How to Spot a Business in Trouble (Before It’s Too Late) with Steve Swayne

In this episode of The Value Agenda, Oliver Colling sits down with Kingsgate Chairman Steve Swayne to unpack how distress really develops inside organisations  and what experienced operators look for long before insolvency is on the table. Drawing on decades of work across private equity, healthcare, manufacturing and retail, Steve focuses on the practical realities of stabilising a business when pressure is building and time is short.

Highlights

• How turnaround professionals think about the early stages of distress
• Why free cash flow, debt structure and covenants matter more than headline profit
• The three fault lines: people, process and risk inside a stressed organisation
• What it means to change the drumbeat from monthly reporting to daily control
• Why talking to lenders, customers and frontline staff reveals more than internal reports
• How “odd behaviour” and displacement activity show a business is close to the edge
• What leaders can do now to create runway and protect value

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Transcript

SPEAKER_01 0:01

Welcome to the value agenda. When a business is in distress, everything feels urgent. But what's the one thing that really matters? Being able to identify and prioritize where the value lies quickly becomes the most important thing of all. I'm Oliver Colling, and my career has been built around helping businesses do just that. In each episode of the Value Agenda, we'll be interviewing experts who have a rare ability to look at a complex organisation and identify where real value is hidden. This is the value agenda. Let's get into it. I'm joined by Steve Swain, our chair. Hello, Steve. Hello. Nice to see you again. And today we're going to look a little bit more at what circumstances might prompt a turnaround project and how you actually start to spot those.

SPEAKER_00 0:57

That's an area which is very well researched. There's lots and lots of evidence on this. And the signs can be divided essentially quantitatively and qualitatively. So let's talk about the numbers. So there's a number of scores that credit rating raters use to look at the potential future financial viability of a company. And they are things like Z scores, there are things around cash flow, there are things like free cash flow to and their debt levels, and there are a number of ratios which I won't bore the listeners with, but they are very well known. And of course, there's the credit raters themselves who have become increasingly sophisticated over the years and rate the effectively the ability of a given company to repay its debts. In terms of internally, the company should be measuring a number of things. Most companies will spend a lot of time focusing on eBIT or PBT, and EBIT misses some items or might not give the full story, and PBT tends to give more. But what company can't get away from is free cash flow. So essentially the acid test of a business, is it giving off free cash? And is that going up or down? And how large is its relative debt to that free cash flow? And that's essentially how you measure a company's financial viability. Now there are a number of other reasons why a company could go bust, which won't necessarily be publicly available. So one of the key ones is there an over-concentration of one particular customer, or is there an overconcentration in one particular project? So if that particular project doesn't work, or if that particular customer goes bust or decides not to deal with you anymore, that obviously has very severe consequences. So within the company that will be known, but externally that's obviously quite hard to get. But that is measurable. So you can look at the concentration of the customer base or the concentration of the projects, or indeed the RD spend and what where that's spent. The other thing that within the company is the nature of their debt. So if the debt is short term and can be called in at will, obviously that's a much more precarious situation than if it's a revolving facility and there's long-term debt. So it depends on how the debt is structured, because obviously if it's structured with a more long-term frame in mind, then that gives time to do things. And then of course there's a number of other things, which can't really be measured by numbers, but is a matter of contract. What is the contract around that debt? What are the covenants with the lenders and when do they what what are the metrics used? When do they kick in? So that's another whole range of things. So if I was inside a company, as opposed to looking at externally, those are the sort of things I would look at. I would look at the debt, look at the debt structure, covenant structure, I would look at the RD spend, I would look at the customer base concentration, I would look at the bad debt profile of that customer base, because bad debts from customers are often a thing that can cause problems.

SPEAKER_01 4:44

In my experience, I've come across an awful lot of businesses, some of whom are quite sizable, who, in spite of all those things you're talking about, which are absolutely the vital pieces of data that tell you how your business is performing, either don't do it very well or don't do it at all. Why do you think that is?

