Governance Arbitrage: Case Study #2 : A Multi-Shareholder Private Company Case Study of Governance Model Transformation

Note: For confidentiality purposes, certain information is omitted from this paper

This is the second case study of the impact that a change to a Value Maximization Governance model can have on the performance and value of a company. The first case study was of a public company: The replacement of the entire board of Darden Restaurants by activist investment firm Starboard Value. In so doing, this was as close to a hostile takeover as is possible without actually acquiring the entire company. And, as the article revealed, the change in the board was significant as was the performance and shareholder value that followed. This second case study is of a multi-shareholder private company.

The Value Maximization Model has a crystal clear governing objective of optimizing capital allocation and maximizing company performance and longer-term shareholder value. It is a real “shareholder primacy” model unlike what the consensus believes public company boards to be. At the time of my involvement in this company in the case study, we did not talk about having a Value Maximization Model — that is a term I later created for my book. But our intent, like the “greedy,” “bad” capitalists that we were (and still are), was to make this company as valuable as possible if it could be saved.

Considerable business details regarding this company are included. In my view this is necessary to provide clarity as to the mindset, analytical focus, thought processes and actions that flow from a capitalist value maximization model of governance.

The Situation

Overview

The company was a privately held wholesale distributor that had resulted from the roll-up a several of its industry’s largest players, each operating a multi-state distribution platform serving different geographic areas. The largest of the individual companies that had been amalgamated into this company had a paternalistic culture which become the dominant culture of the combined entity.

By the end of the second year as a combined entity, EBITDA had declined by 62% and debt had doubled. As a result, estimated shareholder value had declined by ~90%. And not surprisingly, the comparison to industry key metrics complied annually by KPMG placed the company at the lowest level of performance. While there were many factors involved in the performance decline, ultimately the board of directors was accountable.

In the third year, on top of the aforementioned declining performance, the company received a near fatal blow. The vendor supplying its largest product by both revenue and profit made a decision to bypass distributors by going direct to the end users with its own sales force and logistics operations. The loss of this major product, on an annualized basis, put the company into a material negative EBITDA situation and on the verge of bankruptcy.

The following provides a more detailed summary of the situation at the outset of the turnaround:

Analysis

The Board

· Board has no clear governing objective(s)

· Only one outside board member with any governance and value creation track record

· All other board members were owners but lacked the business sophistication to maximize the company’s potential, especially in the context of the increased size and complexity of the combined entity

· No real strategy much less a value maximization plan with clearly targeted major initiatives

The Business

• No new blockbuster products released by major product supply companies in five years; assessment is that none are in the pipeline and should not be counted on for future growth
• Costs materially higher than industry best of class benchmarks; no systemic focus on cost reduction or efficiency improvement. Worst performance metrics in industry.
• Relationships with major vendors poor due to both weak performance with key lines and management’s lack of sophistication in relationship development and maintenance resulting in inability to increase volume and market share
• Too many SKU’s and dollars tied up in inventory of slow moving and lower margin products
• Current Asset management poor. Inventory turning only 4 times per year and Accounts Receivable focus on past due collections rather than targeting desired Current Level.
• Company has several non-core businesses with low gross margins and significant logistics and administrative costs
• Administrative function spread between operating units and corporate office resulting in lack of efficiency and higher costs
• New ERP system not fully operational and legacy systems unable to provide data needed to improve and manage the business
• Basic mode of functioning of incumbent management was day to day focused combined with a “paternalistic” type culture with no accountability or high performance standards and completely lacking speed and sense of urgency.
• EBITDA decline of 62%, increase in net debt and estimated equity value decline of 90%
• Shortly before the takeover, the vendor supplying its largest product by both revenue and profit made a decision to bypass distributors by going direct to the end users with its own sales force and logistics operations. The loss of this major product, on an annualized basis, put the company into a material negative EBITDA situation and on the verge of bankruptcy.

Takeover, Reorganization & Stabilization

The Board

• Takeover of company; Henry Wolfe becomes non-executive chairman
• New board developed, including one new member from a private equity firm. New board members all business savvy capitalists with various value creation track records.
• Board agrees that the primary governing objective is to maximize the value of the company during the holding period via optimization of capital allocation and maximization of operating performance.

