Corporate Governance And Financial Constraints On Strategic Turnarounds

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Corporate Governance And Financial Constraints On Strategic Turnarounds

This is an author produced version of Corporate governance and l|nanc|a/ constra|nts on
strateg|c turnarounds.
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Toms? S. and ?ilatotchev? l. (200?) Corporate ?overnance and financial constraints on
strate?ic turnarounds. Journal of Mana?ement Studies. pp. 40?-433. lSSN 0022-2380
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Filatotchev, Igor and Toms, Steven (2006) Corporate governance and financial
constraints on strategic turnarounds. Journal of Management Studies, 43 (3).
pp. 407-433.

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Corporate Governance and Financial Constraints on Strategic Turnarounds


By


IGOR FILATOTCHEV
King’s College London
150 Stamford Street, London SE1 9NN
Tel/Fax: +44-207-8483965
e-mail: [email protected]

and

STEVE TOMS**
Department of Management Studies
Sally Baldwin Buildings
University of York
York YO10 5DD
Tel: +44-1904-434122
Email: [email protected]













* An earlier version of this paper was presented at a conference on the ‘Corporate Governance
Life-Cycle: The Research Agenda and Practical Implications ’ 10-11 April 2003, Bradford,
UK University of Bradford School of Management, and Business Policy and Strategy
Division of the Academy of Management Annual Conference, August 2004, New Orleans,
USA . We are grateful to Mike Wright, the editor and three anonymous referees for their
insightful comments.

** Corresponding author



Word count: c.12,000
1

Corporate Governance and Financial Constraints on Strategic Turnarounds


Abstract
The paper extends the Robbins and Pearce (1992) two-stage turnaround response model to
include governance factors. In addition to the retrenchment and recovery, the paper proposes
the addition of a realignment stage, referring specifically to the re-alignment of expectations
of principal and agent groups. The realignment stage imposes a threshold that must be crossed
before the retrenchment and hence recovery stage can be entered. Crossing this threshold is
problematic to the extent that the interests of governance-stakeholder groups diverge in a
crisis situation. The severity of the crisis impacts on the bases of strategy contingent asset
valuation leading to the fragmentation of stakeholder interests. In some cases the consequence
may be that management are prevented from carrying out turnarounds by governance
constraints. The paper uses a case study to illustrate these dynamics, and like the Robbins and
Pearce study, it focuses on the textile industry. A longitudinal approach is used to show the
impact of the removal of governance constraints. The empirical evidence suggests that such
financial constraints become less serious to the extent that there is a functioning market for
corporate control. Building on governance research and turnaround literature, the paper also
outlines the general case necessary and sufficient conditions for successful turnarounds.

2

Corporate Governance, Financial Constraints and Strategic Turnarounds



INTRODUCTION
In their seminal article Robbins and Pearce (1992) suggest a two-stage turnaround model that
has recently attracted a lot of attention in academic and practitioner literature. According to
this framework, a turnaround situation arises when performance criteria are sufficiently
depressed to warrant a turnaround response. A turnaround response consists of activities
likely to overcome the firm’s troubles and return it to match or exceed prior performance. The
response consists of a retrenchment stage that might comprise “restructuring”, “downsizing”
and “downscoping”, with a particularly strong emphasis on cost and asset reduction required
for mitigation of the conditions responsible for the financial downturn. As a firm achieves
stability it moves to the second stage of turnaround and engages “recovery response”
strategies, which may include new market entries, mergers and acquisitions, new product
development, etc (Robbins and Pearce, 1992, pp.306-307).
However, such outcomes presuppose that entry into the first recovery stage is
unproblematic. In this paper, we argue that there are important ex ante conditions that must be
present in order that managers might enter the retrenchment stage. Specifically, managers
must gain the support of finance providers for the proposed strategy and, as part of the
process, realign profit expectations notwithstanding differences in short and longer run
outcomes, so that there is a consensus of objectives between principal and agent groups. By
introducing this additional turnaround stage, referred to below as the “re-alignment” stage, the
paper extends the Robbins and Pearce (1992) model.
More recent research on turnaround suggests that the performance outcomes of asset
and cost retrenchment are contingent on industry dynamics, which, in turn, affects the
3
underlying value of the firm’s assets (Morrow et al., 2004). This paper extends these
arguments further and makes a contribution by suggesting that financial constraints on
turnarounds may represent important factors affecting the success of this strategy. These
constraints are linked to capital structure and differential expectations about financial returns
among governance groups.
The strategy research literature has tended to neglect the financial aspects of
turnarounds. Even so, financial distress, which occurs where firms fail to maintain their
capital and hence the value of the claims of financial stakeholders, might be expected to be an
important feature of most (if not all) strategic crises faced by business organizations. The
contention of this paper is that turnarounds cannot be sensibly analysed without taking into
account the context of the financial obligations and related governance arrangements.
There are many cases where retrenchment is possible and indeed made easier for
management when the onset of a crisis provides justification for unpopular decisions (Grinyer
et al., 1988, p.95), but as this paper illustrates, this is not always the case. Where it is not,
there will be a failure of an important necessary condition for turnaround success.
Specifically, if the turnaround model is extended to include financial constraints and
governance factors, allowing for their impact on managerial flexibility and turnaround
performance (Jensen, 1986; Morrow et al., 2004), there are circumstances in which they may
have the effect of preventing entirely the pursuit of all subsequent strategic options. The
reasons why financial arrangements may impose serious constraints on such strategic options
are twofold. These are explained in detail below. In summary they arise first because financial
structure imposes fixed costs that are accordingly difficult to reduce without altering
ownership rights. Secondly because in a crisis there might be a greater economic benefit to
owners from the continued employment of all deployed assets relative to the opportunity
benefit of turnaround strategies (Morrow et al, 2004), and asset sales are linked directly to
4
reordering of financial claims in circumstances of financial distress. Finally, the development
of the market for corporate control (MCC) may increase the probability of firms adopting
turnaround strategies since it increases the potential exit benefits to existing shareholders and
provides financial resources during the recovery stage. The MCC refers to the existence of
conditions, for example liquid share markets, transparent and flexible managerial labour
markets, appropriate institutions of financial intermediation, promoting the realization of the
collective value of the firm’s assets (Hitt et al., 1996).
Whereas many of the studies referred to above have used the individual firm, the
current study also uses the industry as the unit of analysis. An important reason is that the
paper develops strategic factor market (SFM) theory to explain asset values at the industry
level. In the SFM approach such values can be related to normal economic returns, but also to
accommodate the expectation that such asset values are influenced by industry level effects,
particularly capacity utilization.
The principal motivations of this paper therefore are threefold. Firstly, it aims to
assess the importance of financial constraints as explanatory factors in the success or
otherwise of corporate turnarounds. Secondly the paper aims to show that there are
circumstances where financial constraints arising from crisis situations may impose a hard
constraint on other strategic options, thereby preventing endogenous turnaround regardless of
the attitudes, competencies and strategies of incumbent management. In other words, although
prior studies emphasised managerial inaction as an important cause of turnaround failure (e.g.
Barker and Mone, 1994; Hambrick and Schecter, 1983; Hofer, 1980; Schendel, et al. 1976;
Weitzel and Jonsson, 1989), inaction may not in itself be the product of poor management,
particularly where financial constraints operate. Thirdly, whilst recognizing that finance, but
not strategy, based research identifies financial restructuring as an integral component of
turnarounds (e.g. Brown, et al., 1993; DeAngelo and DeAngelo, 1990; Franks and Tourous,
5
1994; Gilson, 1989; John, et al., 1992), the paper shows that strategic and financial aspects of
turnarounds are inseparable. To examine these propositions the remainder of the paper is
divided into three further sections. The first develops a theoretical model explaining
circumstances in which it might be expected that financial constraints impact directly on
strategic decisions. The second examines an empirical case providing an exemplification of
failure to restructure under hard financial constraints. The final section draws conclusions.

