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Mike McTaggart on predicting distressed companies

Michael McTaggart, CPA, CA, CBV, LIT
Partner, Consulting & Deals
PwC Toronto

Smart as a whip (he earned the gold medal on the 2013 National Insolvency Exam) and keenly aware of the changing nature of restructuring work, Mike McTaggart has carved out a unique and very successful approach to his insolvency practice. Mike sits down with us to explain how he predicts companies that will get into trouble and why he thinks CCAA filings will bounce back to higher levels.

1) You’re a big believer in using analytics to identify companies in distress. Can you explain some of the tools you use or have created?

I have been running predictive distress models for over 10 years and the information and tools available for analysis today are fascinating. We attempt to go well beyond the tried-and-tested financial ratios which can be quickly run and understood.

Currently our main platform is a machine learning algorithm that essentially runs in real-time on publicly traded financial information (both quantitative and qualitative). The algorithm was developed by leveraging decades of insolvency data and identifying underlying patterns in pre-insolvency financial disclosures which, if better monitored, may have indicated pending distress. For example, we now have an entire series of triggers to look for which we had not previously correlated with financial distress. Leveraging this model to sift through the noise, we’re better positioned to focus on specific industries, sectors or capital structures that are likely going to face significant headwinds.

When we pick up on a company in our model and think it would interest a private equity client or lender we connect the dots and attempt to mobilize quickly. I love this part of the job because you get to test your thesis with some pretty smart people. If the idea and the conversation get momentum it is a lot of fun.

2) How does management of distressed companies typically react when you present them with some of your findings?

I find it fascinating how many companies do not pick up on the symptoms when they start to experience distress. Most CEOs, CFOs and directors are not conditioned to look at their business with the same lens we use and I think this leads to missed indicators in critical situations.

I remember one situation where we had been following a company we identified in our model for a long time. We cold-called the CEO and got a meeting with him and the CFO. On our second or third meeting with the management team, everyone was continuing to dance around the pending liquidity issue we knew was there. Tired of wasting time, we asked, directly:

1) When do you expect the Board to cut the dividend?
2)Have you started to consider options around refinancing your convertible debentures? (which were maturing in 18 months).

Both questions were largely ignored; but, clearly triggered a reaction from the senior management we were meeting with. We eventually got engaged to do some cost reduction work but management was still ignoring the dividend or convertibles question. Fast forward two years later – the dividend has been cut, the stock price has collapsed, an activist investor has taken control of the board, the CEO has been let go, the CFO is gone and the convertibles have been converted with the share price in the pennies, basically wiping out any existing equity….I guess the point of this story was that when we started raising the issues the company had a lot of runway, but by the time they decided to deal with them there wasn’t enough time.

3) You mentioned that your model helps you focus on specific industries, sectors or capital structures that are likely going to face significant headwinds. What are the trends you’re seeing right now?

Bloomberg, the Wall Street Journal, the Economist and the Globe & Mail have all published recent articles on zombie companies. Research shows this trend is an issue in Europe, specifically in Italy, France, Spain and Germany. Tony Simon, an investor from Vancouver has been publishing information on this phenomenon for a while. Here is the definition as published in the Globe, according to economist and author Daniel Lacalle: a zombie firm “is a company that merely survives due to the constant refinancing of its debt and, despite restructuring and low rates, is still unable to cover its interest expense with operating profits, let alone repay the principal.” Google this theory – it is pretty interesting stuff.

I definitely see elements of this theory in our data. There are some companies that I personally have been watching for years that have continued to exist despite poor financial performance. We are trying to understand what is driving this trend and what would be the event or series of events that would cause these companies to seek out transactions to correct their capital structure.

Outside of the model, our team has recently published some interesting points of view on mortgage investment corporations (MICs). We have spent a lot of time talking with successful MICs, lawyers, bankers and regulators on these structures and I think we now have a pretty solid list of risk attributes we would look for in certain MICs.

4) CCAA filings are down this year (14 YTD October 31, 2017) vs last year (37) and previous years. Do think filings will bounce back up? Or is it indicative of any trends, such as the use of other restructuring tools?

Great question. I think we have definitely seen CBCA restructurings getting leveraged a lot on balance sheet restructurings which seems to be a logical move. I think if there is an opportunity to correct a leverage issue by converting debt to equity without disrupting the operations it is probably worth exploring.

In my opinion, the best way to answer the question around the 62% decline in CCAA filings would be to lay out some observations and conversations I have had over the past year:

  • When I talk to our M&A team they are sold out. The same goes for our Transaction Services team. That tells me that there is a lot of money in the market financing deals.
  • The conversations I have had with PE funds is that it is very crowded in the market and multiples are high.
  • When I talk to my contacts in NYC in the distress space they tell me that there are a lot of covenant light notes being issued.
  • The data produced by Bloomberg and others that take pulse of these markets echo those points. Stock markets are near all-time highs while interest rates remain near all-time lows.

If we go back and look at the major drivers of restructuring transactions, mergers gone bad would be towards the top of that list. Paying a premium for synergies that never transpire is a very expensive mistake. So if there are an abundance of deals in today’s market being financed with easy access to leverage at very high multiples, I would say the future looks pretty good for restructuring professionals.

The hardest part about running predictive analysis or developing thesis for distress is that you are often well ahead of the market. It takes the market time to come around and start to notice the attributes our skill set tends to gravitate toward. So the companies we are likely going to be working with in the coming years are the ones that are making the headlines right now.

5) What is one thing that most people you work with would not know about you?

I once hitchhiked over 4,600kms through BC, the Yukon and Alaska…camped the entire way. One of the best experiences of my life. Any chance you get to go north…take it.