Financial restructuring — Core of business turnround....

CMA. CS. Sanjay Gupta ("PROUD TO BE AN INDIAN") (114220 Points)

30 October 2010

Financial restructuring — Core of business turnround

Financial structure :

Whatever the type of business, an appropriate financial structure is crucial if growth and development are to be nurtured. The financial structure needs to provide maximum flexibility, overlaid against the need for cash flows, working capital, and a return on investment. A company also needs to build in protection against risks, such as interest and exchange rate fluctuations, seasonal economic changes, slow paying debtors and illness or premature death of key players, etc.

An optimal financial structure depends on :

Cost of debt and equity
Risk and return profile of the business
Size of the company
Management control
Floatation cost
Bankruptcy costs

Before finalising the proper financial structure, the following steps should be looked into :

Step 1 :

The required rate of return for pure equity, according to the Capital Asset Pricing Model, depends on how risky the firm or project is relative to the market (its Beta)

ROEU = RF + Beta (RM – RF)

Where,

ROEU = PURE (UNLEVERED) ROE REQUIRED

RF = RISK-FREE RATE

RM = Market Risk

Beta (RM – RF) = RISK PREMIUM (which depends on Market risk premium and Beta)

Step 2 :

Leverage (Debt) increases the expected rate of return on the equity. This is simply because leveraged investments are riskier than unleveraged ones.

ROEL = ROEU + D/E(ROEU – RF)

Where,

ROEL = LEVERED ROE REQUIRED

D/E = DEBT TO EQUITY RATIO

D/E (ROEU-RF) = RISK PREMIUM DUE TO LEVERAGE

Since both the expected return and the risk increase, the net effect on the value of the project is unclear.

Step 3 :

Introduce taxes. Because interest is tax deductible, debt can provide a tax shield. The effect of the tax shield depends on the proportion of debt in the financing mix, and on the corporate tax rate. From the proposition that

Value of levered firm = Value of unlevered firm + Value of tax shield

We can derive the tax version of the Step 2 equation :

ROEL = ROEU + D/E(1 – T)(ROEU – RF)

Where, T = Tax rate

Step 4 :

Use the levered, tax-adjusted required return on equity to find the present value of all future cash flows.

Step 5 :

Change the assumptions as you see fit, either because they are wrong, or to perform sensitivity analysis.

Debt benefits companies by providing a tax advantage, thereby making the cost of debt lower than that of equity. However, if the return of the company is not assured, then a higher level of high debt can prove to be costlier than equity. Hence, debt is a double-edged sword. A proper mix is essential. The size of the company and the nature of the business can also determine the financial structure — the greater the size, the higher could be the debt : equity ratio.

Management control is also a crucial factor in deciding the fate of the company, as diversified control may lead to unconformity of decisions whereas, unified control or majority management control leads to efficient working.

Bankruptcy involves a lot many costs. Direct costs are legal fees and court costs. Indirect costs arise from discontinued operations, the hesitancy of customers to purchase the product and the unwillingness of suppliers to extend any credit. These costs make it unlikely that a firm will push its debt equity ratio very high. If we take the bankruptcy costs into account, then there may be an optimal capital structure where the marginal tax advantage equals the marginal bankruptcy costs.

It should be noted that marginal bankruptcy costs may be different across firms. This may explain why all firms do not have the same level of debt-equity.

Indicators of poor financial health :

A company’s financial health depends on its turnover, revenue generated and its ability to repay its obligations.

The following are indicators that suggest poor financial health :

Quantitative indicators :

Worsening debt equity ratio
Decreasing Debt Service Coverage Ratio (DSCR)
Sub optimal current ratio
High interest/(EBITDA) ratio

Qualitative indicators :

Build-up of current liabilities
Asset-liability mismatch

Reasons for poor financial structure :

A company has to make proper decisions regarding the appropriate structure. However, for various reasons, even the most carefully considered decisions can fail to achieve the desired results.