A GOVERNANCE BASED-MODEL OF TURNAROUNDS

Previous strategy research on the turnaround process commonly focuses on pre-identified
stages. For example these might be the efficiency driven operating turnaround stages and
entrepreneurially driven strategic recovery stages (e.g. Bibeault, 1982; Robbins and Pearce,
1992; Slatter, 1984). These response stages are linked to the process of organizational decline
and crisis, and related to the incidence of internal and external causes (Barker and Duhaime,
1997; Bruton et al., 2003). External causes are related to environmental changes that make the
firm’s existing strategy inappropriate, whereas internal sources of decline are associated with
managerial error (Barker and Duhaime, 1997). Some authors indicate that both sources of
decline may overlap (De Witt, 1998) demanding a complex managerial response in terms of
operating solutions (e.g., retrenchment) and strategic solutions (asset reconfiguration, market
re-positioning, etc.).
Whilst there is consensus on these elements of the turnaround process, there has been
considerable debate about the importance of business turnaround strategies in the strategic
restructuring and “re-invention” process (see Filatotchev et al., 2000, for a review). Barker
and Mone, (1994, p.395) suggest that retrenchment is not a cause of turnaround performance
but rather a consequence of a steep performance decline during which a firm’s financial
6
performance is extremely poor, an assumption supported by Barker and Duhaime (1997).
There is also debate about whether such retrenchment strategies are necessary conditions at all
as precursors for subsequent strategic turnaround actions (Castrogiovanni and Bruton, 2000).
According to the latter view, strategic actions may be sufficient for successful turnarounds in
some contexts and recourse to retrenchment strategies may be unnecessary or even counter-
productive (Hoskisson and Hitt, 1994; Schreuder et al., 1991). Any attempt to extend the
Robbins and Pearce stage-based approach must also deal with these criticisms.
A general defect of all existing approaches in the strategy literature is the relative
absence of research on the financial aspects of turnaround (Morrow et al., 2004). Both agency
(e.g., Jensen, 1986; 1993) and strategic management (e.g., Kochhar, 1996; Kochhar and Hitt,
1998) research acknowledges that the structure of financial liabilities and related governance
aspects may have an important impact on the firm’s strategic decisions. Jensen suggests that
“changes in financial and governance policies generate value-creating changes in behaviour of
managers and employees” (Jensen, 1993, p.869), emphasising the governance role of debt-
holders. Kochhar and Hitt (1998) find strong reciprocal links between the firm’s capital
structure and corporate strategies, such as acquisitions and product diversification. Kochhar
(1996) has developed a theoretical model that brings together analysis of capital structure,
firm resources and strategic decisions and recent research has increasingly acknowledged the
importance of governance factors as a constraint on managerial activity as part of the
turnaround process (Daily and Dalton, 1998).
Whilst the Robbins and Pearce (1992) framework is a useful starting point, it is
therefore underdeveloped in certain respects. Specifically, their arguments that, depending on
the severity of the crisis, strategic repositioning must be preceded by cost reduction or asset
sales is underpinned by the assumption that these financial strategies exist freely as options in
all cases. Robbins and Pearce (1992) and other studies (e.g., Hambrick and Schecter, 1983;
7
Slatter, 1984; Grinyer, et al 1988, Grinyer and McKiernan, 1990) recognize the importance of
retrenchment, they assume it to be an outcome of managers’ rational strategic response to
organizational crisis. The contention of this paper is that the introduction of governance-based
constraints restricts the availability of these options and can have a decisive impact on the
turnaround process.
To consider strategic resources and their allocation through governance mechanisms
in tandem, a strategic model is developed in this section, in which several further strands of
theory are synthesised. These are strategic factor market (SFM) theory, corporate governance
and accounting analysis of asset valuation and determination of financial returns. Combining
these elements, a model, summarized in figure 1, can be used to analyse the turnaround
process.

Figure 1 about here

The first layer in figure 1 presents three stages of the turnaround process. Stage 1 is
an addition to the standard turnaround model, stressing the importance of existing governance
arrangements and, in particular, the requirement for a re-alignment of expectations and
strategic objectives of managers and external investors (equity holders and banks). Stages 2
and 3 broadly correspond to the Robbins and Pearce (1992) model of strategic turnaround.
Moving from left to right, successful completion of the first stage is a necessary condition for
commencing the next, so that for each there is a financial constraint in the second layer and a
strategic outcome in the third layer, which depends on the completion of each respective
stage.
The second layer in figure 1 refers to evaluations by shareholders and debt-holders of
rates of return, as well as the revenue generated by possible asset disposals, which, in turn,
8
depend upon profit rates and asset valuations consistent with each of the three turnaround
stages and strategic outcomes. The transparency of these processes influences the
effectiveness of monitoring by financial stakeholders and their evaluation of the likely
financial and strategic outcomes of each turnaround stage. Where the expected rate of return
(ER) of the managerial turnaround strategy is less than the investors’ required rate of return
(R), and expected realizable value (NRV) is less than book value (BV) of assets, there is no
benefit for stakeholders in supporting managerial strategic decisions. NRV depends on the
present resale market value of assets whilst BV is the discounted sum of the expected stream
of profits from continued deployment. At stage 1, therefore, there is pressure to re-align
interests and expectations of managers and financial stakeholders, so that these converge.
Successful completion of stage 2 requires net realizable value (NRV) to equal or exceed book
value (BV). Finally, where ER is greater than R it is rational to enter or invest (Edwards, et
al., 1987). These are also necessary conditions respectively for the completion of stage 3 and
the overall transition through the re-alignment and retrenchment stages to a successful
turnaround.
The corresponding strategic outcomes in the third layer of figure 1 correspond to the
appropriate turnaround stage. Failure to complete the first, re-alignment stage, results in
strategic outcome 1, a continuation or “do nothing” strategy, with rate of profit expectations
based on the BV of invested capital. Such an outcome is likely where BV exceeds the NRV of
asset disposals. The second, retrenchment, stage requires some realization of invested capital,
for example through disposal of old assets, exit from unprofitable segments and other
downsizing activities, so that funds are available to finance the recovery strategy. For success
in this stage , it is necessary that NRV exceed BV. If the condition is not met, there will be a
reversion to the “do nothing” strategy. Expected returns from reinvestment of the proceeds
from asset sales must then exceed the required rate of return, or if not, downsizing or
9
complete exit becomes the realized strategy. Only if both of these stages are complete can
firms attempt the third stage recovery stage. Entering this stage is of course no guarantee of
turnaround success, which depends on the expected and later actual returns exceeding the
required rate of return once investments in new assets have been made.
Each element of the model in figure 1 depends on an interpretation and synthesis of
different elements of theory, which are now discussed in turn.

