Jan van der Walt
CEO: Corporate Renewal Solutions
16 May 2006
Contrasting informal turnaround with turnaround during formal insolvency
Conference: Managing a Turnaround, WBS, 15 – 19 May 2006
Contrasting informal turnaround with turnaround during formal insolvency:
What constitutes a turnaround situation?
Can an insolvent business be turned around?
Timeline of financial distress
Management-led turnaround
Informal creditor workout
Business rescue
Wrap-up
“What's in a name? That which we call a rose by any other name would smell as sweet.” – William Shakespeare
3WBS Conference: Turnaround Management Contrasting informal turnaround with turnaround during insolvency
Stanley J. Goodman
"To produce a noticeable and durable improvement in performance…
to turn around the trend of results from down to up,,,
from not good enough to clearly better…
from underachieving to acceptable …
from losing to winning."
What constitutes a turnaround situation?
WHAT CONSTITUTES A TURNAROUND SITUATION?
Stuart Slatter and David Lovett
"Firms whose financial performance indicates that the firm will fail…
in the foreseeable future…
unless short-term corrective action is taken."
The Turnaround Finance Group
"Turnarounds involve saving an insolvent…
or potentially insolvent business…
from terminal insolvency…
and returning the business…
to a stable financial and operational position."
So does turnaround refer to addressing distressed situations, addressing underperformance, or any improvement?
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Turnaround definition Trigger Triggered by:
Broad definition Reacting to symptoms of decline or failure
Very pro-active board
Management
But happens seldomly
Middle road definition Reacting to profit or solvency crisis
Triggered by a financial stakeholder
–Mostly board
–Sometimes bank
Narrow definition Reacting to cash crisis Bank or other type of lender
A turnaround situation can be defined in terms of the turnaround trigger
WHAT CONSTITUTES A TURNAROUND SITUATION?
Unfortunately, in practice a turnaround tends to be triggered only when a crisis develops.
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Alternatively, a turnaround situation can be defined in terms of the stage of corporate decline
Stage of decline
Visibility Description
Phase 1 Decline – the hidden phase
Visible from the inside
“Pre-emptive turnaround”
Phase 2 decline – the subtle phase
Visible from the outside
“Business correction”
Phase 3 decline – the overt phase
Visible to all “Classic turnaround”
WHAT CONSTITUTES A TURNAROUND SITUATION?
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Definition Financial situation
Management Systems
Turnaround of underperforming businesses
Underperformance Intact Intact
Turnaround of distressed businesses
Distress Intact Intact
Deep turnarounds Distress Good managers have left
Broken systems
Another way is to define a turnaround situation in terms of the seriousness of the situation
WHAT CONSTITUTES A TURNAROUND SITUATION?
Deep turnarounds are the most difficult, and one probably deals with already insolvent businesses.
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When does business transformation become turnaround?
CrisisTransformation / Turnaround
Effective and timeous response to underperformance
No, ineffective or slow response to underperformance
Failure
Liquidation
Turnaround
Turnaround viable Turnaround not viable
FailureTurnaround
Turnaround viable, and effective and timeous response
to the crisis
Turnaround not viable, or no, ineffective or slow response to the crisis
Insolvency
South Africa is waiting for new business rescue legislation to make turnaround during insolvency a reality
WHAT CONSTITUTES A TURNAROUND SITUATION?
Successful performance
Transformation Underperformance
Effective and timeous response to industry drivers
No, ineffective or slow response to industry drivers
From business transformation to turnaround
8WBS Conference: Turnaround Management Contrasting informal turnaround with turnaround during insolvency
For our own branding purposes, we distinguish between business transformation and turnaround based on our mode of involvement
Fin
anci
al p
osi
tio
nC
risi
sN
on
-cri
sis
Insolvency
Time
Decline
Turnaround
Corporate renewal at different levels of financial
health
Remedial business
transformation
Proactive business transformation
Distress
Prosperity
Turnaround: Possible leadership
changes
Emergency management
Funding issues
Rapid pace of execution
More assertive and directive
Business transformation: Leadership alignment
No crisis
Funding not an issue
More measured pace of execution
More participative
It is a case of the business transformation consultant vs. the turnaround practitioner.
