Getting your house in order
Understand your counterparty risks
It is very important in the present climate to understand your contracts and your counterparty risks. We are finding an increasing number of clients “stress testing” their contracts and considering the consequence of an insolvency event. This is good practice; particularly since to identify weaknesses in structures and counterparty risk upon insolvency may afford you the time to fix it before things do go wrong.
Where are the documents?
Connected with understanding your contracts and your counterparty risk is knowing where the documents are! In good times the collection of original documents and the file of conditions precedent very quickly gets passed to the junior members of the team and it can be surprising just how much ‘uncertainty’ that can arise in the archive process. If your portfolio includes companies already in distress (or likely to be in the near future) it is advisable to recall the archived documents and ensure that you have all the right originals and registration certificates. You do not want to be in the position of missing crucial papers when the time comes to act quickly.
Record your decisions responsibly
You will invariably have notice of pending financial difficulty. Certain sectors (such as bulk shipping) may be facing significant difficulties irrespective of the quality of your borrower’s assets or management; some borrowers may ‘misplace’ or ‘forget’ to provide the regular management accounts or audited financials or other information typically required under your finance documents may be slow in arriving - these actions can set alarm bells ringing with more experienced bankers.
As the warning signs start to manifest themselves, correspondence between back office, credit, origination and internal restructuring teams will start. All of your teams need to be aware that at some time in the future those emails, which are internal correspondence, may need to be disclosed in proceedings (or in some jurisdictions under data protection laws). Your discussions should therefore be business like and in a manner and tone that avoids professional embarrassment. Make sure your team knows this.
Rescue or not?
In the Asia financial crisis, most defaults were dealt with through a contractual workout borne more out of necessity than desire, as many of the bankruptcy laws gave little creditor protection. In general terms, a number of jurisdictions with more developed insolvency regimes have also moved in the last 10 years towards facilitating a process that seeks to protect all creditors (as opposed to just secured creditors) by fostering an atmosphere, that as far as possible, rescues the corporate or enables it to trade its way through financial difficulty.
For example, in 2003 the right of floating charge holders in the UK to appoint an administrative receiver was (in most circumstances) replaced with the requirement to appoint an administrator who owes duties to a wider body of creditors than just the charge holder.
In some respects there has been a convergence in approach to financial distress between developed and less developed countries with an overall preference to maximize enterprise value as opposed to straight asset disposal. Some Asian countries have in the intervening period updated their bankruptcy regimes (such as China) to facilitate a rescue culture but the processes remain largely untested to date. This convergence arguably gives us (in an Asian context) greater flexibility than ten years ago.
All decisions, when facing a company in financial difficulty, have to be made with a clear understanding of its financial soundness and this can best be determined through a combination of valuation techniques including:
- Discounted Cash Flow
The value of EBIT or EBITDA discounted back using an appropriate discount rate of cost of capital.
- Comparable Multiples
The market valuation multiples of similar companies.
- Asset-based value
The market valuation multiples of similar companies Invariably the book value or market value of assets on a liquidation.
Obtaining the right information from management (particularly current liabilities) and a realistic stress testing of future income is a must to undertake this exercise and access to this information must be the key driver of any willingness to enter into a temporary standstill arrangement when problems first arise.
What are your options?
Acting early and taking advice early are imperatives in this situation. Situations can deteriorate incredibly rapidly and to understand your options and those of other stakeholders are fundamental. The options will include:
- Rescheduling and/or restructuring of debt;
- Asset sales or disposals (known as “Accelerated M&A” in distressed scenarios) perhaps combined with a reduction in head count or retention or replacement of senior management;
- Debt for equity swaps;
- New debt - structures can include super-secured, convertible loans or new loans with stapled warrants;
- New equity - either in the form of equity or junior or mezzanine debt;
- Pre-pack sales at operational level (now common in Europe) or insolvency proceedings being used as a restructuring tool;
- Security enforcement.