Strategic factor markets

SFM theory offers a theoretical basis for rationalizing decisions, common to turnaround
situations, to enter or exit specific activities and markets or market segments. It is a means of
analysing the cost of acquiring new resources required to support the firm’s product market
strategy (Barney, 1986) or in a turnaround situation it might be extended to consider the value
of asset disposals (Morrow et al. 2004). The benchmark comparative is the economic value of
an asset where SFMs are perfectly competitive (Barney, 1986). Imperfections in such markets
will be reflected in higher entry costs, for example where the acquisition of the appropriate
technology is expensive in the case of turnarounds (Morrow et al, 2004) By extension, SFMs
create exit barriers where the asset resale market is thin.
For Barney (1986, pp.1231-2, 1236-7) the MCC and capital sources are also SMFs.
The model in figure 1 extends Barney’s (1986) approach to offer a financial dependency
perspective to incorporating differential evaluations of strategic options and their expected
profits from the perspectives of managers, shareholders and debt holders. In crisis situations,
this governance component of the model is particularly important, as the views of the non-
managerial groups about asset valuation and prospective profit streams are of great
importance, impacting on the employment or withdrawal of capital. Also important is the
10
degree of consensus or divergence in expectation between principal and agent. As argued
above, divergence may prevent turnaround and consensus may be a necessary condition for
turnaround. Figure 1 reflects these relationships by suggesting that managerial decisions about
the turnaround process are endorsed or contradicted by external finance providers.

Governance arrangements

Previous research linking capital structure and the firm’s strategy decisions acknowledges that
information asymmetries between incumbent managers and external providers of finance create
agency costs (Kochhar, 1996). Without reliable data on the new strategy’s risk and value
outcomes, finance suppliers will be either unwilling to fund new strategic projects, or charge
higher premiums because of the potential for adverse selection and moral hazard (Kochhar and
Hitt, 1998, p.603). However, notwithstanding differential access to information, it also possible
for these expectations to converge so that principal and agent groups agree on the strategic
choice, particularly in the case of the tripartite discrete choices offered in figure 1. Insofar as
principals do not support a particular choice where it might otherwise be rational, the
governance structure constitutes an exit barrier. Bearing in mind information asymmetries and
related risk problems, external financiers may use their voice-based governance powers to
favour strategies with less potential upside but lower risk associated with them, and this direct
strategic involvement may be driven by limitations on their ability to diversify their
investments. Intervention by capital suppliers utilizing governance mechanisms is more likely
and may be more effective when the base of asset valuation alters, because owners and
managers will simultaneously seek new information about asset valuations in the new
circumstances.
1

11
Corporate governance research may accordingly be extended further by taking into
account industry dynamics and inherited governance mechanisms that have evolved at previous
stages of industry development (Cameron and Whetten, 1981; Quinn and Cameron, 1983).
More specifically, because of their inherent inertia, governance arrangements that have evolved
as a result of financing rounds at the growth stage may create substantial strategic barriers when
industry’s fortunes change (Arthur, 1989). Some researchers have recognized potential
governance constraints on managerial incentives to design and implement strategic restructuring
in declining industries (e.g., Filatotchev and Toms, 2003; Hambrick and D’Aveni, 1992). In this
paper we develop this framework further by suggesting that restructuring barriers may also be
explained by financial constraints associated with governance factors.
In conditions of uncertainty and heightened information asymmetry, managers and
owners may evaluate these opportunities differently, and their preferences with respect to
strategic options may not coincide even when managers are not engaged in self-serving
behaviour (Sanders and Carpenter, 1998). In addition to differences in expectations, managers
and external investors may have different time horizons which may have further impact on
their strategic preferences (Bethel and Liebeskind, 1993; Brickley et al., 1988; Kochar and
Hitt, 1998). More precisely, where BV is greater than NRV, principals’ views are more likely
to converge on the steady state strategy and non-entry of the subsequent stages, even though
managers may advocate retrenchment in the expectation of a subsequent long-run turnaround.
Taking these factors together, the conditional availability or non-availability of finance
may under certain conditions act as an entry barrier (Jensen, 1986; 1993). Similarly in
conditions of industry decline, exit decisions will be mediated by corporate finance and
accountability factors. Whether or not firms downsize and/or exit will depend in part on
whether the NRV of assets allows financial stakeholders to liquidate their position without loss
of capital. If such values are low compared to the value of profit streams from continued use,
12
then active monitoring by financial stakeholders may prevent retrenchment (Jensen, 1993). The
governance and financial performance link is a further important aspect of these relationships.
In terms of governance factors, the relationship between shareholders, debt-holders and
managers in figure 1 depends on voice-based governance mechanisms and the presence of a
liquid share market including the MCC (DeAngelo and DeAngelo, 1990; Eisenhardt, 1998;
Franks and Mayer, 1997; Hart, 1995; Jensen, 1986; 1993). These are the observable outcomes
of complex interactions of these governance arrangements, which rely on different channels
of monitoring and control. Voice-based governance, for example, relies on boards of directors
and their committees that perform their fiduciary duty to ensure managers maximize value for
shareholders (e.g., Hoskisson et al., 1994; Kochhar, 1996), or direct influence of large-block
shareholders who have enough power to control managerial discretion (e.g, Schleifer and
Vishny, 1986). More recent research, however, indicates that institutional investors may have
different investment objectives (Hoskisson et al., 2002)
2
. A number of authors emphasise an
increasing governance role for debt holders who may have a superior access to the firm’s
information (Jensen, 1993; Citron et al., 1997; 2003), particularly in countries with
“relationship” governance systems such as Japan (Kim and Hoskisson, 1996).

Financial returns

Theoretical models show that economic profit reconciles to cash flows generated by an asset
or group of assets in any given time period and the difference in their opening and closing
valuations (Edwards and Bell, 1961, Edey, 1962). It follows that strategic entry and exit
decisions can be related to level of profit and asset valuation (Edwards, et al., 1987; Shleifer
and Vishny, 1992). Replacement cost (RC), BV and NRV, reflect in turn differences in value
between new technology and deployed assets and between historic cost and current market
13
values. Firm specific risk associated with each strategy is higher in a crisis and it becomes
more likely that expectations will diverge between principals and agents, so that entry into the
re-alignment stage is problematic. In turnarounds, asset values, which change according to
intended use, and act as collateral, are also important inputs into governance groups’,
including particularly debt-holders’, decisions about whether to endorse or sanction strategic
redirection.
Another way in which investors’ attitudes change is if existing assets are under-utilized,
either through temporary changes in demand or through longer-run over-capacity problems.
In such cases, losses are incurred as a result of spreading fewer units of output over a higher
cost base. In certain conditions of asset specificity, managers have an incentive to diversify
the uses of such assets (Teece, 1980). In conditions of changing technology, capital losses
arising from obsolescence may be also expressed as asymmetries between NRV and BV of
assets on the assumption of continuing use. Further, declining realizable values of specific
assets may create exit barriers where their use can be continued at low marginal but high
average cost, for example in conditions of excess capacity.
The final point of reference in figure 1 influencing the relationship between managers’
strategic decisions and external financiers is ER. As already noted, profit levels will affect
deployed asset values as differentially perceived by external stakeholders. A further important
aspect impacting on ER in figure 1 is the firm’s cost structure. Where industries are affected
by downturns and crisis conditions the firm’s cost base, and the impact of costs not easily
variable in the short run will be a crucial determinant of both expected profit and the ability of
managers to stabilize cash flows. Fixed costs typically arise from sunk and specialized assets,
which are sources of entry barriers and competitive advantage under the assumptions of SFM
theory. A further possibility, investigated below, is that the fixed cost structure acts as an exit
barrier where the fixed costs themselves arise from restructuring.
14

