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The Slow Burn of Corporate Distress

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The major credit rating agencies have recently been on the receiving end of numerous rebukes for perceived slow response times in downgrading Enron's debt ratings as the company's fortunes unravelled within a matter of weeks. Some critics contend that the long-standing procedures and methodologies employed by the rating agencies are laggard, too reactive and inadequately responsive to sudden, perhaps dramatic, changes in corporate credit risk and liquidity. Fast-track financial meltdowns have indeed become less remote possibilities since the late '90s as myriad corporations have grown increasingly dependent on capricious sources of short-term credit or confront refinancing dilemmas on maturing high-yield debt. In some instances there have been aggressive accounting practices in the areas of revenue recognition and off-balance sheet financing. Meanwhile, commercial paper investors and other short-term lenders have become ultra-discriminating, having already demonstrated a willingness to abandon a suspect company virtually en masse if its credibility or viability is even obliquely impugned in investing circles. The "bank run" mentality is no longer the exclusive problem of banks. Responding to such criticism while still defending the validity of their traditional methods, rating agencies have responded to this newly recognized vulnerability to shocks with new gauges of liquidity risk for hundreds of companies, such as Moody's Liquidity Risk Assessments (LRAs) for major issuers of commercial paper.

As real as these new risks may be, the bold headlines and accompanying stories we read these days inadvertently leave the impression that financial distress in this new millennium materializes abruptly, then spreads like wildfire across a corporate landscape. Like some underground coal mine fires, financial distress can smolder unquenched for years. The full body of recent evidence we present herein suggests this is so—that financial distress is still far more likely to be a slow burn that the majority of singed companies are nonetheless unable to extinguish even when ample time to do so is seemingly available. Notwithstanding the soap opera-like drama surrounding the spectacular, massive wreckages of Enron and Global Crossing, financial distress remains very much an insidious, gradually erosive phenomenon. The general pathology of financial distress remains remarkably similar across most companies and industries irrespective of the unique facts and circumstances behind each one. Much like a surprise visit from a nosy neighbor, financial distress rarely forewarns of its arrival, seems relatively innocuous at first appearance and lingers far longer than expected.

Measuring and Monitoring Corporate Distress

We undertook to measure and monitor patterns in corporate distress across recent time through the use of Altman's Z-Score model, which for this purpose was used as a summary measure of distress rather than its traditional role as an outright indicator or predictor of firm bankruptcy. (It wasn't our intention to test or validate the predicative ability of the model. There is exhaustive research in that area. Rather, we used the output of the Z-Score model as a valid measurement of corporate distress from the outset.) Altman's renowned Z-Score model used a statistical classificatory technique known as multiple discriminant analysis (MDA) to identify specific financial variables that were able to discriminate or distinguish successfully between a large sample of bankrupt and non-bankrupt firms at a statistically significant level.

Altman's model utilized five financial ratios as input variables that were able to assign or classify correctly 72 percent of the 33 failed manufacturing firms in his original sample two years prior to their eventual bankruptcy. Overall, it correctly assigned 83 percent of the total sample of 66 companies. Building upon the similar academic endeavors of the mid-sixties, Altman's seminal 1968 model has since become the cornerstone of bankruptcy prediction models. His popular discriminant function is defined as follows:

Z = 1.2(X1)+1.4(X2)+3.3(X3)+0.6(X4) +1.0(X5)
Where X1 is working capital/total assets
X2 is retained earnings/total assets
X3 is EBIT/total assets
X4 is market value of equity/book value of total liabilities
X5 is sales/total assets

These ratios explicitly measure a firm's relative liquidity, longevity, operating profitability, leverage, solvency and productivity—virtually all aspects of corporate performance are accounted for by the function. The cut-off boundaries for Altman's Z-Score function are:

Bankrupt Group: Less than 1.81 (our distressed group)
Zone of Ignorance: 1.81 through 2.99 (our undetermined group)
Non-bankrupt Group: Greater than 2.99 (our non-distressed group)

Recent Patterns in Corporate Distress

We calculated Z-Scores in each year of the four-year period of 1997-2000 for large (annual sales in excess of $100 million) publicly traded American manufacturing companies (SIC Codes 2000-3999) in COMPUSTAT's database of currently active companies. More than 1,100 manufacturers from dozens of industries met these criteria. For each year, every company was classified into one of the three groups noted above (which we will herein refer to as distressed, undetermined or non-distressed, respectively) based on its annual Z-Score. The Z-Score classifications and tallies of all companies for each year, as presented in Chart 1a, coincide with the broader economic observation that the relative performance of U.S. manufacturing in the '90s peaked around mid-decade. The relative under-performance of U.S. manufacturing thereafter was primarily attributable to the accelerating growth of the overall U.S. economy (Chart 1b), particularly in 2000. To its credit, U.S. manufacturing GDP still increased at well above the rate of inflation through the end of the decade.

