Liquidity versus Solvency: A Lesson in Lacking Money, a guest post by Vic Taglia

As managing partner of GGG and the Turnaround Authority, I get the pleasure of providing guest posts by our other partners. The following post is by our newest Partner, Vic Taglia.

Lehman: From Illiquidity to Insolvency to Bankruptcy to Liquidation

You’re likely familiar with the Lehman failure of 2008. The business model of Lehman and other investment banks relied on leverage of up to 50 to 1 (a 2% capital ratio) and its creditors’ belief that the collateral pledged for these borrowings would maintain its value.

The investment bank business model relies on the market to provide liquidity to allow the investment bank to carry billions of dollars of securities. When Lehman’s creditors began to doubt the value of the securities already pledged, they demanded more collateral.

This led to a liquidity problem; Lehman couldn’t get the cash it needed to operate. When Lehman ran out of collateral to pledge, it had a solvency problem. Bankruptcy and liquidation followed.

Game over.

Understanding the Path to Illiquidity or Insolvency

An industrial business frequently relies on its bankers and other creditors to provide liquidity to operate through open accounts payable and lines of credit. That’s normal.

So long as the business cycle from purchases of raw material through production, distribution and collection remains on schedule, a business can continue to operate. If the schedule is disrupted however, a liquidity problem emerges. Now the business needs to find cash.

Working capital fixes include lengthening payment terms to vendors, offering prompt payment discounts to customers and finding external financing from a friend, a bank or a partner.

This will work until someone loses faith in the business and decides to stop participating in the extended payment terms, the prompt payment discount or the rolling over of bank debt. At this juncture, a new plan becomes critical.

What asset can the business convert to cash? What can it sell for cash now? Equipment, vehicles and real estate are all illiquid assets, but they all have value today—probably much less today than if you had six months to sell, but if you need cash now, you become a very motivated seller.

The end game starts when you discover that these illiquid assets are really illiquid.

Surviving Illiquidity or Insolvency

You can’t sell them fast enough or for enough money to save your business, for instance. If you collect all your receivables, sell all your equipment, all your real estate, all your inventory and still can’t cover your debts, you are now insolvent.

A liquidity problem can lead you to a reorganization filing in the bankruptcy court. Your business can survive a reorganization, perhaps with different owners, employees, and strategies, but insolvency will lead to liquidation.

Illiquidity can be temporary and fixed with relatively simple steps – but you must act quickly. First, identify what can be sold now, for cash.

Insolvency is more difficult; you need more capital, debt relief (forgiveness, payment holiday, etc.) or other more drastic help, and you don’t have a compelling story to attract this help.

Obviously you want to avoid both of these situations. Remember, though, you can survive illiquidity, but rarely insolvency.

What are your experiences with illiquidity and insolvency? Please ask any questions about these differences or what to do if they arise in the comments section below.

Corporate Liquidations Suggest a Double-Dip Recession Might Still Hit

Every pundit and his brother has a prediction about whether or not we’re in for a double-dip recession.

If we’re to believe the government’s indicators and message, our economy is improving. But it’s not hard to manipulate statistics and present them in the best light. After all, part of a recovering economy is consumer confidence and a return to lending and spending.

Companies Keep Going Out of Business

However, based on GGG’s last three years’ client base the economy isn’t looking so up. That is, more of our clients than ever before required asset recovery, surrendered to bank demands, and have operating losses. Even those that turn around are taking longer than our standard experience.

Now, before you go questioning the quality of our turnaround abilities, it’s worth mentioning that for the majority of our history, workouts were 95% of our business model, with a fantastic 90% success rate based on our client’s – not our – goals.

In 2008 and 2009, however, various forms of asset recovery were 50% of our business. More companies out there are failing or have failed and that makes more business for which we just go in to clean up the mess and recover as much value as possible for whoever is getting paid out.

In my opinion, that just sucks. I love turnaround. I love creating value. I love saving jobs. Shooting the company and burying it -though we do that and do it well – are not the sign of a fun time or a healthy economy.

Will We Double-Dip the Chip?

At the end of 2010, we’re still seeing significant asset recovery situations – around 25%.

Sure, that’s better than the 50% of the two previous years, but it’s still high, and as far as I’m concerned, the number of failing businesses that are past the point of turnaround is a sign that we may not be able to avoid a double-dip recession.

Another indicator of this problem – and one with which I work intimately – is the number of companies failing because they can’t find refinancing after the FDIC takes over their failing bank.

The dip might not be deep or as jarring as the first, but history tells us that it will still postpone a decrease in unemployment and a return to a normalcy in lending.

What To Do

So my advice, both personally and corporately: stay liquid.

That’s how our successful clients stay successful and defy market trends at times like these.

Use that liquidity in an emergency, to wait for wonderful investment opportunities or to buy out competitors when they falter – you could get great deals at low multiples or for deeply discounted asset values.

Consider Fortune 100 companies. They’re keeping more cash on their balance sheets than ever before and buying businesses or repurchasing their own stock at traditionally lower prices.

Everyone else may be dipping but staying liquid could keep you floating.

Until next week, watch out for the alligators.*

*I’ll explain the alligators in an upcoming post so stay tuned . . .