Synthesis and extensions

Our arguments underpinning the theoretical model in figure 1 suggest that external financiers
may impose constraints on managerial turnaround decisions. When their expected returns and
net realizable value of asset sales are less than required rate of return and book value
respectively, they will use governance channels to force managers to preserve status quo.
Retrenchment actions may be taken when investors expect that assets sales will generate
revenue higher than their existing book value. Finally, expected returns from investment at
the recovery stage must exceed the required rate of return, or if not, downsizing or complete
exit becomes the realized strategy. However, our model has a number of important internal
and external contingency factors, such as presence of an MCC and financial structure of the
firm.
The MCC is a SFM, in which differential expectations about future financial returns
lead to overpayment by acquiring firms thereby creating acquisition premiums.
3
The MCC
utilizes all three valuation reference points in figure 1, where acquisition motives vary from
accessing new and difficult to replicate assets, obtaining new streams of cash flow, or
purchasing bundles of assets with high separate realization potential. Where demand for new
finance is high, for example where technical development is rapid, there will be pressures to
alter governance, accountability and reporting structures in favour of outside financial
stakeholders. All these governance mechanisms are important since they facilitate the rational
comparison of financial outcomes from the strategic options faced by current financial
stakeholders. The combined potential effect of these governance factors on the probability of
turnaround success is illustrated in figure 2.

15
Figure 2 about here

As figure 2 suggests the presence of a MCC is likely to promote turnaround
opportunities, since it increases the potential realizability of exit values and also offers new
financing opportunities during the recovery stage. With no MCC, there is no reason why book
values should not exceed market values or vice versa, since exit values can only reflect the
break-up value of the corporation. The positive impact of developed capital markets on
strategic restructuring has been acknowledged both in the strategy and corporate finance
literatures (e.g., Brickley, et al., 1988; Doukas and Travlos, 1988; Eisenhardt, 1989).
Alignment between asset base and financing arrangements is also likely to impact
directly on turnaround capacity. Some researchers recognize different impacts on turnaround
strategy associated with equity as opposed to debt financing (Kochhar, 1996). In theory,
banks have a priority in repayment in turnarounds and restructuring
4
. Given that banks are
first in the queue, there may be incentives for banks to wind things up to recover some value,
even where shareholders might persist, with positive consequences for restructuring and
capacity reduction.
5
However, banks are also exposed to financial constraints related to asset
valuation. Whereas bank loans are secured against replacement value of the assets, in a
bankruptcy banks recover a liquidation value (Morrow et al., 2004)
6
. A study by Franks and
Mayer (1997), for example, provides evidence that debt-related governance has been a
handicap in achieving downward adjustments (i.e. labour and plant downsizing) during an
international economic slowdown.
7
Problems with restructuring of South Korean chaebols
can be used as an example of banks putting good money after bad in a situation when they can
recover only a fraction of the original loan to a struggling company.
8
There may thus be a
failure to exit from non-viable projects in a timely fashion. Financial economists also
recognize that financial structure of the firm and governance roles of debt and equity
16
providers may have an important impact on organizational responses to performance decline
(Aghion and Bolton, 1992; Hart, 1995; Grossman and Hart, 1995). Although there may be tax
advantages to debt finance in some circumstances normal priorities for financial claims
increase bankruptcy risk from the perspective of residual equity stakeholders (Altman, 1984),
and by corollary reduce the probability of turnaround. For these reasons, figure 2 suggests a
probability continuum, where turnaround probability is promoted by the existence of a MCC
and within each set of institutional arrangements in general is higher where debt is lower.
The relationships suggested in figure 1 and 2 offer several advantages in the analysis
of strategic decision-making discussed above. To begin with, they present a logical
framework for the analysis of financial performance using accounting data. Although the
determination of performance is important in the fields of strategic management (Ketchen et
al, 2004) and industrial organization, many economists are reluctant to use accounting data
due to its perceived lack of reliability (Mueller, 1990, Schmalansee and Willig, 1991).
However, the Edwards at al. (1987) analysis, whose assumptions are integrated into the
model, suggests an analytical solution to these problems provided appropriate valuation rules
are followed. Whilst financial performance may be a worthwhile measure for evaluating
strategic outcomes, it is also useful for analysing the effectiveness of governance systems. For
example, the MCC can be analysed with reference to wealth effects, where the distribution of
gains from merger transactions is a function of differences in RC, BV and NRV. Finally, the
framework is consistent with recent developments in financial theory, which has shifted
emphasis from the value irrelevance of capital structure and dividend decisions to the
relationships between active or passive investor monitoring arrangements and the value of the
firm (Jensen, 1993). These relationships are increasingly recognized elsewhere, particularly in
comparative and historical analysis of governance systems (Whittington and Mayer, 2000,
p.13-14).
17

FINANCIAL CONSTRAINTS ON TURNAROUND: EMPIRICAL EVIDENCE

Research methodology

Researchers of organizational decline propose that the roots of a firm’s decline can either be
based in an industry downturn or be based in firm-specific problems (Cameron et al., 1987).
Industry-based decline occurs when “a firm’s industry shrinks in size or munificence,
reducing the number of firms the industry can support and causing the firm and many of the
other firms in the industry to suffer performance declines” (Barker and Duhaime, 1997: 18).
As opposed to firm-level declines caused by managerial strategic mistakes, industry-based
decline creates a homogenous population of struggling firms, and this makes causal links
between firm-level performance and business turnaround strategy less ambiguous (Cameron
and Whetten, 1981). Morrow et al. (2004) also suggest that industry dynamics may play an
important moderating role in terms of the relationship between retrenchment and firm’s
performance.
Building on these arguments, we chose the British textile industry as an empirical
illustration of the theoretical model for a number of reasons. First, the industry is endemically
cyclical and therefore presents frequent opportunities through time and in different
international and institutional settings to analyse survival threats and managerial response.
Second, whereas turnarounds in the US textile industry have been examined elsewhere
(Jensen, 1993; Robbins and Pearce, 1992), the depression that affected the British textile
industry was more serious, and the British case therefore provides a useful test of the limits of
existing models suggested in the above discussion. Two particular cases, the slump of the
1920s and the corporate restructuring from the 1960s onwards, allow us to demonstrate the
18
necessary and sufficient conditions for corporate turnaround with varying levels of debt and
equity finance in the absence and presence of a MCC.
In terms of research methodology, we use a quantitative and qualitative historical
analysis, since “organizations are complex, variable-rich phenomena that can be studied from
multiple perspectives” (Daft and Lewin, 1990, p.2). Following other quantitative and
qualitative studies on business turnaround, we used a combination of case analysis of
individual firms (e.g., Ruiz-Navarro, 1998), and analyses of published accounts of from
different periods by experts, business writers, public press, etc (see Bruton, et al., 1994; 2003;
for a similar research methodology). In addition, we conducted a detailed analysis of
published financial data for sub-samples of firms at different stages of the industry life-cycle.
This approach allows us to develop a longitudinal study across several organizations which is
essential when one analyses complex and dynamic interrelationships between finance,
organisational processes and strategy (Daft and Lewin, 1990; Lee, 1999). Cross sectional
multiple industry content studies are inadequate for capturing these sequential patterns and for
the assessment of under-researched process aspects of turnarounds (Chowdhury, 2002).
Another specific advantage of the longitudinal approach as distinct from studies focusing only
on the present time is that governance mechanisms, laws and capital markets can be explored
as variables of interest as they change through time. In particular, the presence or absence of a
MCC can be contrasted with the effects of (de)regulation, capital availability, workforce
education level and socio-economic stability on asset restructuring.

