01. November 2008

Turnaround Case Study: SaarGummi - From Corporate Orphan to Outperformer

While the public awareness of private equity has increased considerably in the recent past, this heightened awareness mostly derives from multi-billion buyout deals with extensive press coverage. Even though only a limited number of such transactions take place each year, the equalization of those mega buyout deals with private equity has dominated public discussion. In contrast to the large and often highly leveraged transactions, special situations represent a niche segment of private equity with completely different dynamics.

Characteristics of Special Situations 

The special situations segment generally applies to transactions unsuitable for standard auction processes due to targets not fulfilling certain characteristics that are usually perceived necessary prerequisites for buyout transactions (e.g. stable cash flows, proven profitability track record, growth potential). In addition to restructurings, turnarounds and insolvencies this segment also includes corporate spin-offs. In the latter case, selected business units are often disposed because of low profitability or strategic portfolio reviews by their parent companies. These units (so-called "corporate orphans") have often suffered from insufficient management attention for years prior to the sale and, hence, show a depressed profitability and are often further burdened by excessive corporate overhead charges. Once transformed into standalone companies, profitability might be restored and further growth potential  realised, making them attractive buyout candidates. However, similar to turnaround situations, this type of situation is not readily available at the time of the sale but has to be built with considerable efforts on the buyer´s side. Therefore, only a comparatively small number of specialists focus on this difficult, management intensive niche market.

Restructurings and turnarounds represent another type of special situations. Businesses that have slipped into crisis due to a variety of reasons (e.g. excessive expansion, unexpected change in market environment, increased competition, collapse of key customers/suppliers) represent interesting investment targets for specialised private equity companies, as long as there is still a healthy core. To a lesser extent, this also applies to insolvencies, even though insolvency proceedings and over-indebtedness increase complexity while significantly decreasing flexibility of such transactions. Ideally, restructuring and turnaround needs are identified by management and former owners at an earlier stage, as soon as certain losses have been accrued or profitability has suffered. At this stage, a sale to a special situation investor who combines operational and strategic restructuring expertise with the possibility of providing fresh funds to the company should be considered as a viable option.

Value Levers in Special Situations

The success of ordinary buyout transactions often depends to a large extent on financial engineering and opportunistic timing with regard to market cycles. In contrast, the reconstitution of sustainable long-term profitability by means of top-line growth, cost savings, process optimization and portfolio measures is at the core of special situation investments. More specifically, these value levers can be classified along three categories: liquidity-related, profitability-related and revenue-related measures.

In the short term, liquidity-related measures implement a strict cash and debt management as well as the optimisation of working capital. This can be achieved by renegotiating payment terms with customers and suppliers and optimising inventory through custom-fit production and supply chain planning. In addition, factoring, leasing and the liquidation of non-operating assets are one-time opportunities to quickly alleviate liquidity constraints and free up funds for cash consuming operational and strategic restructuring measures. In the medium term, actions to restore profitability have to be initialised. Most obviously, all cost items should be examined with regard to their savings potential. While shifting procurement to low-cost countries can lower material expenses, outsourcing of administrative functions might lead to lower overhead costs. Similarly, the production footprint has to be benchmarked with industry standards and the shift towards low-cost sites ought to be considered. A thorough review of incentive structures can help to align employees´ and management´s interests with those of the investors. Finally, revenue-related measures should secure a positive long-term outlook for the business. The possibilities of phasing out unprofitable products or exiting regional markets should be evaluated and additional market niches with promising growth perspectives identified instead.

While listing these restructuring measures appears simple, the implementation can be a tedious and cumbersome undertaking, making it home turf for special situation investment advisors such as Orlando Management. In the following section, the case of SaarGummi, an investment of Special Situation Venture Partners advised by Orlando Management, will illustrate how profitability and revenue-related measures have been successfully realized in the context of a corporate spin-off with significant turnaround needs.

