The aftermath of the pandemic and continuing shock to the economy has caused the balance sheets of businesses and corporations to be severely impaired. The negative effects are expected to continue until there is a clear end to the pandemic. Consequently, businesses are becoming insolvent and mere debt service moratoriums are unlikely to be sufficient, more so for small and medium enterprises (SMEs) that did not have large capital buffers as they entered the crisis. Restructuring and debt resolution offer a viable solution. However, an important challenge is how to achieve fairness in debt resolutions. The first step to achieving fairness is ensuring that the restructuring is consensus-based and conducted transparently, thus enabling meaningful discussions between stakeholders.
Preference for debtor-in-possession restructuring
The preference for restructuring is a workout proposed by the borrower, normally referred to as a debtor-in-possession restructuring. Thus, legislation in many countries has court-assisted processes to enable this type of restructuring. Moreover, detailed analysis by Danaharta (the national asset management company) on the recovery of non-performing loans following the Asian financial crisis (1997-98) demonstrates that debtor-in-possession is the preferred route.
This is compared with liquidation or creditor-appointed judicial managers (during the crisis, special administrators had a similar role albeit not court-appointed) as the entrepreneurial involvement is critical in maintaining the viability of the business and, importantly, preserving the intangible value of the business.
The debtor-in-possession model leverages upon the entrepreneur’s hunger, business acumen and experience, unquestionably critical success factors in a debtor-in-possession restructuring. Further, the borrower, given sufficient time and opportunity, can revive the business, reducing the probability and consequences of laying off workers, and knock-on effects on suppliers, customers and confidence in the sector as a whole, especially if the distressed business is a significant player.
Restructuring that is fair and avoids undesired outcomes
While the above is accepted, the challenge in debtor-in-possession restructuring is the question of fairness to the parties involved in the restructuring. This is beyond the basic requirements of restructuring, which is offering a higher recovery to creditors compared with liquidation, and respecting security positions and ranking of providers of capital.
The perception of unfairness can occur post-restructuring even if all parties agreed to the restructuring with their eyes wide open and there was considerable discussion on fairness during the restructuring negotiations. Post-restructuring, the following are the undesired outcomes if a disposal of the business takes place shortly after the restructuring:
1. Legacy shareholders recover their capital partially while creditors who were in priority suffer losses, thus the creditors feel short-changed; or
2. Providers of new money (hereafter referred to as new money), who should have been in a preferred position, suffer immediate losses on disposal.
Another undesired outcome is the company becoming a zombie with excessive unsustainable debt, defeating the purpose of restructuring. In such cases, perhaps it would have been better that the business was liquidated, and assets sold to others who can better utilise it.
The reference to disposal is an extreme case but a substantial over-performance of the business or a significant upward revaluation of assets post-restructuring could cause legacy providers of capital to feel short-changed and believe representations made during the restructuring negotiations were less than honest.
The above can be avoided if there is a sound understanding of the going concern value as opposed to just the breakup or liquidation value. The desired result is for a restoration of the balance sheet post-restructuring that is right-sized and to facilitate new debt and/or equity investment, which is crucial for growth. Such restructurings should simultaneously optimise the recovery for all stakeholders, recognising their rights, be it in an informal restructuring or a formal scheme of arrangement under company law.
Role of enterprise value in restructuring
Determining the right enterprise value on a consensus basis paves the way to a desirable restructuring outcome where there is a return to year-on-year profitability and growth of the business post-restructuring. Stakeholders should reach a consensus, and failure in determining the right enterprise value will subsequently lead to the undesired outcomes referred to above.
Dealing with impairment
An important component of understanding the enterprise value is an appreciation of the balance sheet and determining if it accurately reflects the carrying value of assets and liabilities. Otherwise, it could be detrimental to new money, which is the lifeblood of successful restructurings (see Diagram 1).
Scenarios for restructuring based on enterprise value compared with pre-restructuring debt levels
There are pertinent scenarios in comparing the enterprise value and the capital structure of the business pre-restructuring. In the first scenario (see Diagram 2), the enterprise value is above the value of debt. If the level of debt is sustainable, then there is no impact on the capital structure. A large portion of restructuring is carried out in this manner with perhaps an element of upfront cash payment and terming out debt with some accommodation of interest charged.
However, if the level of debt is unsustainable and given the desire to achieve acceptable gearing ratios and debt service coverage ratio (DSCR), then part of the debt would have to be converted to equity or hybrid instruments. There is no loss in value to creditors as the value of the hybrid or equity issued commensurates with the intrinsic value of the instrument and the enterprise value. In this case, the enterprise value has been deemed simply to be the asset value/book value, but other means of computing the enterprise value such as the discounted cash flow (DCF) method and earnings basis can be employed.
The characteristics of the post-restructuring balance sheet in this scenario are as follows:
• Surviving debt is sized at a sustainable level — determined using cash flow forecast, that is DSCR and gearing;
• The debt-to-equity conversion is then undertaken with reference to the intrinsic value of the shares or market price, but post-restructuring equity issued to creditors is not the controlling interest;
• The size of capital on the financial statement remains the same post-restructuring but type of capital employed changes; and
• Existing shareholders remain in control and subscription for new shares by existing shareholders is not required to gain control of the company but to support post-restructuring funding requirements.