The 1920s: A turnaround failure

In 1920 the British cotton textile industry enjoyed a post war boom. Many firms recapitalized,
selling equity to financial syndicates and investment groups (Thomas, 1978, p.156). These
19
changes took place in a highly unregulated environment. The industry was highly
competitive, made up of small, specialized firms, employing well-trained and educated
workers (Fowler, 2003; Higgins and Toms, 2003). Within a year, the boom, along with export
orders collapsed (Burnett-Hurst, 1932; Dupree, 1996, pp.270-71; 283-90). Figure 3 illustrates
the extent of the boom and subsequent slump in terms of average company profitability.
According to the Robbins and Pearce (1992) model the first response should have been at
least cost reduction, and given the severity of the crisis, asset reduction. Neither of these
responses materialized, although as the crisis lengthened they became increasingly important.

Figure 3 about here

The discussion that follows differentiates between industry level and individual firm
strategies, and a short note is required to explain the interactions between managerial
behaviour in both contexts. Because the individual firms were highly specialized, there were
limited opportunities for downscoping within the product range, although downsizing the
scale of operation was possible. Through associations of manufacturers, strategies were also
determined at industry level, one example being the collective action taken to organize short-
time working as a response to the over-capacity problem. The result was to sustain the weaker
firms and to share reduced output over the same fixed cost base (Keynes, 1981, p.582).
Downsizing at firm level was therefore on the basis of a capacity sharing exercise at industry
level. As the ensuing discussion demonstrates, the model in figure 1 works reasonably well
whether applied to industry or firm level, and in the general case, it must be stressed, these
somewhat unusual firm and industry interactions may not be present at all.
The main reason for the failure of the industry to restructure was the impact of
governance-based exit barriers. Specifically these barriers were associated with the presence
20
of outside financial syndicates, which had invested in the industry during the recapitalization
boom. To explore this further, we collected financial and economic data that was available for
147 firms from the spinning sector for the period 1926-1931. These data show that where
firms had recapitalized, and thus where the impact of outside investors was greater, the
attrition rate of firms was lower and the rate of dividend payment higher. Out of a total of 70
recapitalized firms, 57 (81.4%) adopted continuation steady state strategies during the period
compared with 57 out of 77 (74.0%) non-recapitalized firms. These steady state strategies
typically involved fierce price competition for the available contracts on the basis of covering
marginal cost (Economist, 9 December, 1922, p.1076). From the point of view of the industry
a necessary condition for turnaround was the exit of some firms as a solution to over-capacity
problems (Keynes, 1981, pp.583-4, 591) and that was the strategy chosen by the residual
firms. A further necessary condition was retrenchment of the existing cost base and
reinvestment in new equipment so that unit costs could be reduced and overseas
competitiveness restored. However the effect of the governance constraint, which again was
pronounced in the recapitalized firms was to ensure that cash secured from contracts was paid
out as dividends. The mean dividend rate for recapitalized firms was 5.8% compared with
1.6% for non-recapitalized. In summary, governance factors prevented industry turnaround by
constraining exit and prevented firm level turnaround by reducing cash available for
reinvestment thereby preventing entry into the recovery stage.
The presence of debt also tended to reduce the probability of turnaround success. In
the sample of spinning firms referred to above, high debt was associated with liquidations and
complete exit from the industry. The debt to total capital ratio for liquidated firms was 43.6%
compared with 34.8% for the surviving firms, illustrating the role of debt as a constraint on
turnaround for individual firms. At industry level, in market value terms leverage ratio for all
firms was made infinitely worse by the rise in bank debt to finance working capital and
21
trading losses and collapsing share values (Higgins and Toms, 2003).
9
Keynes (1981, p.584)
refers to 200 mills on an unsound financial basis for this reason.
Although there were important differential effects of governance factors, different
groups of shareholders and debt holders faced basically the same decision, which involved
comparing expected profits from existing operations with the profitability of the retrenchment
strategy.
10
Putting aside some expectations that the downturn was cyclical and temporary,
even low profit expectations from continuation were preferable to the alternative. Asset write-
downs would entail a re-ordering of financial claims to the detriment of the new investors
who had bought in the recapitalization boom. Asset disposals at other than scrap value were
prevented by the collapse of the second hand machinery market (Bowker, 1928). Collapsing
export markets created spare capacity, whilst new technical advances in spinning and weaving
processes rendered deployed assets increasingly obsolete (Ryan, 1930). Because there was no
liquid share market and there was no functioning market for corporate control, decision-
making on retrenchment and capital redeployment remained in the hands of individual
investors (Higgins and Toms, 2003). Labour markets were not a significant constraint and
firms were able to impose short-time working on the basis of industry wide agreements
(Bowden and Higgins, 1998). Investors chose rationally according to figure 1 to accept
marginal profitability on their sunk investments in preference to the almost total loss of
capital that would arise from exit. The result was paralysis, and subsequent stage strategic
options that ought to have opened up in the Robbins and Pearce model failed to materialize. A
crucial remaining question is that since the exit option was closed, why did firms not consider
other strategic alternatives?
Figure 1 suggests a comparison of the expected returns from deployed assets against
those from the purchase of new assets. Newer and more efficient machinery was available
(Board of Trade, 1932, p.135) that would have assisted firms seeking marginal contracts and
22
the option to undercut competitors. However there were several objections to this strategy. As
we have seen above, as profits became available in successful companies, investors were
quick to demand dividends as a means of liquidating their previously sunk and at risk
investments. The most obvious objection from the investors’ point of view was that having
lost capital already, this would be throwing good money after bad. A further consideration
was that newer machinery was under patent protection, more efficient and therefore more
expensive (Joshi, 1935, Sandberg, 1974). To deploy these machines efficiently required
integration of spinning, intermediate processes and weaving (Higgins and Toms, 2003),
effectively the complete reorganization of vertically specialized factory buildings or the
construction of new ones. Taken together this strategy amounted to heavy commitment to
high fixed cost assets in conditions of uncertain demand. In addition to cash flow from current
operations and the proceeds of asset sales from the disposal of old capacity, it is likely that
new financial sources would be required to sustain these investments. As has been shown,
none of these sources of funding were available.
Ultimately crisis conditions and the failure of individual firm responses prompted
outside intervention. To save the banks from bad loans and financial collapse the Bank of
England intervened to close cotton firms down (Bamberg, 1988). This was not the first or last
occasion of government intervention in lieu of strategic action by industry participants and
where such interventions are necessary there may be further examples of strategic paralysis
and turnaround failure.