WHAT CONSTITUTES A TURNAROUND SITUATION?
Contrasting informal turnaround with turnaround during formal insolvency:
What constitutes a turnaround situation?
Can an insolvent business be turned around?
Timeline of financial distress
Management-led turnaround
Informal creditor workout
Business rescue
Wrap-up
10WBS Conference: Turnaround Management Contrasting informal turnaround with turnaround during insolvency
The financial health of a business can be accurately determined for any performance situation
Z-Score: Thoroughly tested and broadly accepted distress-
prediction model
Developed by Professor Edward I. Altman of the Stern School of Business at New York State University:
– Active participant in the Turnaround Management Association
– Chairs the association's Academic Advisory Council.
The Z-Score applies statistical techniques (Multiple Discriminant Analysis) to financial ratios (profitability, solvency, cash, etc.) to determine the overall health status of a business:
– Healthy Zone: Business is in good shape
– Danger Zone (zone of ignorance, zone of uncertainty): Warning signals, exercise caution
– Failing Zone: High likelihood of bankruptcy within one year
Note that there is are Z1, Z2 and Z3 Scores depending on listed
vs. unlisted, and manufacturing vs. non-manufacturing.
CAN AN INSOLVENT BUSINESS BE TURNAROUND AROUND?
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The most daunting task faced by turnaround practitioners is turnarounds that are triggered to late – the rule rather than the exception
Turnaround action should ideally commence When the Z-Score starts declining, At the latest when a company enters the Danger Zone
In practice, however, turnarounds:– Suffer from late starts, or
– They take too long before taking the shape of a serious turnaround intervention
Once in the Failing Zone, the business is, in the absence of turnaround action, likely to be bankrupt within a year (95% probability)
This situation presents turnaround practitioners with the most difficult scenario possible - that of the "deep turnaround":
– Banks will not lend
– Difficult, if not impossible to find private equity funding
– Suppliers stop supplying, tighten up on credit terms and/or ask for upfront payment
– Key clients will not buy or hedge their bets by shifting their purchases to more stable competitors
– Key staff are long gone to better situations or preparing to move
“It is far easier to tread on an acorn than on an oak tree” – Neil
Harvey.
CAN AN INSOLVENT BUSINESS BE TURNAROUND AROUND?
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Let’s look at an example of how the Z-Score was used to forecast turnaround results at a listed distressed company
2003: Z-Score graph reflects history, and turnaround plan inclusive of debt repayment schedule agreed with bank (informal creditor workout)
Share price was R0-35 at the time
Company not insolvent
Turnaround plan soon thereafter attracted R20m private equity investment (not reflected in Z-Score) at R1-20/share
Share price increased to R2-00 within months
Company adhered to bank debt repayment schedule
Today: forecast problems realised, share price has dropped
Today: bottom 5% of its sector on stock exchange
CAN AN INSOLVENT BUSINESS BE TURNAROUND AROUND?
A business in the Failing Zone has a 95% chance of formal bankruptcy, but can be turned around.
Contrasting informal turnaround with turnaround during formal insolvency:
What constitutes a turnaround situation?
Can an insolvent business be turned around?