SPEAKER_00 5:01

You're now moving into the qualitative. So I'm so just in terms of the pure numbers, those are the sort of numbers I would look at, depending whether I was inside or outside of the company. When we look at the qualitative issues, so we really this free area is people, process and risk. So let's talk about process. So process by meaning is the governance. So is there governance? So do the board look at the right things and RB they being fed correct information? And under that little category, there's been lots of problems, as you and I well know, within business. So do the board review the financial information properly and methodically, and is that information being given correctly and in a timely manner to the board? And that's a whole subject within itself. The second area is risk. So we've talked about a couple of risks. So the big project risk or the big customer going bust or leaving risk. But there's lots of other risks. There might be legal risks, there might be environmental risks, there might be all sorts of happenings within the external environment, and are they being monitored? And risks should be part of a risk register, and that should be reviewed by the board. And what the board is really interested in is those risks that have a high likelihood to happen and have a high impact. So most risks sort of is the likelihood of it happening high or low, and is the impact high or low? And obviously the particular ones you want to focus, you've got to focus on all of them, but the ones with the higher impact and the high likelihood. And those can cover the whole gamut of issues. From legal, from employment issues to supply chain issues. So that's one that's been in the press of late. Suddenly a retailer finds that it's that it hasn't had good governance supply chain, and part of its supply chain is being delivered by effectively slave labour or or one of its suppliers is dealing in practices with a rogue country, a rogue state. There's all those sorts of things can trip up clients. So the risk that whole risk area is another really important area. And then the third area is people. So starting right at the top, does the board function as a board? Is it actually doing its job? Does the chair manage the board? Does the CEO report correctly to the chair? Do the NEDs actually hold the CEO and its team to account? Is it looking at the strategy? Is it understanding the risks? Is it on top of the finances? All those sort of questions around a board level. And then we go down below the board, the first question, is there a succession plan if the CEO fails? So we do we know who that individual could or should be. And then we look at the executive team. Same question as the board. Is the executive team I'm obviously talking about a larger organisation here, but is the executive team working as it should? Is it a team? Is it debating things? Does it cover all the areas? Is it covering all the risks? Is it communicating appropriately upwards? And is it communicating appropriately downwards? So then we talk, for want of a better word, all the workforce are below the the executive team. Are there any issues there? How is a whole range of things? How is sickness absence measured? Is performance measured appropriately? All the sort of HR metrics, is it a healthy, well-trained, motivated workforce that's bought into what the the culture and the direction and the strategy that's been set by the board and the executive team, yes or no? And if not, what can we do to fix it? So those are all the people issues. A lot of people issues are around non-performance. So a lot of organisations don't deal with performance particularly well, and so that often is a is an area. And then going on to the sort of and I don't know what category that I want to put this, so I'm just going to call it odd behaviour. So there's a category called odd behaviour. So in distress situations, I've seen odd behaviours. One of them is focusing on the wrong thing, which is really a governance issue. But it's but it's odd. The classic example, I had an example of a distressed organization, and I read the the board minutes, and probably about given that they were several weeks from going bust, they'd spent half the board meeting talking about the Christmas party. Odd behaviour. So that uh that's displacement activity, that's people in denial effectively. Odd behaviour, and this is more to do with fraud, which we've been involved with a few times, been asked to look at situations, are there movement of assets or cars or or third party transactions th that are not right? Again, that's in that odd behaviour bucket that need to be looked at. And then I think there's uh in the odd behaviour, are there cultural aspects of the organisation which are negatively impacting the performance? In that uh and this is mainly to the family firms, is there a member of the family that is in the executive leadership that just shouldn't be there and is just not being dealt with and it's causing lots of problems, lots of resentment within the organisation, and it's just an added problem to the financial difficulties they've got. And then I suppose if you look outside the organisation on the people side, is there trust between the organisation and its clients, its key clients? Do they trust each other? Do they actually know each other? That's an interesting question. So do they actually understand the individuals that are in decision-making positions within the clients and is there trust to regular communication? And it would be always surprised me that the answer to that is no. In many distressed organizations, that obviously needs to be rapidly fixed. And then there's a number of other stakeholders. So one of them is the lenders. Is there regular and transparent and communication with the bank? Often that's not the case. Often that it's a surprise to the bank that there is a situation which they should have been told about. Is that all clear? And then a lot of organisations work in a regulated environment. So I got involved in a large care home a couple of years ago where the relationship, the communication with the regulator, which is a CQC, had been really poor, and there was a lack of trust, and the they failed an inspection regime, and that could have been avoided, and that then led to financial problems. So some of this is about trust and communication between the management team and the staff and the and the regulator. And just going back on the trust side. So another common one is what the board and the executive team think is happening in the organisation is not, or something else is. But if there's a complete disconnect between the board and what's actually happening within the organization, that's usually a recipe for trouble.