Post 1960: A turnaround success

By the mid 1980s, Britain’s textile industry was reportedly better managed, more resilient and
far more competitive than it had been for decades (Van de Vliet, 1988). Such a recovery was
23
remarkable in the context of the steady decline of textiles spanning back to 1920 and the loss
of markets to cheap labour based competition (Singleton, 1991). The interesting question
from the perspective of figure 1, therefore, is what had changed since the paralysis of the
inter-war period?
There were two important and related changes. First, a combination of Bank of
England imposed financial restructuring in the 1930s and profitable contracts during wartime
allowed the surviving companies to rid their balance sheets of debt finance. Second, starting
from the abortive ICI Courtaulds takeover bid in 1961, a liquid market for corporate control
began to emerge. In terms of figure 1, the 1950s to a certain extent mirrored conditions of the
1920s. Claims of the equity owners were based on obsolete assets with low realizable values,
whilst replacement costs for new machines continued to escalate. In the 1950s, an illiquid
share market promoted the strategy of continued use of existing assets, again exacerbating
problems of over-capacity after the post-war boom collapsed in 1952, producing a new slump
in corporate performance (figure 3). Although limited exit was promoted when larger firms’
capital was used to buy out shareholders at a price below asset book value but higher than
realizable value (for detailed examples, see Filatotchev and Toms, 2003), these rationalisation
attempts were rare. Instead, to secure survival, firms opted for political lobbying and subsidy,
capacity sharing arrangements and price fixing deals. Price fixing was operated through the
Yarn Spinners’ Agreement. Its abolition through legislation in 1958 accelerated the
rationalisation of the industry along with the subsidy scheme of the Cotton Industry Act 1959
(Higgins and Toms, 2000). The Act provided financial assistance for withdrawal from the
industry and coincided with the beginning of a series of tariff reductions removing protection
from overseas competition in the home market. In the 1960s there was a series of take-over
transactions that further and quickly rationalized the industry, resulting in the rapid
24
concentration of the industry (Hannah, 1979, Rose, 2000), forcing remaining firms to adopt
turnaround strategies to ensure survival.
Although there were parallels between 1929 and 1959, in that both witnessed
government intervention to enforce capacity reduction and rationalization, there were some
very interesting differences with respect to figures 1 and 2. Most crucially, the creation of a
market for corporate control meant that turnaround strategies could more easily be carried
through. Unlike in the 1920s institutional investors did not demand excessive dividends. From
an analysis of the accounting records and share registers for a sample of 45 firms in the period
1959-1970, there was no correlation between institutional shareholding and the rate of
dividend payment. We made comparisons between 10 successful turnaround firms (defined as
firms that were trading profitably in 1970) and a sample of 10 similar sized firms that failed in
the period 1964-1970. The average dividend payment (as a percentage of profit) of the
surviving firms was 37.3% compared with 50.3% for failed firms. The successful firms
reinvested available profits to fund capital equipment purchases, thereby allowing them to
enter the recovery stage. Turnaround successes spent twice as much on capital equipment as a
proportion of turnover. In contrast to the 1920s, successful survivors were not prevented by
governance constraints from making the reinvestment required in the recovery stage. From an
analysis of their share registers, turnaround successes had an average of 27.4% of capital
owned by institutions, in contrast to 16.7% for failed firms. These firms also had low debt to
total capital ratios (13.0%). Unlike in the 1920s, investor groups were able to envision and
accept alternative strategies, including restructuring and reinvestment.
An important reason for the non-application of the dividend constraint in the 1960s, in
contrast to the 1920s was the development of a liquid market for corporate control. This also
reduced exit barriers and the way paved for industry restructuring. In the 1920s there were no
cases of companies being taken over by other companies, whereas in the 1960s a large
25
number of companies were bought and sold.
11
Once purchasers were available, the incentive
of incumbent investors to enforce the continued use of old assets strategy was greatly reduced
because the market capitalization of the firm provides an alternative basis for the NRV break
up value from the investor’s point of view. The point is well illustrated by the acquisitions of
David Alliance. For example the balance sheet of Rothwell Ltd showed book value net assets
of £1,337K in 1962, and Alliance offered £1044K for the shares, in excess of the market
capitalization of £783K. Cash consideration was the norm for acquisitions in this period since
exiting shareholders enjoyed high earnings yields vis a vis acquiring shareholders, for
example the acquisitions of Smith and Nephew (Foreman-Peck, 1995). The amalgamations of
the early 1960s transformed the British cotton industry into the most concentrated in the
world (Rose, 2000, p.287). The motivation for these acquisitions was related diversification
from established businesses adjacent to cotton and wishing to control supply. This motive
explained Smith and Nephew’s acquisition of mills in Brierfield and the Rochdale area in the
1950s, the acquisition of Lancashire Cotton Corporation by Courtaulds and ICIs acquisition
of Viyella (Foreman-Peck, 1995, Rose, 2000, Owen, 1999). Product relatedness and
associated economies of scope explain why acquiring firms could in many cases offer a price
in excess of NRV without destroying value for their own shareholders. Rationalization
nonetheless followed acquisition in many cases by the major combines, thereby facilitating
the capacity reduction and asset replacement that had been impossible in the 1920s and
difficult before 1960. For the first time therefore investment in new machinery as a cost
reduction strategy became a realistic option for large sections of the industry.
12
In the
companies taken over by David Alliance that ultimately became Coats Viyella, in Courtaulds
and in Smith and Nephew, old mills purchased from incumbent shareholders were re-
equipped with modern machinery (Ormerod, 1996, Foreman Peck, 1995). Unlike in the inter-
war period the important recovery stage component of the turnaround model could be
26
implemented. Channels of new equity-based financial sources for these projects via City
financial networks were utilized (Toms and Filatotchev, 2004) for the first time since the
reflotation debacle of the 1920s.
13


