector solution motivated by interests of investors, managers, employees and other stakeholders of the corporation. The solution is turnaround private equity investment by specialized companies and funds. Turnaround private equity is motivated by profit like any other investment activities. It is based on reframing the activities (assets) of a distressed firm, rearranging the liabilities to fit the new direction of the firm and manage the process of the turnaround. If successful, the private equity investors make an exit and leave the firm to continue and grow with other owners.
Turnaround private equity investment is based on the most basic principle in economics, the principle of factor intensity and comparative advantage, (known by economists as the Heckscher-Olin model). Simply put, the basic idea is that what counts is the combination of the factors of production and not the product or the service that is produced by using them. For example, if a manufacturer of cast aluminum auto parts finds out that its client disappeared and that the company loses money and it cannot service the debt in the balance sheet, the right response is to look for a place where the production capacities of high quality precise products of cast aluminum and the management capabilities to deal with a large multinational company as a client can be redeployed. Once a solution for this issue is found the next item on the agenda is to renegotiate the debt and raise new equity if necessary. Such a change requires new approach, change management capabilities and rearrangement of the liabilities of the companies to creditors and employees as well as an investment of new equity. These capabilities is what turnaround private equity professionals bring to the table. In terms of basic economics turnaround private equity investors and professionals are looking beyond the current failed activities of distressed firms and ask the question how can they combine the assets in place (factors of production) of the target firm for the private equity investment with the ideas, capabilities, and the money of the private equity investors to rebuild the failed firm and generate new value?
Assets vs. liabilities private equity and the crisis
Private equity is perceived as one of the contributing factors to the current financial crisis and the growing depression in the economy. Yet, in this memo private equity is presented as a way to resolve the crisis. The apparent contradiction is due to the fact that there are two types of private equity investment; private equity investment that reflects excess liquidity and private equity that reflects an idea to change a company for the better coupled with the capability to implement the change. Using the accounting paradigm it can be said that private equity of the first type is based on the liabilities side of the firms and that turnaround private equity is based on the assets. Turnaround investment begins with the question how to improve the assets of the firm? Hedge funds and mega buyout funds often begin by looking for “cheap money” as their leverage factor. Excess liquidity private equity funds were a contributing factor to the crisis, turnaround private equity companies and funds help to resolve the crisis.
Turnaround private equity as a change agent
Change and capability to manage and implement the change are the two necessary conditions for a successful turnaround private equity investment. Unlike portfolio managers and hedge fund managers whose main concern is to select the best assets for their portfolios or hedge funds, managers of turnaround private equity are seeking assets that they can change for the better. This is a difference between passive and active investment. A passive investor makes money by selecting the most appropriate assets for the portfolio, an active investor creates value by selecting assets that he (or she) can change and improve. In time of crisis like the current situation there is a great need for a change. People who manage turnaround and buy and build private equity investments are by definition and by experience effective managers of change and their organizations are change agents.
Opportunities and needs in time of crisis
It is a banal but true statement that crisis creates opportunities. In the case of the current crisis there is congruence between the opportunities to generate value and the real need to change the practice and the spirit of the economy. With all the importance of major macro policy changes, changes in the structure of the compensation packages of senior executives in financial institutions and major global firms and other system-wide changes, there is a real need for grass root changes at the level of small and medium size firms. Turnaround private equity is an appropriate agent for such changes. There is a need for redirection in the production, marketing, and the way that firms do their business to fit the business policy and practice to the new post-crisis world. Many of the processes of redirection are similar across different firms and therefore turnaround private equity professionals and investors have a competitive advantage in identifying the opportunities and manage them in a way that generate value for all parties involved.
Exit is good news for those who stay with the firm
Private equity investors and professionals think about exit. A successful turnaround private equity investment can be described as follows:
- An opportunity for a turnaround is identified. At this stage the value of the company is very low relative to the potential.
- A business plan is prepared and the target company or a pert thereof is acquired by the private equity investors.
- A change plan is implemented and if successful the value of the company goes up. Production, sales, cash flows and other aspects of the business are operating in a satisfactory way.
- The private equity investors realize some of the generated value by selling their parts to other shareholders who continue to operate the company.
Exit is a sign that the company is now stable at a higher value than before. In many cases a failed company becomes viable. Once the turnaround is completed it is the interest of the private equity investors and the other stakeholders of the company that the private equity investors will sell their holding to normal long term investors.
Professor Tamir Agmon, a world-known expert on private equity finance, is Managing Partner of PEG (Private Equity Group) in Israel and a Professor of Financial Economics in Israel and in Sweden.