SPEAKER_01 13:44

That's really interesting, Steve, because that picking up on a few of the points you made, I was interested in family-owned businesses.

SPEAKER_00 13:51

Yeah.

SPEAKER_01 13:51

I remember coming across a family-owned business a few years ago, which was, I think it was fourth generation, had been very successful. But as the generations have gone on, more and more of the family basically stayed on the payroll. Yeah. Yeah. And they got to the point where actually the biggest financial drag on the business was the fact that there were X number of relatives who were on the payroll who didn't contribute anything to the business. And so actually getting them, and they're also shareholders, getting them to accept that actually the party's over, if you want the business to continue, you're not going to be paid for doing nothing. Yes. Was quite a hard discussion. Yeah, of course. So that's quite an interesting point. And I think it's it touches on that communication. Yeah. Do the board and the executives actually have a good view of what's going on in the organization? Because if you are driven by different measures, so for example, the family, the most important thing is to keep the business going no matter what. Whereas your executives may not have the same kind of view. That's a big difference. Again, coming down to that governance. And I think the third point I pick up on is that you mentioned about banks. It never ceases to amaze me how many businesses have such poor relationships with the banks. I mean, I've always tried to make it as not quite a mantra, but and not to be best friends with your bank, because you don't want to be talking to the bank every day, but have that trust, have that relationship, particularly when times are good. Because if you're a good customer, then when the things turn a different way, much better to have that kind of conversation with that trust in place rather than turning them and say, Oh, we've got a problem, looks like we're going to breach our covenants next week because you're not going to get much of a hearing at all.

SPEAKER_00 15:26

No, and forewarned is full-on. A lot of it is about where does the company end. So if you see the company as an ecosystem which includes its suppliers, its lenders, its clients, so every communication, you should think about all those stakeholder groups. And so that it's communicated because they're all part of the same ecos. They're part of the same company. The company doesn't exist if the bank doesn't lend it any money. The company doesn't exist if the customers stop buying the products and paying their bills on time. So it's this view that the company begins and ends at the factory wall, which of course it doesn't. It's an ecosystem which has a number of stakeholders and it's getting people to understand that and making sure that the communication follows that. Obviously, you will communicate slightly differently to a bank, perhaps to a customer, obviously, but the main points need to be in both communications and it needs to be clear and transparent. So going back to the subject, so there's a number of behaviours, a number people, number process issues, and then there's a number of number issues, which some of which can be seen externally to the company, and some of them can be seen internally into the company. I guess from a owner's point of view, and I'm now talking about private equity, about a GP effectively, is they will have access to the internal numbers and they will know often before the management team that there's an impending issue, and they will very clearly, I'm sure, communicate that to the management team. The issue they often have is that other side of things around the governance, around the people issue, because they're quite you've got to spend lots and lots of time in the organisation to understand that. And it's not something you can get from a spreadsheet. It's not something you can even get from a board meeting, because people practice board meetings in front before they meet with those are you really getting the true story? And that's where we come in. So we can get to the truth or s or see the wood from the trees or whatever little metaphor that you wish, but it's about getting to the nut of the issue, or it'll be multifactorial because it always is, and it's the real story, which unfortunately fortunately, because we're dealing with people, you can't see always from the P ⁇ L, the balance sheet, and the cash flow, and monthly reports. And I think also it always amazes me what you can find by just talking to a few of the big customers. And also talking the proverbial talking to the receptionists, we all know that one. Talking to people that touch the customers on a regular basis, their perception of the problems are often very accurate, and so it's that sort of thing that needs to be done. But the key point I want to make is it's relatively not easy. The way of understanding that there's a potential stress coming forwards is a well-trodden path. But the the issue is getting the management to act on it. Because often when we've if I had a pound for every time somebody said to me, I wish you'd we'd spoken to you earlier, I wish you'd appeared earlier, I'd be a rich man. It's this sitting on the information, they know what's the problem, or or a lot of the problems, and then sitting on it and then not acting. And then the owner finds out they haven't acted, fires the CEO, puts in the new CEO, so that's another six months or nine months, and the problems then in a year's time the problems uh got actually got worse than the times I've seen that story as well. So because they don't get to the bottom of it and they need to get to the bottom of the issues, and perhaps don't clearly understand the issues. So that that is the trick, is early intervention as soon as possible, and good quality and I would say this, but it's true, external intervention can lead to a lot less heartache and more expense later down the road, and even worse, a failure within a portfolio.