Implications

The empirical example shows that linkages in process between the main stages of the Robbins
and Pearce, (1992, p.291) model are far from automatic. In the light of the examples it is
worth reconsidering this model and extending its scope with reference to figure 1. Perhaps
most significant, as demonstrated above, is the requirement to add a re-alignment stage as a
precondition for firms entering the retrenchment and recovery stages. However, there are
further and subtler extensions, illustrating the potentially problematic preconditions for
transition in the remaining stages. In the Robbins and Pearce model, financial problems are
addressed at the first retrenchment stage, which aims to stabilize operations and restore
profitability by pursuing cost and/or asset reductions. Recall that the expected return in figure
1 and the subsequent realized level of profit reflects the cost base of the firm. Where cost
reduction strategies are pursued, the process is facilitated where the cost base of the firm is
variable. Where the cost base is fixed, it is more difficult to stabilize cash flow without also
altering the strategic basis of activity. To the extent that financial distress is severe and/or
strategic health is weak, asset reduction becomes increasingly imperative for turnaround
(Hofer, 1980; Pearce and Robbins, 1993). However, as the illustration suggests, the causes of
financial distress may also impact on the disposal value of assets. This is very important
because the effectiveness of asset reduction strategies as a precursor to subsequent recovery
depends substantially on the ability of the firm to generate cash flow from these disposals.
Although the literature uniformly presupposes this to be possible, in the empirical illustration
27
and in the general case there are difficulties arising from asset specificity, liquidity in the
second hand market and similar exit barriers.
Special cases may be derived from the model in figure 1, which illustrate the impact of
combined factors on turnaround strategies. The first is where asset values impose a hard
constraint on exit strategies and prevent constrained firms developing second stage recovery
strategies through reinvestment in product/process innovation. The typical economic model
assumes no capital rationing (Weingartner, 1977), but capital allocation to an industry depends
on governance structures and lending conditions. With very high levels of capitalization, high
asset specificity and low resale values in external markets, financial and physical capital
supply becomes highly inelastic, or subject to hard rationing. In other words, positive net
present value (NPV) projects will be rejected even when the outcome is positive with a high
degree of certainty. Where these conditions apply, it is difficult and perhaps even impossible
for incumbent management to apply the standard turnaround prescription. In the case of
British textiles in the 1920s, sunk investment in old machinery and the attitudes of investors
prevented investment in new machinery, even where firms were otherwise returned to profit.
Low resale values for highly specific assets prevent stabilization of cash flow in the
retrenchment stage. Nor can overhead costs be reduced, where as in this case they arose from
fixed financial claims. Even leaving these problems aside nothing can be done in the recovery
stage even if it can be entered, as the positive NPV projects that must now be rejected are the
necessary investments in new product and process. In terms of figure 1 parameters this means
that however much crisis conditions drive down financial performance, the economic rate of
return from the “do nothing” strategy is superior to the loss of capital associated with exit at
low resale value. Meanwhile lack of cash flow from such realizations and the hard rationing
constraint prevent reinvestment in new products and processes, however profitable they may
28
be. Financial claim holders will therefore rationally, through the governance structure,
impose the “do nothing” strategy on management.
As far as the role of debt finance is concerned, the explanation is similar to Hart and
Moore (1995), but the scenario presented here shows the holders of equity in recapitalized
assets to be in the same position. It follows from the scenario in the 1920s that although debt
compounded the problem, even without debt, outside equity holders can impose similar
constraining strategies on management. In terms of figure 2, although debt made the problem
worse, in the absence of a market for corporate control the turnaround problem would have
been almost as formidable for all equity financed firms. In these circumstances, shareholders
will aim to extract any remaining value from assets in use, for example by undercutting
competitors to obtain marginal contracts. Such limited strategies may further intensify
competition. Where the crisis is generated by a sudden and sustained fall in demand, failure to
exit due to the relationships suggested above will accentuate the crisis further by creating
over-capacity. These features characterized many staple industries in the UK and other
industrialized economies in the 1920s and 1930s. By the 1960s, although the underlying
causes of industry decline remained, turnaround at the level of the individual firm was made
possible by the evolution of the market for corporate control, a mechanism not available to the
politicians and industrialists responding to the slump conditions of the inter-war period.
14


DISCUSSION AND CONCLUSIONS

Some turnaround researchers suggest that retrenchment strategies involving the sale of critical
assets might be detrimental as a result of trading short run survival for longer run strategic
advantage (Barker and Mone, 1994). The ultimate objective of retrenchment is to improve
organizational efficiency and increase performance relative to the environment, but results from
29
the few empirical studies in this area are mixed so far (Bowman et al., 1999, p. 45). Moreover, a
number of studies indicate that across-the-board layoffs and ultimately the relinquishing of
market share may produce performance trade-offs resulting from the loss of critical employees,
lower employee commitment and morale (see, for example, Hoskisson and Hitt, 1994).
The model presented in this paper suggests a more complex story. First, re-alignment
of expectations is required so that principals see the opportunities in terms of revised expected
returns arising from agents’ proposed turnaround strategies. Retrenchment remains an integral
part of the turnaround process for the reasons suggested by Robbins and Pearce (1992), but
realignment is a precondition and governance constraints may therefore prevent the
retrenchment stage being entered. Second and closely linked, the paper has illustrated that
asset sales are not always discretionary and governance arrangements may prevent such
disposals, particularly where outside investors favour their continued use as a means of
fulfilling dividend expectations. As the case above illustrates the problem is acute in
specialized firms, but may be less likely in multi-product firms where managers are more
likely to be able to re-deploy resources from one sector to another. More generally, it is easy
to see how such problems are mitigated by the existence of a market for corporate control, but
without establishing a precise linkage between the existence of such markets and the efficient
deployment of assets. For example, as mentioned above, the market for corporate control may
push managers into downsizing the firm in an inappropriate or harmful fashion (Hoskisson
and Hitt, 1994). Even so, any advantages of strategic flexibility arising from the functioning
of the market for corporate control are only precisely apparent where managers avoid
investment in highly specific assets with associated high levels of fixed cost. Investments in
such assets, which have entry barrier characteristics associated with difficulty of replication
by competitors, are the sine qua non of superior performance according to the SFM theory. In
short, firms cannot have their cake and eat it. They either commit themselves to high fixed
30
cost sunk investments paying the price in the event of a crisis, or they avoid them and thereby
avoid crisis, but instead fail to achieve competitive advantage and only receive the normal
profit levels at the given stage of the business cycle.
Another important implication is that the development of the market for corporate
control is closely related to industry development and therefore more general economic
development where such development depends at least in part on asset restructuring. Other
socio-economic factors often associated with restructuring, such as capital availability via a
functioning stock market and banking system, an educated workforce and a deregulated
economic framework can all be present, as the case illustrates, but are nullified without a
functioning market for corporate control.
Although our research uses historical empirical evidence, this paper has important
implications for more contemporary research on business turnaround, especially in countries
that do not have developed and liquid stock markets, such as transition and developing
economies. For example, in their study of retrenchment and downsizing strategies in
transition countries, Filatotchev et al. (2000) show that in the absence of a market for
corporate control, privatization programmes resulted in insider ownership and a consequent
failure of ailing, formerly state-owned enterprises to restructure and modernize. In addition,
research on the roles of banks in transition economies suggests that over-exposure of financial
institutions to loans to inefficient enterprises created a “systemic failure” when banks impose
financial constraints on restructuring and closure enterprise of heavily indebted failing firms
(Saunders and Sommariva, 1993). The study therefore complements others, which have
examined international variations in institutional contexts. Generalization is limited due to
such variation, although one with important implications for asset restructuring in developing
countries is the relationship between increased market governance and efficient resource
allocation (Hoskisson et al, 2004, p.527).
31
To conclude, the paper has shown that a complete theory of turnaround requires
researchers to incorporate asset valuations as part of their analysis and show how such
valuations influence the selection of strategic options, impose constraints on managerial
action, and motivate their principals to enable or restrict the implementation of such options.
To understand these complex dynamics, researchers should examine the precise options
available to managers through auditing imperfections in the firm’s strategic factor markets,
including particularly financial markets and the market for corporate control. In general they
should develop longitudinal frameworks encompassing industry life-cycles that relate firm
strategic dynamics to the valuation of strategic factor inputs and to structures of corporate
governance.
32
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Figure 1: Financial constraints on corporate turnarounds – an analytical model



Turnaround
stage 1:
Re-alignment
Turnaround
stage 2:
Retrenchment
Turnaround
stage 3:
Recovery
Strategy 1:
Continuation, do
nothing
Strategy 2:
Downsizing,
downscoping, exit
Strategy 3:
Reinvestment,
diversification
ER

> R


ER < R;

NRV > BV
ER < R;

NRV < BV
Shareholders;
Debtholders

Managers
Abbreviations:
ER = Expected return
R = Required rate of return
RC = Replacement cost
BV = Book value
NRV = Net realizable value
Intended strategic change
Key:
Strategic outcome
Profit expectations
Governance relationships
43

Figure 2: Corporate Governance and Turnaround Probability



Market for corporate control Debt/Equity ratio Turnaround Success Probability

Yes Low High

High

No Low

High Low

44



Note: The data series is collated from accounting data for all quoted firms, in the Stock
Exchange Official Intelligence, 1920-1948 and on the Cambridge University Companies
Database, 1949-1985. Return on capital is profit before interest and tax divided by the book
value of shareholders’ equity plus long term loans.
Figure 3: Average Profits in Cotton and Textile Industries,
1920-1985
-5.00
0.00
5.00
10.00
15.00
20.00
25.00
30.00
1
9
2
0
1
9
2
4
1
9
2
8
1
9
3
2
1
9
3
6
1
9
4
0
1
9
4
4
1
9
4
8
1
9
5
2
1
9
5
6
1
9
6
0
1
9
6
4
1
9
6
8
1
9
7
2
1
9
7
6
1
9
8
0
1
9
8
4
Year
R
e
t
u
r
n

o
n

c
a
p
i
t
a
l
45
NOTES

1
Apart from financial, there may be other constraints on strategic restructuring. For example,
in an owner-manager firm, founders or second generation owners-managers may have
personal links with the business that would inhibit them from retrenchment and downsizing,
and this problem is accentuated by a paucity of alternative employment opportunities
(Schulze et al., 2001). This discussion goes beyond the scope of our paper where we focus on
relations between external finance providers and hired managers.