Timeline of financial distress
Management-led turnaround
Informal creditor workout
Business rescue
Wrap-up
14WBS Conference: Turnaround Management Contrasting informal turnaround with turnaround during insolvency
The timeline of financial distress provides a timeline perspective to turnaround situations
The timeline of financial distress provides a framework for: Legal considerations
Who is in charge of the turnaround
Cost of a turnaround
Success rate of turnaround
TIMELINE OF FINANCIAL DISTRESS
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The timeline of financial distress distinguishes between four processes
The 4 stages in the timeline of financial distress:
Informal Processes Insolvency Processes
Shareholder-led correction
Informal creditor workout
Business rescue Liquidation
Emerging problems Acute and worsening problems
Insolvency but possible viability
Insolvency and unlikely viability
Turnaround in the absence of creditor and legal issues
Informal agreement between management and creditors (banks) to reduce indebtedness
Present: judicial management and Section 311 Compromise of Creditors
Future: new business rescue legislation
Realisation of the distressed company's assets and the distribution of proceeds to its creditors
Management retains the initiative and controls the turnaround agenda
Terms of workout agreement dictates agenda
Banks hold the power
Court-driven – inflexible and expensive
Historically a low success rate
The timeline of financial distress is adapted and extended from Matthias Kahl, “Economic distress, financial distress, and dynamic liquidation”, Journal of Finance 62 (February 2002) pp.135-168Used by the G10’s Contact Group on the Legal and Institutional Underpinnings of the International Financial System to describe insolvency arrangements and contract enforceability
TIMELINE OF FINANCIAL DISTRESS
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As a troubled business moves along the timeline, costs increase, but the success rate and management power decrease
TIMELINE OF FINANCIAL DISTRESS
Management-led
turnaround
Informal creditor workout
Business rescue Liquidation
Failure
Underperforming company
Timeline of financial distress
Turnaround – stabilised, funded
and fixed
Highest success rate
High success rate
Low success rate Failure
Failure Failure
Time
Informal processes Formal processes
Cost/Success rate
High success rate High failure rate
Low cost High cost
Power of directors and management
High None
Distressed company
Debts worked out and possibly turnaround
Rescued – sold/funded or
turnaroundDissolved
If sold/funded but not fixed
If worked out but not fixed
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What are the costs of financial distress, and how is the success rate defined?
Direct costs: Management consulting fees
Accounting fees
Legal fees
Indirect costs: Additional management time
Loss of employees, customers and suppliers
Success rate: Claimholder recovery rate – traditional measure used by insolvency industry
Company survival rate – more in the spirit of the new business rescue culture
Job retention rate – we would like to see this measure too
TIMELINE OF FINANCIAL DISTRESS
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To which stages does turnaround apply?
Turnaround and the timeline of financial distress:
Informal processes Insolvency processesManagement-led
correctionInformal creditor
workoutBusiness rescue Liquidation
Turnaround applies by definition
Turnaround applies where the intention is to trade a distressed business out of trouble
If the workout intention is to merely restructure the distressed business, only some aspects of turnaround management may apply e.g. crisis management and financial restructuring
Judicial management – not applicable
Section 311 Compromises of Creditors – could be
New business rescue legislation:
– Turnaround can take place within formal insolvency procedures for the first time
– Note that a distressed business can be “rescued” by refinancing or selling it too
Turnaround hardly ever applies
TIMELINE OF FINANCIAL DISTRESS
Contrasting informal turnaround with turnaround during formal insolvency:
What constitutes a turnaround situation?
Can an insolvent business be turned around?
Timeline of financial distress
Management-led turnaround
Informal creditor workout
Business rescue
Wrap-up
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Turnaround should ideally occur as management correction
For directors and management:
Directors and management remain in charge of the agenda
For creditors: Action is taken by
management to protect the exposure of creditors without the need for creditors to intervene or to invoke a formal insolvency process
For all Highest success rate and
the lowest cost of all processes applied to troubled companies
Benefits Companies where early
warning signals of impending distress are recognised early enough and acted upon
Companies that are underperforming but not in financial distress
Distressed companies supported by benevolent shareholders:
Distressed subsidiaries of strong groups which support management-led correction financially
Organisations in the public sector
Where and when
Management-led turnaround:
Triggering normally by a concerned Board of Directors
Most turnarounds take place in the form of management correction
Examples: SA Post Office (Maanda
Manyetshe)
Edgars (Stephen Ross)
Transnet (Maria Ramos)
SAA (Khaya Ngqula)
Further characteristics
Failure of management to react timeously and successfully to early warning signals of distress normally leads to intervention by creditors.
MANAGEMENT-LED TURNAROUND
Contrasting informal turnaround with turnaround during formal insolvency:
What constitutes a turnaround situation?
Can an insolvent business be turned around?