SaarGummi as a Typical "Corporate Orphan"

SaarGummi, founded in 1948, is a manufacturer of rubber products which was acquired in 2004 from the energy conglomerate RAG (now Evonik), who decided to focus on its core energy activities. While products for the automotive industry (especially car body sealing systems) constitute the core of SaarGummi´s activities, the company also acts as a specialty supplier for the shoe, construction and railroad industry. For example, all Birkenstock soles are produced at SaarGummi. Since 1998, the company had gone through a  phase of rapid international expansion with plant openings and acquisition in Brazil, Canada, the United States, Mexico and the Czech Republic. At roughly € 300m of consolidated revenues, the business had shown losses for several years in a row in the negative single-digit EBIT margin range. On closer examination, the sites in the Czech Republic and Spain turned out to be highly profitable with positive double-digit EBIT margins. In sharp contrast, the plants in the United States and Canada were heavily loss-making, especially due to underutilisation and high quality costs. The innovative strength had suffered, and both the absence of management attention as well as the high rate of unionisation and code-termination effectively prevented adjustment needs at that point in time. To sum up, in 2004 SaarGummi represented all but a typical buyout target.

Nevertheless, SaarGummi was evaluated as an attractive special situation investment opportunity due to the following characteristics: With state-of-the-art production facilities on a global scale (except for China), the company was very well invested compared to industry standards. As number four in the European market, the competitive position appeared sound and the order book was fairly diversified among large OEMs. It was envisaged that a new, dedicated management team with restructuring experience along with a package of measures would be able to transform SaarGummi into a highly profitable first-class automotive supplier.

Turnaround Focus I: Reviewing the Regional Footprint

The intensive restructuring process commenced by stopping the bleeding of the North American operations, which was accomplished by selling the Canadian and Mexican plants to a US competitor only seven months after the acquisition. Simultaneously, the relocation of labor intensive production from Germany to Eastern Europe was initiated. Furthermore, two add-on acquisitions were realised; a smaller one with two sites in Germany, and owned by a former SaarGummi manager who then became the COO of the entire group; and the sealing systems business unit from Continental AG. While the two acquired Continental plants in Slovakia and Spain strengthened SaarGummi´s low-cost presence, the acquired German plant had to be shut down. Without significant business interruption, the machinery and equipment of that German plant was relocated to the Czech and Slovakian plants. The Eastern European expansion was finalised by the consolidation of the two existing Slovakian plants onto a newly built greenfield site. Finally, a number of joint ventures in India, China, Korea and Russia were initiated in order to become more competitive in tenders for global platforms increasingly developed by large OEMs.

Turnaround Focus II: Unlocking Hidden Reserves

In the context of a group-wide quality system, the implementation of an unbureaucratic employee suggestion system with ad-hoc cash rewards and public acknowledgement through senior management accelerated the improvement of operational processes. Finally, the adoption of a 40-hour week without compensatory wage increases in Germany helped to regain international competitiveness. An important element of the restructuring process was the development of a trustworthy relationship to unions and employee representatives throughout the acquisition and transformation process.

Besides the optimization of existing processes, a number of innovations enabled SaarGummi to resist the price pressure from OEMs and further gain market share. For example, replacing steel with plastics in certain applications led to reduced raw material costs and weight, whereas newly developed pigmented sealings constituted a cost efficient substitute for the labor-intensive process of applying fabrics onto interior sealings in high-class models.

From Laggard to Leader

The outcome of the restructuring was impressive and a positive high single-digit EBIT margin was achieved by 2007, only three years after the acquisition. At the time of the sale, the order book was well built-up and diversified, indicating considerable further growth potential. As some of the competitors faced significant financial difficulties or even became insolvent, SaarGummi emerged as a reliable prime supplier of car body sealing systems for the automotive industry. The operational excellence was manifested by the "Global Excellence in Operations (GEO) Award" which was awarded to the German parent plant in 2007. Despite unfavorable market conditions with material prices seeing new record levels, SaarGummi´s market position and continous improvement and innovation initiatives safeguard sustainable profitable growth in the upcoming years.

As shown in the case of SaarGummi, concentrated ownership and strong governance exercised by private equity investors can be successfully applied to restructuring and turnaround situations. However, the special needs and high complexity of such transactions can hardly be adressed in standard auction processes, but must be worked out in detailed discussions. In contrast to restructuring advisors, special situation investors do not only provide management advice but are also able to contribute funds for restructuring measures and add-on acquisitions. Finally, as the example of SaarGummi illustrates, interests of special situation investors and target businesses are generally well aligned: the investment success of the former primarily depends on the sustainable operational success of the latter.