2
Tihanyi et al. (2003, p.197) acknowledged that the identity of owners has important
organizational implications because different owners may have different objectives and
expectations. For example, some authors (e.g., Brickley et al., 1988; Kochar and David, 1996)
differentiate between “pressure-resistant” and “pressure-sensitive” institutional investors.
Pressure-resistant institutions, such as investment funds, are unlikely to have strong business
links with their investors, and they may have stronger influence on strategy choices and their
performance outcomes (Hoskisson et al., 2002). On the other hand, “pressure-sensitive”
investors such as banks are likely to have business relationships with the firms in which they
invest (Kroszner and Strahan, 2001). Because they often have an obligation to support the
management’s agenda, their governance role tends to be more passive compared to “activist”
investors (Tihaniy et al., 2003). However, more detailed analysis of roles and expectations of
different owners goes beyond the scope of this paper.

3
In the 1990s such premiums averaged 40%, although it has been shown that if the premium
is greater than 25% it is unlikely that the acquiring firm will earn back the premium (Sirower,
1997). Some premiums may be appropriate because of the expected synergy while others are
likely to represent overpayments.

46


4
In the UK, in the event of bankruptcy control rights pass to the secured creditors. Conditional
upon default, they have an exclusive right to decide whether, when and how to seize the
company’s assets and liquidate them. A designated secured creditor appoints a registered
insolvency practitioner, the receiver, to take over all powers of the firm’s board, and to make
sure that sufficient funds will be realized to repay the debt to the secured creditor. The
receiver has no duty to consider interests of other lenders, and has decision-making rights
over whether to sell the firm as a going concern or close it and sell it piecemeal (see Franks
and Sussman, 2004, for a detailed discussion). Unsecured creditors have few control rights
and do not participate in the sale of firm’s assets. However, they have some liquidation rights
and they can apply for a winding up of the firm by a liquidator. Unlike the receiver, the
liquidator operates on behalf of all creditors, but without a power to change the order of
seniority (Armour and Frisby, 2001).


5
For example, in their study of bank-driven restructuring of small and medium size UK
companies, Franks and Sussman (2004) indicate that the concentration of collateral and
liquidation rights the hands of the main bank gives it a dominant position in restructuring a
defaulting firm. However, they also find that the bank’s dominance makes it “lazy” in
monitoring, relying heavily on the value of its collateral in timing bankruptcy decisions.
Citron et al. (1997) explore the role of loan covenants in the relationships between banks and
management buy-out (MBO) firms. They find evidence of close bank/MBO relationships and
bank involvement in effecting turnaround of financially troubled MBOs.

6
For example, in their study of 42 failed MBOs Citron et al. (2003) provide evidence that
secured creditors recover only 62 percent of the amount owned. However, this percentage
47

increases where the distressed buy-out is sold as a going concern, which may explain why
banks in their study prefer this form of restructuring. Franks and Sussman (2004) report
similar recovery rates using a larger sample of financially distressed firms in the UK.

7
More recently, banks have endeavoured to avoid liquidations using “corporate recovery”
services provided by accountancy firms. However, although this may help banks to recover a
higher proportion of their problem loans, “corporate recovery” firms cannot eliminated
financial constraints on turnaround strategies of highly leveraged firms.


8
This behaviour resembles what Ross and Staw (1993) call “escalating commitment” when
explaining how organizations become committed to losing courses of action over time. These
authors suggest a number of determinants of escalation that include, in addition to
psychological and social factors, such strategic aspects as project closing costs, salvage value,
“sunk costs”, etc. A possible impact of these factors on banks’ decisions to provide further
finance to failing firms may shed a new light on the limitations of debt-based governance, but
this discussion goes beyond the scope of the paper.

9
The average leverage ratio for all 147 firms was 37% with a standard deviation of 33%,
indicating that many firms were highly levered. If the market value of equity is used instead
of book value, the situation for the highly geared firms was much worse. By 1931, many
companies experienced collapses in share values, resulting in very low market capitalizations.
For example Laurel and Compton spinning companies both had capitalizations of < £5000 but
outstanding debt of more than £40000 (source: Tattersall’s). There were many similar cases.

48

10
Leading accounts of the crisis of the 1920s (Keynes, 1981, Bamberg, 1988) concentrate on
the role of the banks and ignore the shareholders. Such emphasis is incorrect, and the
shareholders played as important role (Higgins and Toms, 2003). The dynamics of the
turnaround model and the coincidence of interest between debt holders and shareholders
highlighted in this paper support the re-interpretation of this chapter of economic history.

11
From 1900 there were waves of mergers in textiles (Hannah, 1979). These were voluntary
amalgamations and associations, often accompanied by stock market flotation or re-floatation
(Macrosty, 1907, Higgins and Toms, 2003). There were no share-for-share bids for control in
the open market and hostile bids on such a basis did not occur in this or any other sector until
the 1960s (Littlewood, 1998).

12
This restructuring was undertaken when the firm became part of larger, vertically
integrated combine, and this represents a departure from the original Robbins and Pearce
(1992) turnaround model that focuses on strategic choices of an independent firm. However,
restructuring strategies involved retrenchment and modernization that are outlined by Robbins
and Pearce (1992) framework.

13
Evidence on re-equipment at Coats Viyella and utilization of financial networks,
particularly nominee accounts held by Rothschilds was taken from an interview transcript
with a former senior executive of the company.

14
There were other legal and regulatory changes that may have had an impact on success or
failure of turnaround strategies during the period of study. For example, the UK contractualist
approach to bankruptcy and liquidation has changed since its formative years in the late 19
th

49

century from not imposing any constraints on the contract to the accumulation of a body of
case law that has standardised particular lending instruments (Franks and Sussman, 2004).
Court-administered Administration and Company Voluntary Arrangements procedures of the
more recent Insolvency Act further even out the allocation of rights in bankruptcy across the
secured and unsecured lenders and provide the company with temporary protection from
creditors’ actions. However important they may be, these legal developments do not change
the main arguments of this paper. Similarly, Note 1 above emphasises possible impacts of
family control on business strategy. Because hardly any new textile firms were founded after
1920 but the attrition rate was slow during the protracted subsequent decline (Rose 2000,
Higgins and Toms, 2003), it is reasonable to suppose that the proportion of family firms to
publicly quoted remained approximately constant.

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