Preserving Cash in a Distressed Business

The Problem

When a business is in distress, cash is the most important asset. Operating conditions are nothing like normal course, and during times like these there is a clear business case for bringing in a Chief Restructuring Officer. However, the tension is that bringing in a CRO requires pulling cash from the business at precisely the moment it can least afford it. It is worth asking whether there is an alternative model — one that keeps cash inside the business while also attracting the right experience to the situation.

An Alternative Model

The alternative is straightforward, but it requires a CRO with both conviction in the outcome and the risk appetite to co-invest their fees. Instead of a monthly retainer and success fee, the CRO accepts a reduced monthly retainer with equity participation in the transaction. The business retains its cash, and the CRO's financial outcome is tied directly to a transaction. The CRO operates inside the business, carries fiduciary responsibility for the financial restructuring, and is accountable for the outcome. The engagement is structured as an officer role.

This is not a novel concept. When a lender converts debt to equity, they are making the same trade: deferring certain cash recovery in exchange for participating in the upside of a recovered business. Jon Weber, who led operating partner groups at Elliott Investment Management, Goldman Sachs Special Situations Group, and Icahn Enterprises, has written on this directly.¹ Weber advocates that the CRO should share in all value creation from the start of their involvement with the business, including both debt reduction and the equity value created.

The Case Study — Hargrove & Lane

Consider a fictional example, drawn from the common pattern of a middle market specialty retailer that is overleveraged relative to what the business can support and slowly consuming its liquidity in a deteriorating operating environment. The numbers are hypothetical. The dynamics are not.

The problem is not the business. The problem is a cost structure anchored by a fixed lease portfolio and a license fee obligation that has become unsustainable as revenue has declined.

The work required to address a situation like this is specific to the circumstances. Every distressed business has a different mix of operational, financial, and stakeholder dynamics. What is required is a CRO who will assess those quickly, establish credibility with the licensor, the landlords, critical vendors, and the management team, and execute against a plan that fits that specific situation.

How Financial Restructuring Creates Equity Value

The CRO's job is to reduce the obligations suppressing equity value. The business does not need to grow. It needs to be freed from the weight sitting on top of it. The table below shows the result — the same business, before and after. Revenue is significantly lower. Equity value is dramatically higher.

Total obligations include lease liabilities, license fee obligations, and trade payables. Each is addressed through a separate negotiating workstream: landlords through a portfolio lease restructuring, the licensor through removal of the minimum fee floor, and vendors through structured payment arrangements in exchange for continued business. The alternative for each counterparty is a recovery of cents on the dollar in a forced liquidation. That alignment of interests is what makes the restructuring executable.

What to Look For

The Hargrove & Lane profile is not unusual. The pattern repeats across sectors. The key diagnostic question is always the same: is the problem the cost structure and fixed obligations, or is the problem the business? If the business model is sound and the current distress traces instead to a cost structure that is not realistic given current revenues, the financial restructuring thesis is intact.

Situations worth looking at tend to share most of the following characteristics:

• Enterprise value between $20M and $200M
• Fixed obligations, including leases, license fees, earn-outs, or debt, well above what the business can service at current revenue
• Equity value below 10% of enterprise value, or negative
• Cash on hand below $5M or less than 60 days of operating runway
• Gross margin compressing materially from historical levels
• Accounts payable stretched significantly beyond normal vendor terms
• Aged inventory or deferred obligations indicating active cash conservation
• Capital expenditure well below historical run rate
• Restructuring plan executable without the need for outside capital
• Counterparties with an economic incentive in the business surviving rather than liquidating
• A capable management team operating in a difficult structure rather than a broken business
• No fraud, no material litigation, no environmental exposure

Situations to avoid are businesses being disrupted at the unit level, cases with active fraud or material undisclosed litigation, and counterparties already in enforcement mode with no appetite to negotiate.

How These Situations Present

There are two common entry points.

The Board Room

Early signs that lead to a decision to restructure the business are often visible in board meetings. The business is missing financial targets or continuing to decline. The CEO is increasingly viewed as not the right fit for solving the immediate problems. A sponsor who has been patient is beginning to lose confidence — not in the business, but in the team's ability to navigate the situation. The PE investor who has a board seat faces a straightforward question: do I continue to back this management team, or do I bring in a CRO to get an objective read on the situation and lead the financial restructuring?

The decision is not always obvious. Management may be talented. The underlying business may be sound. But when a company is consuming cash faster than it is generating it and management cannot articulate a clear path forward, the cost of waiting is measured in weeks, not quarters.

The Lender

The situation can also present from the credit side. A covenant violation is often the trigger. The portfolio manager covering the loan is typically a generalist, responsible for the full spectrum from origination through exit. The loan often gets referred to an internal specialist or a special assets group, if the lender has one.

At that point the lender faces a set of decisions. They may require the borrower to add an independent board member, typically selected from a short list the lender provides. They may also determine that the business needs a CRO — someone with a clear mandate to assess the situation objectively, stabilize the cash position, and give the lender a real picture of what they are holding.

In either case the lender is rightfully cautious about adding more cost to a situation that is already stretched. This is precisely where the structure of the engagement matters.

A Final Thought

In many cases the traditional fixed-fee and hourly-fee models make sense. But there are circumstances where the cost of outside expertise compounds the very problem it is meant to solve. Any decision about how to structure outside help should start with a simpler question: what gives this business the best chance to survive and recover? The answer to that question should drive everything else.