The Daily Deal
September 4, 2003Source: The Daily Deal
"Their Life's in turnaround" by Vyvyan Tenorio
September 5, 2003
5:00 pm ET
New York, NY, (September 5, 2003) - It took Kaleil Isaza Tuzman a good two years to convince Dan Hart of the need to recapitalize Echo Networks. But in February, after months of intense negotiations, the San Francisco-based streaming music service provider that Hart heads re-emerged as Echo, a Los Angeles-based digital music subscription service. The company was backed by CD retailers, including Best Buy Co., Tower Records and Wherehouse Entertainment Inc. — and an equity investment from Isaza Tuzman's New York-based restructuring advisory firm, Recognition Group LLC.
Recognition is one of a handful of niche workout firms now equipped with a complementary private equity arm designed for special situations such as Echo Networks'.
The investment was just one aspect of Recognition's role as a catalyst for the transaction everyone agreed was critical to the company's survival. Echo Networks had struggled with its online subscription services business model because the record companies were reluctant to license independent middlemen. The new entity hopes to capitalize on the trend toward downloading content with its new backing from the brand-name retailers.
It is the sort of transformation that resonates with Isaza Tuzman, 31, a CEO turned restructuring expert and investor. He knows what it means to flame out. His electronic billing startup, Govworks.com, rode the bubble with about $60 million of venture capital before a fateful plunge into failure; it became the subject of the 2001 documentary hit "Startup.com."
That experience proved invaluable. The articulate, Harvard-trained executive has since redirected his considerable talents to fixing not only small, troubled companies, but also some larger, public enterprises as well.
He's got lots of company. The corporate turnaround business has ballooned into a burgeoning industry, a testament to the spreading contagion of troubled businesses.
The Turnaround Management Association, a trade group in Chicago, now boasts a membership of more than 6,000 professionals, roughly double the number five years ago.
Large distressed investment specialists, such as AlixPartners LLC; Apollo Management LP; Angelo, Gordon & Co.; GSC Partners; KPS Special Situations Fund LP; MatlinPatterson Global Advisors LLC and Oaktree Capital Management LLC, tend to overshadow the small players. These firms have funds at their disposal that can take stakes in companies undergoing turnarounds.
Since the downturn, hundreds of consultants have cropped up — many of them ex-CFOs and laid-off investment bankers. Only a few of these smaller shops have ventured into investing, however. "Not many investors feel comfortable investing in a turnaround without strong prospects of immediate returns," says Randy Lewis, a former bankruptcy lawyer and management consultant who heads Resolution Management Partners Inc. out of Denver. "It has to be a really exceptional opportunity to get people's attention."
It's also a tough niche business. "This is a very difficult way to make a living," says Michael Psaros, managing principal of New York's KPS Special Situations Fund, whose funds invest in larger, midmarket distressed companies. "It usually takes months, sometimes a year or more, to work on companies, and there is a significantly higher degree of risk than [with] traditional buyouts." On the smaller end of the spectrum, a few firms, such as Magna Partners LLC of Oak Brook, Ill., and Capital Risk Management Inc., of Framingham, Mass., have parallel investment vehicles.
Tim Czmiel, one of 300 certified turnaround professionals in the U.S. and a former Arthur Andersen restructuring consultant, co-founded Magna Partners in 2001. Magna's consulting business, which plans to raise its first fund in the fall, is focused on small midmarket companies in the manufacturing, industrial and healthcare sectors. Capital Risk Management, launched in 1996, specializes in turnarounds and distressed-debt situations. Last year it added a private equity arm, Blue Sky Ventures LP, to bid on banks' distressed loans. Blue Sky's $21 million fund, raised from wealthy individuals, targets companies with revenues between $20 million and $50 million. It leverages the companies and then works to turn them around. The goal is 20% internal rates of return. So far, it has made one outright acquisition and five investments in "stranded" venture-backed companies whose backers were tapped out.