SPEAKER_01 20:06

I absolutely agree with that, Steve. And I think it is the role of the chair is very important here. And I was working with a private equity about business a couple of years ago where the independent chair who was acting on behalf of the investors basically removed the CFO and put me in there without any reference to the chief executive of the management team, which was a tricky situation for me, I should say, but ultimately worked in into a successful turnaround. But I think there the action was taken at the right time. How do you make sure that the chair you have in place, and I'm thinking particularly where you've got, say, a minority private equity interest or a majority with other shareholders, how do you make sure that chair is powerful enough and strong enough to recognise the right time to act?

SPEAKER_00 20:53

Well Yes. You're dealing with different individuals. So the chair's role in difficult times is more important than ever. And that might mean that you need to replace the chair. So it depends what the chair's agenda is, and it depends why so the chair may indeed be a shareholder, the chair may be indeed a relative, the chair may indeed been there for too long, all those sort of things. But the chair won't want, generally speaking, won't want to see the business fail. So again, it's about uh clear and concise conversation, which will be very uncomfortable for the chair going through that, and that's often best done by somebody external, and we've often had those conversations. And if the chair then refuses to act, then the action, the course of action is clear. But also it's a knowing who else is on the board. Are there other NEDs, are there NES that could step up to be the chair? We as Kingsgate have stepped into those chair roles ourselves on an interim basis when there has been no alternative. But there are options. But my preferred path is having a frank and honest with the chair, giving them a week or two to act, and then if they don't act, then taking other actions because you don't have much time. No. Every few weeks that you've missed, you're nearer to the cliff edge. So you've got to act with speed. But I think it's important that you're seen to have acted fairly and have a straight so when you know if a new chair goes in, you can say to the rest of the board, okay, this was the situation. We had a conversation with John, and we said this is clearly what needs to happen, and he agreed to do it. He didn't do it for reason X, Y, and Z, so our hands would we've acted. That's a much better conversation than silence or just removing somebody with no explanation, which I've also seen. So I think it's people buy into narratives and stories. So you've got to and it's got it has to be true as well, of course, but you've got to have a story that you've gone through without being overly bureaucratic, a process which is firm but fair with the chair, just like you would with the CEO.

SPEAKER_01 23:25

Again, very interesting analysis there. But let's just think we have a let's look on the positive side. We have a chair who sees the issues, understands there's a need for some kind of external assistance, picks up the phone, calls us. What happens then?