There are basically two reasons for a poor financial structure :

1. Financing reasons, and

2. Operational reasons

Financing reasons :

Higher than prudent level of leveraging for the industry
Project cost overrun
Funds diversion out of the project
Funding of long-term assets with short-term funds
Bunching debt servicing obligations (Bullet repayment).

Operational reasons :

New project coinciding with a downturn in the industry
Inadequate asset sweating
Operating profits insufficient to service debt
Very high level of receivables/inadequate debtor recovery

Corporate restructuring :

Corporate restructuring means any substantial change in a company’s financial structure, or ownership/control, or business portfolio designed to increase the value of the firm.

Corporate restructuring entails any fundamental change in a company’s business or financial structure, designed to increase the company’s value to shareholders or creditors.

Corporate restructuring can be classified into two types :

Financial restructuring
Operational restructuring.

Operational restructuring is the process of increasing the economic viability of the underlying business model.

General perspective :

In India, financial restructuring is a relatively recent phenomenon. Until now, the only recourse available to financially troubled companies was BIFR.

Only after the erosion of 100% of peak net worth is the enterprise declared sick. However, this approach has not helped; hence, the option of financial restructuring.

So far, the number of instances of financial restructuring are few and companies have realised its importance and started financial restructuring as an option for revival.

Corporate financial restructuring involves restructuring the assets and liabilities of corporations, in line with their cash flow needs, in order to promote efficiency, support growth, and maximise the value to shareholders, creditors and other stakeholders.

Financial restructuring may mean refinancing at every level of capital structure, including :

Securing asset-based loans (accounts receivable, inventory, and equipment)
Securing mezzanine and subordinated debt financing
Securing institutional private placements of equity
Achieving strategic partnering
Identifying potential merger candidates

Restructuring objectives :

Optimal capital structure in line with the earnings capacity of the enterprise, i.e. there should exist a proper debt equity mix that is best suited for the company with respect to its cash flows.
Ensure that cash flows are sufficient to meet financial obligations with a margin of safety.
Enable the company to focus on the new business plan. Financial restructuring enables the company to achieve an optimal capital structure. It helps in maintaining its cash flow, thus enabling the company to focus on new business plans.
Restore investors’/creditors’/other stake- holders’ faith in the company and its management. The restructured company should be in a better position to meet its obligations on time, thus restoring the confidence of the stakeholders.
Create a platform for long-term business growth.

The ultimate objective of financial restructuring is to enhance shareholders’ value.

Key issues for successful restructuring :

For a company to achieve success in a financial restructuring scheme, it has to address the major issues, among them :

Situation analysis :

Situation analysis includes the analysis of all positive and negative factors which affect the working of the company.

Stabilising the capital platform :

For long-term viability, the company should avoid distressed asset pricing that would result in loss of corporate value.

Managing third party objectives

and expectations :

The company has to bring the objectives and expectations of creditors, lenders, lawyers, trustees, etc. in line with the objectives and expectations of the company.

Negotiating a restructured term sheet :

Once the company prepares its restructured term sheet, it has to negotiate and persuade third parties and obtain their consensus.

Understanding equity and credit markets :

A company may need to access new sources of funding/credit for restructuring purposes and hence, it needs to understand the conditions in the equity and credit markets.

Steps for financial restructuring :

Financial restructuring is normally done with the help of advisors. There are no fixed steps in this process.

The following are the probable steps which may be applicable while undergoing the process. The list is not exhaustive. :

Arranging lenders’ meeting to discuss various aspects of restructuring.
Formation of a steering committee of lenders depending on numbers.
Working out various options and narrowing down to the preferred option.
Preparation of business plan and ascertaining the viability of the company.
Approval of the board/appropriate authority of the draft business report.
Presentation of the business plan to the lenders/major shareholders.
Interactive session with the lenders/major shareholders/promoters.
Preparation of final business plan after receiving feedback.
The business plan comprises various options available to different parties. These options are presented to the lenders/major shareholders/promoters for arriving at final options. These options are to be negotiated in order to get final options acceptable to all the parties.
After getting the final negotiated restructuring options, documentation of the same is done.
Finally, the restructuring plan has to be implemented.