Timeline of financial distress
Management-led turnaround
Informal creditor workout
Business rescue
Wrap-up
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Should management-led correction fail, creditors – normally the bank(s) intervene
INFORMAL CREDITOR WORKOUT
Acute and worsening problems impair a company’s ability to meet its commitments to its financial and trade creditors
This normally leads to creditor invention
A workout follows negotiated agreement outside the legal framework i.e. out-of-court settlement on a plan to reduce indebtedness
Where And When
Informal creditor workout:
Strong workout capability:“Special portfolio", "credit recovery" or "intensive care" departments in credit or risk management structures
Cannot participate in the management or intervene in the affairs of a troubled company, since the rights of other creditors may not be prejudiced
Yet, banks have considerable influence e.g. make continued and/or further support conditional to an independent review of the affairs of a troubled client, and conditional to the submission of credible turnaround plan
In a multi-banked situation a consortium may be formed, which is of great help to make a turnaround work
In a consortium, normally under independent chairmanship, affected banks join forces to:
Ensure a common approach to the problem
Ensure that no single lender steps out of line and prejudices the overall situation for the other lenders
Sometimes spread the risk
Role Of Banks
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Informal creditor workouts have advantages, but serious disadvantages too
INFORMAL CREDITOR WORKOUT
For directors and management:
Secrecy, avoiding the stigma of a more public formal procedure such as business rescue (and avoiding investigation and challenge of directors’ conduct).
Cost savings relative to formal business rescue
For all: Flexibility in the absence of
legal procedures
Success rate (Franks and Sussman study of UK banks):
75% turned around or switched banks
Average time 7,5 months
Advantages
Informal creditor workout (2):
For directors and management: Although management remains in charge, the agenda is
determined by the terms of the workout agreement
For banks: Degree of "free-riding" by other creditors such as trade
creditors and SARS, who offer little by way of solutions, finance and sharing in the risk during the workout, but who share in the benefits should the workout be successful
Dissenting creditors, normally the smaller ones, may derail the workout by reverting to formal insolvency laws
Have to rely on management's promises, capabilities and integrity to execute a turnaround plan
Should a company go into liquidation following an unsuccessful workout, banks run the risk of being accused of having favoured themselves during the workout
Banks are often blamed if job losses occur as a result of the workout
Disadvantages
Contrasting informal turnaround with turnaround during formal insolvency:
What constitutes a turnaround situation?
Can an insolvent business be turned around?
Timeline of financial distress
Management-led turnaround
Informal creditor workout
Business rescue
Wrap-up
25WBS Conference: Turnaround Management Contrasting informal turnaround with turnaround during insolvency
Business rescue has a number of objectives and benefits
The purpose of business rescue is to preserve the going concern value of a distressed firm, that is insolvent but potentially viable, through:
– Turnaround (which may include refinancing), or
– Refinancing, or
– Keeping it afloat and selling it as a going concern (for turnaround/refinancing by the buyer)
A firm that enters business rescue and emerges intact may satisfy creditors' claims more effectively than a firm that is liquidated
Business rescue is meant to allows a distressed firm to:– Satisfy claims of creditors– Continue in the economic stream i.e. source of business for other companies– Preserve jobs and create employment – Pay taxes
However, SA’s business rescue legislation is antiquated - judicial management not effective.
BUSINESS RESCUE
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Promulgation of planned new business rescue legislation will mark the most significant event in SA’s turnaround industry history
Judicial management to be replaced by new business rescue legislation:– Refer to David Gewer’s presentation on legal aspects– Refer to Ntombi Langa-Royd’s presentation on “Developments in the South African
Turnaround Industry” The Business Administrator may have the benefit of:
– Concursus Creditorum: Creditors and employees' positions will be frozen at the time a company is placed under administration, thereby overcoming the free-rider problem experienced by banks when funding informal creditor workouts
– Ringfencing and ranking as to preference of creditors' interests– Moratoria on debt repayment – Cram-down provisions will bind dissenting minority creditors, thereby overcoming one of the
weaknesses of the informal creditor workout It is understood that new business rescue legislation could task a turnaround
practitioner as Business Administrator to:– Determine turnaround viability– Conduct a turnaround if viable
BUSINESS RESCUE
Turnaround practitioners may, as Business Administrators, be able to operate within a turnaround-friendly formal insolvency
process for the first time.