In the second (see Diagram 3) scenario, the level of debt is more than the enterprise value. In this case, the restructuring becomes more challenging as the capital structure cannot sustain the level of debt even with debt-to-equity conversion. In this instance, the first-loss principle has to be applied and shareholders’ capital has to be written down fully. However, in practice, it is never fully written down as shareholders’ support is required for a debt-to-equity conversion and to sustain the listed status of the borrower.
However, if the write-down of equity holders’ capital is insufficient to match the capital to the enterprise value, then creditors regrettably have to write down a portion of the debt referred to as debt waivers or haircuts. If there is no matching of the capital to the enterprise value, then it is impossible for new equity capital to be injected into the company as they will face immediate loss considering they rank behind creditors. It is critical that the capital structure of the company pre-money — that is prior to capital injection — should equal the enterprise value. The new money, if injected now, reflects fully the new capital of the company. This is shown in Diagram 3.
The characteristics of the post-restructuring balance sheet in this instance are as follows:
• Surviving debt is sized at a sustainable level, meeting the criteria of acceptable gearing ratios and DSCR;
• Equity is substantially written down;
• Remaining debt is then converted into instruments/equity and may be partially waived, and creditors have or would be able to exert controlling interest;
• The size of capital pre-new money on the financial statement is reduced as well as the type of capital funding assets changes; and
• Existing shareholders lose control and subscription of new shares by existing shareholders is also a means to gain control of the company and not merely for post-restructuring funding requirements.
Communicating the restructuring narrative
The computation of the enterprise value and the consequent allocation of capital as described above can be explained rationally as to why it is fair for various stakeholders. This addresses a key challenge in a debtor-in-possession restructuring, that is an acceptable narrative balancing the varying wants of the stakeholders. In the first instance, the narrative must be acceptable and aligned to creditors and existing shareholders for their continued support of the business. They need to be convinced that the compromise made in respect to the stakeholder’s capital advanced is fair. The second narrative must be persuasive for new money to accept the investment risk and reward — that is their investment meets the hurdle rate — and above all, not in a business overburdened with debt and a collapse post-restructuring is imminent.
Revitalisation of the corporate sector with restructuring
In a report following the pandemic, the Group of 30 (an international body of financiers and academics that aims to deepen understanding of economic and financial issues) made several recommendations for governments to evolve effective policies and strategies for the revitalisation of the corporate sector in respect of the economic crisis. The report includes some effective models for government intervention to encourage and facilitate restructuring.
In Malaysia, we are fortunate as we are already ahead of the curve given current practices of existing agencies such as the Corporate Debt Restructuring Committee (CDRC) embracing debtor-in-possession-based restructuring and establishing a clear code of conduct where all stakeholders know the rules of the game.
The informal CDRC mediation process does not require court-assisted restructuring, which involves filings, hearings and others, all of which are costly and time consuming. Moreover, adherence to the Code of Conduct, strict timelines imposed plus coordination with other regulatory agencies such as Bursa Malaysia usually results in quicker restructurings even in large complex cases.
However, the concepts espoused above perhaps have greater practical application to large corporations as listed equity and hybrid instruments are more acceptable to creditors and investors. The challenge is creating a solution for SMEs not to be laden with high levels of debt and to be able to raise new monies.
The Group of 30 report identifies innovative solutions for SMEs centring around policy responses such as industry-led utility models to support servicing and coordination of loans held by banks with private sector expertise and investors. A word of caution is if the matter is purely left to the banks and distressed businesses with no compromise, the risk is it can result in zombie companies that can lead to anaemic economic growth and high unemployment being a feature post-pandemic.
Seeking assistance and help is available
Finally, when faced with insurmountable challenges, businesses ought to seek help. Business owners need to change their mindset of distress/crisis situation. Seeking assistance should not be seen as a weakness but rather viewed as a wise decision and taking charge, ultimately saving the business. There are avenues for the informal approach, which is facilitated by government/regulatory agencies such as CDRC and Agensi Kaunseling dan Pengurusan Kredit — agencies responsible for financial advisory, debt management and small debt resolution schemes.
The edict from the original London Approach, on which CDRC is modelled, envisages that banks have a responsibility to their borrowers in bad times just as in the good times, and forms a sound basis for a fair debtor-in-possession restructuring. Thus, there is no reason why a genuinely distressed business needs to fear seeking help to restructure its business and why the government should not set up specialist organisations and be fully engaged in them to support fair and equitable restructuring.
Ravindran Navaratnam is a partner and executive director at Sage 3, a boutique corporate finance advisory firm advising for major corporations in Malaysia and Singapore. He was formerly the general manager responsible for strategy and corporate finance at Danaharta, Malaysia’s asset management company established at the height of the Asian financial crisis.