SPEAKER_00 23:41

We meet with them, and multiple things happen. Depends on how long we think we've got. But there's a review of the financial information, there's a review of the operational information and customer information. And I'm talking about reviews within a matter of days, not months. There's conversations with key individuals on the board and the exec team. There's almost invariably a conversation with the lender. There's invariably a conversation with the equity owner, the PE, equity owner, and potentially conversations with customers. And indeed unions if that's part of the issue. So those conversations need to rapidly occur over a few days to get a view of what is the situation and what are the key issues. Then we will double back to the chair and the CEO and say, We've been here for five working days, this is what the situation is. Our view is unless you do this, you are going to fail and these are the key things you need to do. When I say sorry, the CEO and the chair, the CEO chair and the board. So there's a collective ownership. And that's the first sort of contact, if you like, where we see what they want to do and their true colours. And depending on their reaction. So if there's denial, then there's about removing those that don't want to be on the bus and replacing them in in in an appropriate manner. Or if there is broad acceptance, then agreeing a plan with very strict timelines and very clearly agreeing who's got their ex on their back for delivering each part of that constituent plan, which will involve some Kingsgate people, and then executing that plan, which will be monitored on a daily, stroke, weekly basis until that crisis stabilisation part of the process is finished, which is probably three or four months.

SPEAKER_01 25:59

So other than obviously the business continuing, what would be the board seeing typically as demonstrating success that the turnaround has been achieved?

SPEAKER_00 26:09

I think what we have a mantra in Kingsgate is we always change the drumbeat. So within any organisation it moves to a certain drumbeat, often to a monthly reporting cycle or weekly managed. And in a turnaround, things have to happen faster. So the drumbeat has to happen faster. So people work harder and faster than they probably have worked before. That's so it will feel different. Meetings will feel and look different as well because they'll be very focused, their accountability will be very clear, and the agenda will be very small. And it will be are those individuals achieving what was agreed in the plan? And if not, why not? And when are they going to do to fix it? So the organisation will feel and look differently. There will also be lots of meetings cancelled and lots of extraneous activity just stopped. So it will be focused on the s I'm talking about the the initial few months here, focused on the survival of that company. And it's almost impossible that everybody's going to survive that journey. Unfortunately. So some people within the organisation will either quit or we will have to arrange for them to leave, because they won't and we need to have that thought through and who's going to replace them and how that's going to happen. So it will look and feel. So there'll be less meetings, much more focused agenda, there will be a few critical KPIs which the board will have agreed, and the communication will be short to the point, clear and crisp, both within the organisation and externally to the stakeholders, until the organisation has been stabilised.

SPEAKER_01 28:06

So see, we've had a few years of economic uncertainty. I think it's fair to say. Yes. Lots of noises coming about growth being key to the country's future health and prosperity. Yeah. Unfortunately, we've seen evidence of businesses contracting and not growing. Yeah. What do you think the outlook is for the turnaround market in general over the next 12 months?

SPEAKER_00 28:27

My first caveat is this is not a forecast. And my yeah, we can't forecast. But we can generally if we look at some trends. So the first key issue is the price of money, but we're not going to go back to the days of zero interest rates anytime soon. So I think that means that debt is more expensive, basically. The second thing is I don't see the opportunity for IPO and the MA activity materially improving either over the next couple of years. So for private equity, that's an issue. And that means that portfolio companies will be within the portfolio longer than they originally forecasted and wished. So they need to be managed to ensure there's more chance of a successful exit when conditions improve, or indeed maybe at a lower price, but at least there's been an exit. Any private equity portfolio, there will be problem children. So that that's the sort of financial side. In terms of the consumer side, taxes are going up. I think confidence is pretty low, interest rates are high. I think the housing market has currently stalled. I don't know whether that's going to improve or not. But most of the sort of unemployment's up. So most of those lead indicators tell me, and I think most people, that the next 12 to 24 months is going to be worse. We have a government that's not willing to take the action other than raising taxes, and is not willing to do what's needed to grow the economy, and we have higher employment taxes, more employment legislation heading our way. So all of that combined is probably quite a toxic mix. And for middle market businesses that mainly sell into the UK, I think it's less of an impact for companies that have a significant amount of sales outside the UK. That's a whole different story. It's probably going to be quite grim.

SPEAKER_01 30:50

So what can businesses do to try and prepare for this if it's going to be quite grim?