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Business rescue overseas, however, is not without problems
High cost: Direct costs representing 24% of book value on entering business rescue (Nachtman et al,
1999) – but still less expensive than liquidation
Low success rate – the USA experience: Baker Smith, President of Morris-Anderson: "Since over 85% of businesses never
successfully emerge with a confirmed plan of reorganization, the cure must be worse than the illness. Most companies die in Chapter 11. Unless a company’s underlying problems are addressed with a turnaround plan or sale, Chapter 11 can’t ultimately save them."
Many firms increase their investment expenditures only by very little in the first two years after a debt restructuring (James 1995)
In each of the first five years after emerging from business rescue, between 35 percent and 41 percent of all firms have negative operating income (Hotchkiss 1995)
More than 75 percent of firms that complete debt restructurings emerge with a leverage ratio that is higher than industry median and most are still significantly more highly leveraged than before the onset of financial distress (Gilson 1997)
Furthermore, between one quarter and one third of all distressed firms re-enter financial distress within a few years after completing a debt restructuring (Hotchkiss 1995 and Gilson 1997)
BUSINESS RESCUE
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The success rate of business rescue is low because it is deemed to be a measure of last resort
Why a low success rate: Formal business rescue is expensive:
– To save costs, management-led correction and informal credit workout are still attempted when formal business rescue should already be taking place
Stigma of bankruptcy– In countries with a legacy of English law like SA, business rescue taking place under
insolvency laws carries the stigma of bankruptcy, leading to loss of prestige, staff and customers
– This is in contrast to Chapter 11 in the USA where bankruptcy carries less of a stigma
Our new legislation will be creditor-friendly i.e. hostile to directors and management:
– Directors and managers resist business rescue since they lose control when a business administrator takes over
– This is in contrast to Chapter 11 in the USA where directors and managers remain in charge (DIP or debtor-in-possession principle)
BUSINESS RESCUE
As a result, a business tends to be in the Failing Zone of the Z-Score by the time that business rescue is triggered.
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We identified a number of key success factors for business rescue in South Africa
BUSINESS RESCUE
Business rescue key success factorsAvoid the need for formal business rescue
Avoid formal business rescue by promoting timeous and effective reaction to early warning signals of distress through educating business
Expediting business rescue
A stronger legal deterrent to directors trading under insolvent conditions
Avoiding “free-fall” business rescue i.e. don’t start looking at turnaround viability only once formal insolvency procedures have kicked in
Instead, use “prepackaged” business rescue:– To achieve the lower cost of informal creditor workout while achieving the
legislative benefits of business rescue– Achieved by first devising a turnaround plan and then invoking business
rescue
30WBS Conference: Turnaround Management Contrasting informal turnaround with turnaround during insolvency
Business rescue key success factors (continued - 2)
BUSINESS RESCUE
Business rescue key success factorsIndustry associations
Turnaround Management Association - Southern Africa Chapter to:
– Promote the turnaround industry– For purposes of information exchange, networking, education and raising the
standards of turnaround across both the informal and formal sectors
ABASA – Association of Business Administrators of South Africa– To regulate business rescue through admission criteria and powers of disciplinary
action
Education Education of industry and government through TMA and ABASA
Educational turnaround conferences like this one today
Education of turnaround practitioners/Business Administrators:– Certified Turnaround Practitioner (CTP) – exam plus proven track record and
experience
– Admission exam for ABASA – could be the same as the CTP exam
– See Professor David Burdette’s presentation on ACTP
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TMA, SA Chapter and ABASA have different roles
BUSINESS RESCUE
Management-led
Correction
Informal Creditor Workout
Business Rescue Liquidation
Failure
Troubled Company
Timeline Of Financial Distress
Turned Around/Restructured/Sold
Highest Success
High Success
Low Success
Minimal Success
Failure
Failure Failure
Time
X
Informal Processes Formal Processes
TMA (Turnaround Management Association)
ABASA (Business Rescue Regulatory Association)
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Business rescue key success factors (continued - 3)
BUSINESS RESCUE
Business Rescue Key Success FactorsTurnaround finance
Need for a turnaround private equity industry in South Africa:– That invests in distressed businesses too as opposed to underperforming
businesses only
Some banks strengthening their distressed debt capability and preparing for turnaround private equity in anticipation of new business rescue legislation
Turnaround, not mere restructuring
Restructuring alone is OK if positive EBITDA or operating profit, but loss-making due to interest charges
But business rescue of businesses with serious strategic, organisational and operational challenges often amounts to merely stabilisation and restructuring of the business
If the underlying causes of distress are not fixed, the required turnaround is in effect postponed or left to a buyer to address
Business rescue won’t happen without a cheque book, and unless the business is fixed, "business rescue" has a temporary outcome.
