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Restructuring: The Hard Truth About Sell-offs Vs. Lay-offs

Published: March 15, 2011 in Knowledge@Australian School of Business
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To sack or to restructure? That's a big question facing companies in trouble. The Europeans think it's nobler to retain staff and join arms to reorganise. Recent evidence suggests that in the US it's commonplace to "let go" at the first sign of a finance crisis, whereas Australians are in the middle, with a leaning towards US practices. "But lay-offs are becoming more acceptable in Australia," says Vince Smith, head of corporate restructuring at consultancy firm, Ernst & Young.

New research from the Australian School of Business has found firms that sack staff are more likely to go bankrupt or be taken over than those that restructure by divesting themselves of under-performing parts of their business. Lay-off firms are less likely to survive, irrespective of whether they are distressed or healthy businesses. And size doesn't matter – a firm's chances of survival improve following divestitures, irrespective of whether it's small or large.

Companies including clothing and household goods marketer Pacific Brands, and miners BHP and Rio Tinto, put off thousands of workers during the financial crisis but have now bounced back. Like any company with maturing debt, Pacific Brands, which had debts of about A$550 million, was pressured by its bankers during the global financial crisis. It had tried to restructure its clothing manufacturing by outsourcing to other Australian companies without success before taking the decision to close 10 factories. The company was criticised for putting 3000 employees out of work during a downturn. But the decision paid off and it is now returning to profitability, having replaced a manufacturing strategy with one that's focussed on marketing brands, and importing from China. Not all firms have been so lucky. Ronan Powell, a lecturer in banking and finance at the Australian School of Business, has followed firms that restructured over the past decade, and discovered that lay-off firms are more likely to go bankrupt than divesting firms (12% versus 6%).

Divesting firms are also more likely to be acquired – at 34% versus 23%. "From a shareholders' and even employees' perspectives, takeover is clearly better," says Powell. "Takeover premiums average 25% - 40%, so shareholders win. While many employees may lose their jobs in a takeover, some would be retained (depending on the motive for the takeover). But more than half of lay-off firms go bankrupt in the year they lay off workers (compared to 27% for divestitures)." This is not surprising, since lay-offs are really a "last resort" decision, whereas divestitures are more likely to be strategic, "although some will naturally be motivated by financial distress as well", says Powell.

Although managers argue that both strategies are used to prolong a company's life, it seems lay-offs fail to ensure survival. The stock market agrees. As Pacific Brands discovered, its lay-off announcements resulted in a significant negative market reaction because they were seen as an indication of poor financial health. And the market also rewards distressed firms for restructuring, reporting a significantly higher cumulative abnormal return for divestitures. "The market appears to be efficient in predicting the consequences of lay-offs and divestiture decisions," says Powell.

Costing Cutbacks

Other studies have shown the expected increased efficiency and cuts to costs arising from lay-offs have not materialised. Sackings dent the morale of the remaining workers, making the decision counterproductive, and the substantial costs involved in redundancy payments can affect firm performance, and hence survival. Powell, with fellow researcher Alfred Yawson, a professor at the University of Adelaide, tested whether sell-offs or lay-offs help companies survive by surveying 1700 UK companies five years after they had announced a restructuring.

Of course, companies differ and characteristics such as profitability, undervaluation, leverage, liquidity, operating cash flow and size, can influence their survival. Poor firm performance resulting from inefficient management is also an important determinant of both takeovers and bankruptcies. Distressed firms put managers under pressure to act and improve the chances of survival. And removing the chief executive in times of distress proves no quick fix – it has been shown to actually increase the likelihood failure. However, having managers with equity in the business reduces failure because it supports good governance through better monitoring and discipline.

It's not surprising that lay-offs do not solve the problem because they involve getting rid of people but keeping the business, argues Peter Moran, a lecturer in strategy at the Australian School of Business. "So when lay-offs don't help, divestitures are less surprising. To think that lay-offs will fix the problem is okay – if there is too many staff or perhaps there's a downturn in demand."

In the US, sell-offs are often followed by large lay-offs, notes Ronald Masulis, a finance professor at the Australian School of Business. "Sometimes virtually the entire work force of the divested division will be put off," he says. "This is especially likely if the firm is being bought by a competitor that has a strong position in the same geographic and product space as the division that's being laid off."

