Underperformance

Financial underperformance is often caused by multiple intertwining factors and for that reason effectively addressing it requires a comprehensive solution.

Welcome to Base of the Pyramid. This newsletter focuses on providing insight into business transformation, restructuring, and turnaround as these concepts apply in the lower middle market (the broadest definition of which I have come across defines this group in the U.S. as companies ranging from $2.5mm to $100mm of revenue, of which there are over 500,000). My aim is to serve as a resource for business owners, executives, service providers and key decision makers active in this world. I look forward to your comments and feedback.

It's early days. A few skeletons are bound to keep jumping out of the closet.

- Alan Moore, Watchmen

Overview

Joann, a craft retailer, recently announced that it would be filing for bankruptcy in order to effectuate a restructuring of the company. On the surface this is not a particularly noteworthy development. Retail as a sector has had more than its share of struggles. Many retailers, facing rising costs, lagging growth, the need to meet consumer omnichannel expectations, declining foot traffic, and unsustainable levels of debt, have pursued restructuring (both in and out of bankruptcy court) in recent years. The sector is troubled, and its challenges continue, with a large number of retailers considered to be at risk of bankruptcy in the near future.

In the case of Joann, however, the story is more complicated. The company had only recently emerged from a prior bankruptcy filing. On March 18, 2024, the company filed for chapter 11 bankruptcy, and it emerged with a confirmed plan of reorganization on April 25, 2024. In short, Joann lasted just over 300 days, from one bankruptcy filing to the next. This is abnormal.

Notwithstanding the morbid curiosity that attracts lurid interest in car crashes and other can’t look away incidents, it is fair to ask why the situation at Joann should matter for those fortunate enough not to be a party to this particular mess. The answer is that Joann’s struggles are illustrative of a tendency of financing underperformance to persist and for underperforming companies to be their own worst enemies, consistently defending an unsustainable status quo and rigorously pushing back on any initiative aimed at creating a new, and value accretive, equilibrium.

What is a useful way to think about underperformance? What tendencies keep companies stuck in a rut of chronic underperformance? How can leaders guide companies out of the rut of underperformance? Let’s dig in.

The Nature of Underperformance

Underperformance is not a prison sentence, doled out maliciously to otherwise virtuous companies and their leadership. Rather, it is more akin to the suffering of the penitent who has forgotten that the hand which brandishes the scourge is their own. It is foremost a mental prison, built brick-by-brick of critical assumptions which evidence whispers no longer apply but which fear insists still hold sway.

Some key points on underperformance:

· It is often rooted in fear. The ambiguity of new paradigms haunts the underperforming company, with the comfort of the status quo and the uncertainty of change standing out as the imposing Scylla and Charybdis of this dynamic.

· It is prevalent. In a recent research paper Edward Altman (NYU), Rui Dai (Wharton Research Data Services), and Wei Wang (Queen's University) examined global “zombie firms”. The team utilized multiple criteria for defining a zombie firm, but the definition I favor considered a firm to be a zombie if the three-year moving average interest coverage ratio (EBITDA / interest) was less than one. Essentially, if profit is consistently insufficient to cover interest expense, the company is a zombie. By this definition, in 2020 19.5% of U.S. publicly traded companies qualified as zombie firms (see Exhibit A). As noteworthy as that finding is, back of the envelope math suggests that the number of zombie firms in the U.S. lower middle market could be staggeringly high (see Exhibits B and C).

· It is a signal. Like pain in the human body, underperformance is a signal to a complex system that something is wrong, and that the status quo is unsustainable, perhaps even harmful.

· It works slowly. The Altman et al research paper found that 15.3% of U.S. zombie firms filed for bankruptcy eventually, with the average time to filing being nearly 4 years after the company achieved zombie status. This implies that on average, a publicly traded zombie could spend seven years or more limping along before eventually restructuring (for smaller, non-public companies it is not hard to imagine some sustaining themselves in this state for far longer).

· It is sustained by stubbornness. Underperformance can be understood as a value destructive equilibrium in which key decision makers are playing the wrong game and refuse to stop.

Exhibit A: Zombie Firms (Publicly traded)

Exhibit B: Zombie Firms (Est. U.S. lower middle market)

Exhibit C: lower middle market estimation methodology

A Transformation Mindset

There is a silver lining for zombie companies, if they are willing to avail themselves of it. Business transformation, especially starting from a state of distress, is an incredibly powerful value driver. The reason that distress is, counterintuitively, a compelling starting point for business transformation is that in moments of existential crisis, everything is on the table, and as such radical, previously unthinkable change becomes conceivable. It is this openness, this tabula rasa moment, that is the glorious and yet fleeting opportunity that distress bestows: a moment of crisis for a company can become the first chapter of a new story of reinvention and value creation. But only if the opportunity is seized, and too often, it is not.

A transformation mindset is marked by:

· Clarity. Being goal-oriented and having a clear, well-defined sense of what success looks like is a crucial, yet often under-appreciated element to a successful business transformation.

· Objectivity. A willingness to accept a present state of distress / underperformance is a necessary but not sufficient condition to any successful business transformation.

· High expectations. Excellence has no upper limit, but mediocrity eagerly imposes a low ceiling on itself and finds contentment in a prison of its own creation. Because of this dynamic, high expectations bias companies towards excellence and inoculate against mediocrity.

· Imagination. One of the greatest advantages that transformation professionals have over incumbent leadership in driving change is the ability to think outside of the framework of a company’s recent history and imagine something new. Very often unexamined industry practices combine with idiosyncratic factors to create and sustain a vicious cycle of value destruction within underperforming companies. Outsiders are often better able to spot these toxic dynamics and are less inhibited in addressing them.

· Patience. This is both the element that marks the cornerstone of successful business transformations and also the crucial organizational gut-check that too many companies fail. Decision makers (owners, lenders, leadership, employees, customers, suppliers, etc.) must be on board for a transformation process. It is often the time component that results in transformational change being taken off the table for companies, as they seek the sugar high of quick fixes that do not address the root causes of underperformance. Restructuring is fast. Turnarounds are fragile. But addressing all that must be wrong with a company for it to meet the definition of a zombie, and rebuilding that company requires both broad scope and considerable duration.

Conclusion

A shockingly large percentage of companies exhibit signs of persistent financial underperformance. Extrapolating from academic research, it seems plausible that in the U.S. lower middle market alone, between approximately 98,000 and 147,000 companies meet the definition of a “zombie firm”. These companies find themselves mired in this value destructive state for a host of reasons, and as a result comprehensively addressing root causes can be challenging. Many companies, Joann being only a recent example, have found that significant investments in change initiatives fail to address the root causes of underperformance and as a result the impact of these change initiatives is evanescent, wasting time, money, and eroding the morale of all involved. Only through a comprehensive business transformation can the causes of the systemic underperformance of zombie firms be addressed and remediated.

About the Author

David Johnson is the founder and managing partner of Abraxas Group, a boutique advisory firm focused on providing leadership and support services to companies in need of transformational change. He is an accomplished thought leader with multiple articles and speaking engagements on the topics of business transformation, change management, performance improvement, restructuring, turnaround, and value creation to his credit. David can be reached at: david@abraxasgp.com.