SPEAKER_00 30:55

So the key thing is to there's two or three things. Is they need to understand their working capital. They need to understand their debt. And they understand whether that's appropriate for how long they need to survive. I'm now talking about businesses that potentially are in trouble. They need to understand their working capital cycle. So they because the working capital death is credit as an inventory. Do they understand that? Is that managed properly? Could that be made better? Can that generate more cash? Then they need to understand profitability, both internally, obviously with costs, but also in customers. Are they making profit out of all their customers? Are there some customers that make more profit than others? Are they dealing with unprofitable customers? All those sort of issues. So it's about having a forensic look at the business and say, so if we have to survive for two or three years and pull our horns in, what does that look like? And what do we need to do to prepare for that? Better cash management, pushing profitability, dealing with profitable customers, reducing the chances of bad debts, making sure we've got the appropriate debt structures and making sure all our stakeholders are communicating in a clear and transparent way.

SPEAKER_01 32:19

And that all sounds very sensible, but it's hardly an agenda for growth.

SPEAKER_00 32:23

So if a business within that environment, because obviously in that sort of grim picture that I've described, there will be businesses that are in sectors that will really grow, because there always is. And their issues are more around overtrading, about having enough cash and enough equity and enough finance to deliver a growth agenda. They're a slightly different thing. So I'm involved in the start-up world as an angel investor, and that's quite interesting because a lot of startups are with really big growth potentials, really exciting businesses, entering to this area. And they've got to they've got to change because the reality is whereas they could meet each milestone of their growth story with a with another raise in, say, year to 18 months, and get to their series A and off they go, those raises are not happening, or those raises might take two years, or the milestones they need to hit are much harder. So actually the story slightly different for growth companies because some of them are pre-revenue, but it's the same story, is that they've it's all becomes much tougher. And obviously, in the environment that I've just described, being a growth business is doubly difficult because it's not an environment which promotes or supports growth. But there will be growth companies and there will be winners, because in every economy, even if the economy is going through a tough time, there will be sectors and particular firms within those sectors that will win.

SPEAKER_01 34:04

Yeah, that's interesting. Always winners and losers, whatever happens in the economic cycle. Yeah. But listening to what you're saying, I think it just emphasises for me the fact that understanding your working capital cycle is key to success. Yeah. Whether you're currently successful, whether you're on that stress-distress curve. And as always, it does amaze me how many companies don't do this very well.

SPEAKER_00 34:24

That's true.

SPEAKER_01 34:25

If you take one message from listening to this, I guess it's manage your working capital better.

SPEAKER_00 34:30

But also if picking your shot, so if you are servicing four markets or four sectors that have different levels of profitability, is that possible to service three? The questions that you might not have asked strategically, now's the time to ask them because it might be a slightly smaller, more profitable business is better than a bigger business that's chewing cash up and then potentially could have problems. So the margin of error is lower because interest rates have gone up, costs have gone up, taxes have gone up, consumers are more risk-averse, all those sort of things. So you've got to improve your situation so you're more robust and resilient business.

SPEAKER_01 35:20

That's a fairly depressing view, Steve. But I think in my view, it's pretty real realistic. Yeah. And it'd be great to come back in 12 months' time and see what's actually happened. I think it's I always find this with economists. Economists always have a view. It's never actually the right one. No. But it's always very interesting. Yeah.

SPEAKER_00 35:37

It's interesting. The the counterfactual to that or the counter is obviously the impact of AI, because everybody talks about AI, and I deal with a number of companies that are using AI, but I just can't it just isn't gonna it just isn't gonna help enough. It may help with productivity. You can use AI agents instead of people in certain circumstances in certain businesses. It will definitely have a positive effect. But I just don't think it's enough to counteract all the negatives that we've just discussed.

SPEAKER_01 36:16

Thanks, Steve, and thanks for sharing all your experience. Some really interesting things there. That's all for this episode of the Value Agenda. I hope this conversation has helped you think about where the real value is in your business. If you'd like to continue the conversation, you can find me and the team on LinkedIn or visit us at kingsgate.uk.com to find out more about what we do. And if you found this episode valuable, please do subscribe, rate, and leave a review wherever you listen to your podcasts. It genuinely helps other leaders find the show.