Monday, May 18, 2009

Marchionne Madness? Can Fiat Really Help Chrysler?

When someone asked Sergio Marchionne what he would do if someone asked him to start a car company from scratch, he replied, "Lie down until the feeling passes." Anyone counting on him to do for Chrysler what he did at Fiat has to be hoping he won't be tempted to lie down soon.

Marchionne is the man behind the nearly miraculous turnaround at Fiat. Before he took over in 2004, Fiat's car company had been losing money at a bankruptcy-inducing rate. In less than two years it was profitable and growing.

The Turnaround at Fiat
How did he do it? He overhauled management, replacing twenty senior managers with energetic talent from the company's middle ranks. He tackled the sales problems at Fiat by revamping one faltering product line, the Fiat Bravo, and introducing a new one, the Fiat 500.

He cut costs, not by closing plants or laying off workers, but by making key processes more efficient. For example, he cut the time to market on the Fiat Bravo from 36 months to 18 months.

He raised €1.5 billion by getting General Motors buy itself out of a joint venture with Fiat. He reduced capital spending needs through joint ventures, like sharing an assembly plant in Poland with Ford. He also worked tirelessly to convince Fiat's managers, workers, and lenders to back his plan.

Successful Turnarounds
Anxious lenders and bondholders are wondering if he can do the same at Chrysler. But with problem credits on the rise and more companies facing turnarounds, the broader question is, what can we learn from all this? What are the hallmarks of a successful turnaround plan?

A good turnaround works in three dimensions: operations, finance, and management.

  • Operations
    The focus in operations is on sales, operating costs, and working capital. The goal is to improve cash flow not just in the short-term but for the long-run as well. New products and better processes were key to Fiat's success.
  • Finance
    Here the focus is on liquidity and financial flexibility. The goal is to increase readily available reserves and extend debt maturities -- boost sources of liquidity now and reduce uses in the future. The GM buyback and the Ford joint venture were ways for Fiat to raise capital and enhance liquidity at the same time.
  • Management
    Management's strategy, ability, and credibility are crucial. Top leaders have to come up with a strategy that addresses the problem(s) and balances operating and financial needs as well as short-term and long-term needs. They have to be able to execute, to make the strategy happen. And they have to convince junior managers, workers, suppliers, lenders, and customers that the plan will work. Marchionne's new management team saw Fiat's problems clearly and worked hard to achieve their new goals. Marchionne constantly promoted his plans to workers, creditors, and shareholders, earning vital support during the crucial transition period in 2004 and 2005.

Friday, May 8, 2009

Michael Foods Term Loans Avoid Effective Subordination

When Thomas H. Lee Partners purchased Michael Foods in 2003, it financed the deal with a combination of term loans and bonds.  All parties agreed that if there was ever a problem, the term loans would be repaid before the bonds.  In exchange for agreeing to take this higher risk, the bondholders receive a higher return than the term loans.

Contractual Subordination
To ensure the term loans are repaid first, the bond documents include a subordination agreement.  This contract between the bondholders and the borrower says that if the company ever defaults on its debt, it must repay the loans in full before it pays anything to the bondholders.  This arrangement is referred to as contractual subordination: the bonds are called subordinated and the loans are called senior (see also our discussion of structural subordination).  Contractual subordination can also be accomplished via a contract between lenders called an intercreditor agreement.

What's the Problem?
The loans had an original maturity of 6 and 7 years, so they are due in 2009 and 2010.  The company is now looking to refinance these loans with new loans with maturities in 2014 and beyond.  These new loans will still be contractually senior to the original bonds, which don't mature until 2013.  The problem is that the new (senior) loans mature after the (subordinated) bonds.  If all goes as planned, the bonds will now be paid before the loans, defeating the purpose of the subordination agreement.  This situation, where subordinated debt is repaid before senior debt because it matures first,  is referred to as effective subordination (a banker friend of ours calls this "first in time is first in line").

What's the Solution?
Michael Foods will need to refinance the original bonds before they mature in 2013.  The new term loans include an "acceleration feature" that will bring the maturity date of the loans forward if the company can't refinance the bonds.  Thus, the loans will always come due before the bonds, avoiding effective subordination.