Recognition Group, launched in late 2000, started off as an adviser, but it began to raise a small private equity fund almost immediately, after it saw opportunities arising from the advisory side as capital sources dried up. Its $17 million KIT Capital Fund, backed by institutions and individuals, now invests in distressed companies with up to $150 million in revenue. "There's a lot you can do with that amount of money because these companies are often right at the cusp," Isaza Tuzman says. "They're not underwater with $100 million in debt, but they'd have $10 million in debt which you can negotiate down to maybe $1 million. Then, if you have a little bit of equity, you can get over the hump." When the firm started in late 2000, it initially emphasized venture-backed technology companies. But it found that VCs were very slow to the punch in restructuring ailing startups. "Venture funds often try to hide the problem and therefore get to it too late," Isaza Tuzman says. "Sometimes that's because they don't want to have to report a loss to their LPs, so they sweep it under the rug or try to do it in-house." The problem for VCs, he says, is that building companies and restructuring them involve very different skill sets. Moreover, VC-backed companies typically have very complex capital structures with several different classes of stock, convertible debt, trade financing and debt. To sort them out when things go sour requires workout expertise, he says. In the current economy, Recognition has been busy, Isaza Tuzman says. It now has three partners and four principals, as well as an office in Washington. In addition to IT and telecom, Recognition works with diverse companies in the New York area, both public and private, in sectors such as food, transport, shipbuilding and infrastructure. To date, it has bid on six companies and invested in three, including the minority stake in Echo.
One portfolio company, KPE Inc., a New York digital media agency, is a point of pride. Recognition took on KPE in November 2001, at a perilous moment. "It was on the verge of not making payroll and had a lot of debt," recalls Isaza Tuzman, who was appointed interim CEO the next month when his firm became an adviser. Recognition decided to acquire majority interest alongside an additional infusion from the previous owner, publicly traded New York advertising firm Grey Global Group Inc. Another existing shareholder, New York's Wasserstein Ventures, a VC affiliate of Wasserstein & Co., did not participate. (Wasserstein & Co. is the parent of the fund that owns The Deal LLC. The Deal also retained KPE for some Web design work in 2000.)
As Recognition saw it, the company had a strong brand; very good client relationships including Princess Cruises, Sony Corp. and Warner Brothers Home Entertainment; and a solid management team. But it was loaded with debt and had lost focus. Along the way, it had branched into venture capital, taking equity in small Internet companies in exchange for its services. With the economic downturn, revenue shrank from $20 million to about $6 million. And it had enough leased office space in New York, London and Los Angeles for a company 10 times its size — leases signed at the peak of the bubble. "Our feeling was, we'd go to the landlords and say, 'Look, unless we're able to restructure the leases and extend the payments, this company will file for bankruptcy and you'll get nothing,'" Isaza Tuzman says. The landlords agreed to make adjustments; so did the creditors. The London office was spun off for a small sum. The company went from 200 employees to 50, then to 30.
The next step was equally challenging: changing the culture from fear to hope. "We sat with the team, who didn't trust anybody, so we laid out everything on the table," Isaza Tuzman says. Overhead costs were immediately reduced. A budget was created and posted on the company's Web server for the staff to access. "We threw privacy out so everyone knew what everyone's salaries were costing," he says. "Kaleil came in and literally brought the company back to life," says Stephen Davis, a New York attorney whose firm, Heller Ehrman White & McAuliffe LLP, represented KPE. In about two months, KPE was again profitable. By late February 2002 it was sold to Mobilocity Inc., a New York mobile technology services provider, for an undisclosed sum. In the summer Mobilocity itself went bankrupt and KPE's assets were sold to Agency.com Ltd. of New York, but Recognition posted a very significant return.