Process of financial restructuring :

Phase I : Due diligence and strategic planning :

In this phase, the operations outlook financial prospects and legal process and obligations are looked at. Then it has to assess the stakeholders’ objectives as well and, finally, on the basis of the previous two aspects, it assesses the restructuring options and formulates a restructuring plan.

1. Operations, financial and legal review :

Review key project agreements
Analyse the debt profile, credit facilities and instruments, and debt service obligations
Review/analyse historical operational performance and financials
Analyse sales projections and revenues
Prepare operational and financial forecasts
Construct a comprehensive financial model.

2. Assess stakeholders’ objectives :

Company’s objectives
- All short-term and long-term operational and strategic plans should be achieved
- Management control and flexibility in operations.
Shareholders’ objectives
- Maintenance of operational control
- Equity issuance
- Likelihood and form of additional support.
Lenders’ objectives
- Working capital — banks versus term lenders
- Domestic versus foreign lenders
- Official agencies versus commercial banks
- Lenders’ financial conditions and positions.

3. Assess restructuring options :

Short-term goals
- Evaluate current liquidity and prospects
- Advise on actions to preserve/enhance liquidity.
Long-term goals
- Determine sustainable capital structure that enables company to :
  - Meet its financial obligations
  - Achieve its business objectives including growth
  - Attract additional capital.
  - Prioritise restructuring options by analysing impact on shareholders, company, creditors
    - Serviceable/non-serviceable debt; refinancing versus restructuring of existing debt
    - Sources of debt and equity financing, including strategic and financial investors
    - Debt-equity conversion including convertibles with puts and calls
    - Assess alternatives to improve operating cash flow including revision of contracts.

4. Formulate restructuring plan :

Develop initial restructuring plan
Prepare information memorandum giving details of restructuring plan
Present/sell the plan to creditors
Based on creditors’ reaction refine Restructur-ing Plan to address the needs of lenders in the context of shareholder and company objectives.

Phase II : Negotiations & Documentation :

After the restructuring plan is formulated under phase two, negotiations with lenders and creditors need to be carried out. It is extremely difficult to bring all in agreement. However, once 75% of creditors/lenders agree to it, final documentation can be started to implement the restructuring plan.

1. Negotiations :

Identify ‘key’ creditors who can serve as opinion leaders and prioritise contact with them
Interface with creditors’ advisors (consultants, accountants and lawyers)
Meet with banks — individually and on a collective basis
Prepare and present road-shows as appropriate
Assist management in negotiations
Co-ordinate meetings for negotiations
Co-ordinate meetings
Form Steering Committee (a committee of key lenders).

2. Agreement :

Minimum 75% of the creditors and lenders (by value) must give their consent and agree to the terms of restructuring plan in order to implement the restructuring process.

3. Documentation :

Negotiation of legal documentation
Getting approvals.

Financial restructuring — Options :

Financial restructuring involves a number of parties. Each of the parties has several options.

Companies have to select the options best suited to them. The following are a few of the options :

Options with regard to lenders :

Step up/ballooning of interest rates
Step up/ballooning principal
Waiving of penal interest and deferred payments
One time settlement of loans at a discount
Reduction in interest rate to bring at par or lower than market
Pushback of interest payment and principal instalments be increased in moratorium
Conversion of interest into debt/equity
Write off of part/full debt
Auction of debt to institutions in the market
Debt to equity/preference swap
Issuance of long-term instruments to lenders like zero coupon bonds, etc.

Options with regard to company :

Arrangement of additional funds by way of debentures, loans, shares, business in cash by promoters
Issuance of additional equity with or without options to get additional funds
Change in management
Sale of non-core assets.

Options with regard to promoters :