While lay-offs are culturally more unacceptable in Europe, US firms take a harder line, according to Ernst & Young's Smith. "It is the first tool in the box to control a downturn in business or a softening of conditions for US managers," he notes. "In Australia, both are used. Certainly in the financial crisis, business lay-offs were used more than divestitures – and they were used with divestitures. I would not see one is more acceptable than another. I have seen quite good results from staff lay-offs and the replacing of senior and middle managers. I have seen other firms that have cut numbers and kept managers and the problem turned out to be the managers." Lay-offs are only part of internal restructuring. Wages are only one part of the cost base – the other parts could be fixed costs such as leases and plant and equipment, Smith points out.

"What we have seen across Australia in the last three years is poor access to credit for businesses and without credit there may not be buyers for a business," Smith says. "That might mean carrying the business losses and cutting costs, instead of losing on a fire sale when it's the wrong time to have it on the market." In Australia, a lot of businesses resorted to lay-offs instead of divestitures because they could not sell the businesses, Smith says, noting that lay-offs are becoming more commonly used. "It's the changing nature of work conditions. The workforce is more part-time with reduced hours. There is also a lot of outsourcing and contractors. It costs more but employers will not have to bare the costs of redundancy or retention if there is a drop off of work."

The mining services and manufacturing industries are good examples of this, according to Smith. "We recently had a mining business in Western Australia with a 110 people, of which 70 were contractors," he says. "When the job came to an end, those 70 were gone in 24 hours. So attitudes are changing too. During the global financial crisis, a lot of employees were thinking 'it will only be a matter of time before I get the chop'. But these days, they understand that is something current managements do in a downturn. Business downplays the lay-offs but a lot happened in the financial crisis, Smith emphasises. "They argue it is necessary for the survival of the company. They could add that it's also good for the bottom line."

Reasons to Restructure

Going into the crisis three years ago, banks adopted a different approach when dealing with troubled clients, according to Smith. In the property market, for example, the Centro Properties Group had debts of hundreds of millions, but if receivers proceeded to realise property assets it would hurt some of the banks' other customers, Smith reports, "so they decided to work it through". "My experience is banks don't appoint receivers lightly. There are a lot of costs involved and there can be a loss of value. Banks prefer restructuring. It comes down to business circumstances and to the bank's confidence in management to achieve restructuring.

"Some businesses can be victims of the market circumstances. More often they are the victims of management incompetence. The buck should stop with the people who run the business. Banks have to decide whether the people who got the business into trouble are the people to get them out of it."

Martyn Strickland, a partner specialising in restructuring at consulting firm, Deloitte, has done numerous turnarounds in the past three years, and notes a big change in the sector following the financial crisis. The banks have matured in the way they deal with underperforming assets, Strickland says. They are more sensitive to the current distressed situations, wanting to work out restructurings and other options. And there is a push for legislation to change insolvency law in Australia. "It is a good debate – industry professionals are split 50-50 on the desirability of reform," he notes.

Before deciding on divestitures and lay-offs, the key issue is working out the problem with the company, Strickland says. Just how unhealthy is the business? Does it have adequate financial controls? How much time is there for restructuring? "In 12 months, I may be able to do a divestiture – if I have cash flow during that period," he explains. "If there's only three months, a different strategy is required. The cash situation decides what you can and can't do. One of the triggers of the financial crisis was companies reducing top line (gross revenue), when they became stressed and could not pay their interest and debts. Insolvency increased during the GFC and is still higher than before. You also need a moderately leveraged balance sheet. If you lose revenue, you also lose earnings and still need to keep the bank happy with interest payments."

Divestitures and lay-offs are viable in the right situations but there may be other issues, says Strickland. "There is no silver bullet. In any approach, a program should include a revenue initiative, a cost initiative and a balance sheet initiative. Frequently, there's a point where a company can turn around effortlessly – and it can be the hardest thing to know when and what this is. Outside eyes are very helpful in helping companies working through their programs and [performing] a turnaround without burning their people, customers and suppliers," Strickland suggests.

Gary Tescher, the managing director of Promentor, won The Turnaround Management Association award for medium-sized business for his work on the telco service company Uecomm in 2010. "Right now turnarounds are flavour of the month because banks will not appoint receivers," Tescher says. "The banks have finally worked out that receivers charge the earth. A bank asked me to fix a fruit-growing company with a A$9 million debt. I said it could be done in two years and they would get back 95 cents in the dollar. The receivers said they could do it quicker by breaking up the business and selling off parts. But after all the receiver's costs were taken into account, the bank got back nothing. The receivers sold the main business for A$4 million, which was underpriced. The buyer got this money back by selling the fruit the business grew which the receivers paid to harvest and for which the bank effectively paid."

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