Most of its cases are highly complex workouts. In one project that became an investment, Recognition started out as a crisis manager to MBS Inc., a Burlingame, Calif.-based human resources events organizer, in early 2001. MBS was sold to PureCarbon Inc., which provided hiring and recruitment technology services. In the course of the MBS sale, Recognition also found an opportunity for PureCarbon to be sold to Nasdaq-listed Workstream Inc., an Ottawa-based provider of human capital management technology. MBS shareholders could potentially benefit from the sale by participating in a bridge loan for PureCarbon. Recognition piggybacked on the investment, in which the investors garnered shares in Workstream. Recognition is now in the process of selling its shares — for a "good" return, Isaza Tuzman says.
The recapitalization of Echo was no less complicated. Founded in 1999, Echo Networks operated one of the largest and most popular streaming music Internet sites. But it found itself without capital as the economy headed south and VCs headed for the hills. It was on its way to obscurity. Isaza Tuzman began engaging CEO and founder Hart in conversations on possible options. "It was clear that the model didn't make sense and private equity would not come in," Hart says. An investment consortium of music retailers seemed the logical solution, but it was Isaza Tuzman who helped Hart come to grips with the idea of restructuring. "The deal was driven by market factors, but Kaleil got me through the shifting landscape and how to cope with it personally," Hart says. "He was like a mentor."
The company had few employees but plenty of creditors and investors, including BMG Entertainment head Strauss Zelnick. With the recap, "We were dealing with more than 50 interested parties," Hart says. Recognition Group got paid for some advisory work, though it ended up not charging for much of Isaza Tuzman's time. The firm did, however, take a small equity share in the reconstituted entity, betting that with the retailers' backing the business would ultimately be successful. "Sooner or later, online consumers are bound to pay for retail subscriber services in much the same way they've subscribed to Apple's iTunes music service," Isaza Tuzman says.
Much of the deal flow for consultants typically comes from banks, lenders, law firms or investors. "You're hired primarily to help a company out of a troubled situation," says Lewis Goodman, a former bankruptcy lawyer who set up his own restructuring advisory firm, Wyndhurst Associates LLC of Baltimore, in 1996. "To look at that company as an investment that benefits your firm is something to be leery of because there could be a significant conflict of interest." Goodman says his firm did have an investment fund in the early days. But he decided that Wyndhurst could best serve the interests of clients as a pure turnaround consultant. Isaza Tuzman, who began his career as a banker for Goldman, Sachs & Co., says his firm never advises and invests at the same time, even though deals emanate from the advisory side. But if his firm is interested in investing, it states its intention up front and clears it with the client. Often, he says, a company is in such dire need for capital that it jumps at the investment. "You have to remember we're dealing with pretty thirsty entities," he says. "Anytime you have water, arguing over the shape of the glass or the temperature of the water is not what happens in the real world."
In those situations where companies are on the brink of insolvency, he says, recapitalizations aren't "subtle" about valuation issues. "You're doing a complete cramdown anyway," he says, referring to the steep equity dilution that earmarks distressed investing. "If there's anyone willing to put in any money, God bless them, and welcome to the table!" Once his firm becomes an investor, it stops advising, he adds. "It's the same as with any investment bank," he says. But, he adds, there's always a risk that deals won't get completed, and having forsaken its advisory role, the firm has also forsaken advisory fees. "You're not certain whether the deal can get done since you haven't completed your due diligence," he says. "It's a fairly risky path." In restructurings, negotiations with owners, particularly in family-owned businesses, are frequently emotion-charged affairs. "People can be very belligerent, sometimes irrational," he notes. Isaza Tuzman thinks it's a tough business that's not always rewarding. "Some people think that restructuring is kind of masochistic, because it's the same amount of work — if not more so — than traditional private equity work, and the returns aren't always better as an asset class," he muses. But he isn't complaining. Coming from his own bittersweet past as head of a failed company, Isaza Tuzman has plenty of empathy to offer clients. He takes comfort from the "psychic benefits" of a successful engagement. As he acknowledges, "You've got to have the right personality for this job."
Contact:
Recognition Group, LLC
Kaleil Isaza Tuzman
212/774-3701
Source: Daily Deal, September 5, 2003