Migration Patterns

For deeper insight into distress patterns, the far more revealing story lies not in the annual classification of all individual Z-Scores (Chart 1a), but in tracking the performance over time of each of the three groups relative to 1997. The classification of all 1997 Z-Scores is indicated in Chart 2. We next proceeded to track the migration, if any, of each company within these three 1997 groups to a better or worse group in each of the next three years.

The Distressed Group

Of the 144 companies classified as distressed in 1997, at best only 25 percent were able to migrate to a better group (i.e., undetermined or non-distressed) in any of the ensuing three years. The vast majority were still classified as distressed three years later in 2000, as indicated in Chart 3. (Obviously, there could be no migration to a worse group since the distressed category is the worst possible classification.) Twenty-seven of these 144 distressed companies, or 18.8 percent, have filed for bankruptcy since the beginning of 2000.

The Undetermined Group

Within the 1997 undetermined group of 245 companies, we noted a far stronger likelihood that a company would migrate to a worse category (distressed) than to a better one (non-distressed). By 2000, a company that was classified as undetermined in 1997 was more than twice as likely to have migrated to the distressed group than to the non-distressed group (41 percent vs. 16 percent), but was most likely to have remained in the undetermined group (43 percent) (Chart 4). No better than 16 percent of 1997's undetermined companies were able to migrate to the non-distressed category in any year between 1998 and 2000. Twenty of the original 245 undetermined companies, or 8.2 percent, have filed for bankruptcy since the beginning of 2000.

The Non-distressed Group

Lastly, we noted that migration patterns for non-distressed companies were highly symmetrical with those of distressed companies; that is, they were far more likely to remain within their original grouping than to migrate (Chart 5). (Migration for non-distressed companies could only be to a worse group.) No less than two-thirds of non-distressed companies maintained their 1997 classification in each subsequent year. However, despite the similarity in pattern, non-distressed companies were slightly more likely to migrate to a worse group than distressed companies were likely to migrate to a better group. Nineteen of the original 727 non-distressed companies, or 2.6 percent, have filed for bankruptcy since the beginning of 2000.

What Does It All Mean to the Turnaround Advisor?

Perhaps the least startling pattern within these data was the inertia of the distressed and non-distressed groups over time—that is, their marked tendencies not to migrate from their respective 1997 classifications. Financial analysts, turnaround consultants and restructuring advisors of all stripes have no doubt observed the historical tendency of highly performing companies to continue to excel and of poorly performing companies to continue to languish. This phenomenon could be deemed analogous to a Darwinian process of natural selection, whereby a particular technology, geographic location or other such edge over competitors confers a distinct survival advantage on its possessor—until the next better "mutation" comes along. Generally, such favorable mutations accrue to those companies who seek them out (e.g., large R&D investments) and are ever less likely to accrue to companies who remain mired in the distressed group over time, as dwindling financial resources and managerial talents and energies are increasingly devoted to mere survival rather than innovation. Certain aspects of a distressed firm's operations may simply be immutable on a large scale.

For many perennially distressed firms, the insinuating turnaround advisor needs to recognize from the outset that senior executives almost surely appreciate the gravity of the situation confronting them and have probably implemented various turnaround initiatives along the way. They may firmly believe they have the situation under control. The deception here is that after prolonged periods of near-failure, management may now tacitly define success merely as the avoidance of bankruptcy or some other goal well short of mediocrity. Yes, bankruptcy may have been averted, but perhaps the unique legal remedies available through the bankruptcy option is the only means by which such distressed companies can avoid extinction and have the opportunity to engineer the requisite mutations to transform the firm into a long-term survivor. The turnaround advisor is the logical party to provide management with this larger perspective.

Far more surprising was the performance of companies in the undetermined group and their chronic inability to migrate up to the non-distressed group. This would imply that financial distress is a broad continuum rather than a specific point along the corporate life cycle. Once a firm crosses this undefined, imperceptible threshold from underperformance into distress, even at an early stage, it exhibits a far greater tendency to deteriorate further rather than rehabilitate. This could perhaps be explained by a culture of hubris and denial—the refusal or inability of senior management to recognize on a timely basis that a critical line has been crossed. Financial covenants within loan agreements or bond indentures deal very effectively with this dynamic, often forcing management to confront certain issues by mandate. Within our practice, we refer to these companies as business regeneration candidates. They present a real challenge to the prospecting turnaround advisor; early-stage intervention is potentially the surest route back to prosperity, but a hard sell to a prospective client who may not yet acknowledge the need for any profound change, especially change initiated by an outside consultant.

Problems cannot be solved until they are defined and understood. In politics and business, a sense of historical perspective is indispensable to this understanding. For the turnaround advisor, this means not only being cognizant of where a prospective or existing client is situated on the financial distress continuum, but how it got there, and how long it's been sitting there.



Journal Date: 
Wednesday, May 1, 2002

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