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Business rescue key success factors (continued - 4)
BUSINESS RESCUE
Business Rescue Key Success FactorsBusiness rescue scorecard
The success rate of business rescue overseas is low
Yet there is much hype from government and in the press, creating false expectations about the prospects for business rescue in SA
We therefore call for a scorecard to measure and the track the success of all business rescue attempts:
– Number and turnover of businesses that survive business rescue– Percentage of jobs retained as a result of business rescue– Claimholder recovery rate as a result of business rescue– Cost of business rescue– Restructuring, sale or turnaround
Avoiding type 2 error
The purpose of business rescue is to avoid making a Type 1 error (Type 1 error = to liquidate businesses that should be rescued)
Conversely, Type 2 error refers to attempting to rescue businesses that should be liquidated
Type 2 error cost = cost associated with the unsuccessful rescue attempt plus the cost of subsequent liquidation
Contrasting informal turnaround with turnaround during formal insolvency:
What constitutes a turnaround situation?
Can an insolvent business be turned around?
Timeline of financial distress
Management-led turnaround
Informal creditor workout
Business rescue
Wrap-up
35WBS Conference: Turnaround Management Contrasting informal turnaround with turnaround during insolvency
Questions?
Cell: 082 853 1414
Land line & fax: 011 477 4414
Business transformation web site: ww.corprenewal.co.za
Turnaround web site: www.turnaround-sa.com
Email: [email protected]
Jan van der Walt
CEO: Corporate Renewal Partners
CEO: Turnaround Solutions
Divisions of Corprenewal, a black-owned management consulting form specialising in business transformation, and turnaround of underperforming and distressed businesses
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Resume of Jan van der Walt
As CEO of Corprenewal, Jan van der Walt has 26 years' experience in business transformation and turnaround management
In his career he served as both senior accountable executive and in advisory positions in the public sector, and in the private sector with clients as large as R5bn turnover
He has wide experience in devising and implementing leadership, strategy, financial, organisational and operational solutions in business transformation and turnaround projects
Jan is an active participant in business transformation and turnaround management conferences, publishing turnaround articles and guest lecturing in turnaround management at business schools
In 2004 he initiated the Task Group for Organising the Turnaround and Business Rescue Industries, which included 100 representatives from various stakeholder groups in industry
The Task Group spawned:– ABASA - Association of Business Administrators of South Africa - a proposed business rescue regulatory body in terms of
future new business rescue legislation• Jan serves on the Interim Executive of ABASA as Treasurer.
– Turnaround Management Association - Southern Africa, the establishment of which Jan initiated and concluded as a founder member.
• He was voted onto the initial board of TMA-SA as director on 29 April 2005. On 6 May 2005 the board appointed Jan as Chief Executive Officer. On 22 September 2005 he was elected Deputy CEO for 2006. He serves on the International Committee of TMA International.
Qualifications– MBA (Stanford Business School), where he studied with a Fulbright Scholarship and specialised in strategy– Honours B.Sc. in Operations Research (University of South Africa)– B.Sc. Industrial Engineering degree (cum laude) (University of Pretoria)
Web page: www.turnaround-sa.com/team/jan van der walt.asp