Other Early Actions

• Board engages top tier turnaround consulting firm
• Lead consultant named interim President & CEO; current CEO, COO and CFO terminated
• Turnaround/stabilization plan developed
• New chairman, one new board member & interim CEO meet with Senior & Subordinated lenders to detail board and management reorg. and to present turnaround plan; work out deal to give bank equity warrants
• Permanent CEO search launched after early semi-stabilization; new permanent CEO named 10 months after turnaround consulting firm engaged. Although full value maximization plan has not been developed, broad strokes of major initiatives have enough clarity to define the experience and track record criteria for new CEO that aligns with company’s value creation requirements.

Value Maximization Plan Development & Execution

Agenda

• Maximize shareholder value through joint effort of board & management; exit end of year 5
• Board provides directives to, and engages with, management re development of 5 Year Value Maximization Plan
• Board & management work together to establish aggressive 5 Year Targets for Revenue, EBITDA, EBITDA Margin and Equity Value

Note: The “Agenda” provides a context for every action from value creation plan development through the completion of the sale of the business. It is clearly a value maximization agenda driven by the new board and new CEO.

Value Maximization Plan Strategies & Major Initiatives

Note: All initiatives carefully identified, developed and executed strictly with the intent to achieve the 5 Year Equity Target. Execution of these initiatives by management and subsequent modifications, changes and additions now become the primary focus of the board.

Initiative: Grow revenue organically through superior performance for vendors compared to competition

• Improve relationships with, and performance for, major line suppliers with the intent of expanding territories licensed to sell by same thereby increasing sales and market share.
• Divest non-core businesses

Initiative: Improve cost structure and efficiency through best of class standards

• Achieve or exceed “Best of Class” for key metrics for distributors in this industry segment (KPMG did an annual study comparable companies which included Best of Class metrics)
• Increase cash flow and velocity via improved performance in current asset management

Initiative: Develop a high performance culture to support new growth and performance objectives

• Shift culture from paternal (no accountability) to a pure meritocracy (full accountability)
• Fully engage, from the start, all key personnel in development of strategies and major initiatives (to include not just operations, sales & marketing & finance but also HR & IT)
• Eliminate “guaranteed” year-end bonus plan and replace with short and long term incentive based program for senior management and key sales personnel including equity buy-in requirements for same

Phase IV: Exit and Results For/Impact On Various “Stakeholders”

Shareholders

· Exceeded all operating and financial targets set at the outset

· Established new best of class metrics for companies in this industry

· EBITDA not only exceeded 5 year target but also achieved in a shorter time frame in addition to receiving a higher EV/EBITDA multiple than anticipated at the outset resulting in material value creation for shareholders.

Creditors

· All senior and subordinated debt retired at full value

Suppliers

· As described earlier in this paper, a major blow to the company was struck when the largest product supplier made a decision to go direct to the end user. As a part of the strategy developed to grow revenue and thus EBITDA, after a couple of years of this supplier’s direct operations, a proposal was made to this supplier to give our company an opportunity to function as a distributor again. The concept was that if we could generate more profit for the vendor than their direct operation, we would be again awarded a longer-term contract. Due to the extraordinarily talented CEO we had engaged and the also highly talented salesforce the company succeeded in generating more profit for the vendor than their direct operations. This was a huge win for the company but also a huge win for the supplier.

· Due to an increased focus on the procurement function, several non-product suppliers were replaced by those who were willing to offer lower prices and/or better quality. This approach was very helpful in taking unnecessary costs out of the business.

Employees

· Incumbent CEO, COO and CFO terminated.

· The bottom third of the sales force were terminated due to very low performance. Those sales people remaining were given larger territories.

· The corporate headquarters experienced a significant reduction in employees as it had a major over-staffing problem.

· Take careful note of this: Several years into the improvement of the business I received a letter from one of the company’s vice presidents. She had written on behalf of the management and employees to thank me and the rest of the board for engaging the current CEO several years before. In the letter she said in reference to the CEO “He is the toughest SOB that any of us have ever worked for. Yet, he is able to lead us to perform at levels we did not previously believe possible. The company is doing better than at any time in the past and we (all management and employees) are happier here than we have ever been.

Conclusion:

This was an extraordinary victory no matter how it is measured. The journey was from near bankruptcy to the best in the industry. The lion’s share of the credit goes to the CEO, senior management team and the sales force. Under horrific conditions, they were able to not only achieve the aggressive targets set but also exceed them. What an incredible team they proved to be.

The above said, none of this would have happened without the first mover: The shifting of the governing objectives to the optimization of capital allocation and the maximization of longer-term operating performance and shareholder value. This intent created the context for all that followed including the criteria for new board members, the functioning of the board, the process implemented for permanent CEO selection and the ongoing engagement on the part of the board to ensure full accountability. This was a definitive example of governance arbitrage.