Introduction
Since the global financial crisis that took place in mid 2007 till early 2009, there has been growing concern that the corporate sector is being burdened with too much debt. This has resulted in an ongoing concern which is founded in the belief that highly-leveraged firms could default in large numbers in the event that there is major recession or unprecedented crisis such as the very challenging Covid-19 pandemic.
Many of financially distressed firms choose private renegotiation of their corporate debt rather than seek bankruptcy protection. There has been a number of insights into the corporate debt restructuring decision in which about half of financially distressed firms successfully restructure their debt outside of the bankruptcy protection procedure. If strategically and appropriately negotiated, financial distressis more likely to be resolved through private renegotiation when more of the firm’s assets are intangible, and relatively more debt is owed to banks or financial institutions. On the other hand, private negotiation is less likely to succeed when there are more distinct classes of debt outstanding owed to many different trade creditors.
Shareholders generally fare better under private renegotiation than bankruptcy protection application. The market usually anticipates and appears to be able to identify which firms are more likely to succeed at restructuring their debt outside of the bankruptcy protection procedure. Private contractual arrangements for resolving corporate default are generally less costly to the legal remedies provided by the bankruptcy protection procedure.
Corporate Default and Debt Restructuring
In the event of corporate default and in the face of debt restructuring, a firm must restructure the terms of its debt contracts to remedy or avoid default and it is commonly faced with two choices; it can either file for bankruptcy protection or attempt to renegotiate with its creditors privately. The alternatives are similar in that relief from default is obtained when creditors consent to exchange their impaired claims for new securities in the firm depending on circumstances and other factors.
Whether financial distress is resolved through bankruptcy filing or private renegotiation depends on two factors. First, stockholders and creditors will collectively benefit from settling out of court when private renegotiation generates lower costs than bankruptcy. Second, the lower-cost alternative will be adopted only if claimholders (creditors) can agree on how to share the cost savings. Attempts to settle privately are more likely to fail when individual creditors have stronger incentives to hold out for more favourable treatment under the debt restructuring plan.
Bankruptcy practitioners determines that efforts to settle outside of the bankruptcy filing are more likely to succeed when relatively less debt is owed to trade creditors, and more is owed to bank lenders. The difficulty is particularly severe for trade debt as the number of trade creditors is usually quite large, and their claims are relatively different. A debt restructuring plan is commonly considered successful if the firm does not file for bankruptcy within a year of the last reference to the restructuring.
If, however, the firm cannot move back successfully along the value line, then distress may grow to the point that the firm’s value decreases sharply (assets value deterioration) and perhaps to its liquidation value in extreme cases (e.g. Hyflux Singapore, The Business Times, June 2021). This will occur when disappointing cash flows occur, lowering the unlevered value of the firm, and/or asset sales are disappointing or impossible (usually due to changed market conditions) and coupled with unprecedented crisis that was previously not expected nor factored in (scenario planning).
Corporate Failures – Why do they happen?
Without a doubt, the most plausible reason for a firm’s distress and possible failure is, among other things, managerial incompetence. There are many reasons for failure, and of course, most firms fail for multiple reasons, but management incompetence isgenerally at the core of the problems. As corporate failures dictate, the ultimate cause of failure is usually simply running out of cash, but there are a variety of reasons that contribute to the high number of corporate failures and other distressed conditions in which firms find themselves.
These reasons include:
- Unsustainable decline in revenue.
- Deteriorated assets value.
- Huge capital expenses.
- Enormous financial losses due to unsuccessful expansion.
- Chronically unhealthy industries in the market.
- Deregulation of key industries.
- High real interest rates in certain periods.
- Increased leveraging leading to overleveraging.
- Huge corporate debt.
- Slow and pro-longed corporate restructure.
- Unprecedented crises (global financial crisis, Covid-19 crisis, etc)
Managing a Financial Turnaround – What should be done to avoid corporate bankruptcy?
Corporate Deleveraging – Cutting down the financial leverage
As corporate finance suggests, to be successful a highly leveraged firm must reduce its debt substantially and usually within a short period of time after the restructuring transaction to strengthen its balance sheet. It goes without saying that firms with toxic debt can face a substantial blow to their balance sheets. Consequently, failure of not achieving this deleveraging is apparent leading to the consequent increase in corporate defaults and possibly bankruptcy if not achieved substantially and timely.
Deleveraging can be done voluntary (financial strategy) or not and the latter can result from forced distressed exchange issues whereby the creditors of a distressed firm agree to accept a package of new securities in lieu of the existing debt. Invariably, this package contains equity in the troubled firm which tests the ability for firms to accomplish an equity-for-debt swap. Deleveraging can also be prompted by the fear of a crisis situation such the unprecedented Covid-19 crisis where firms are exposed to even greater debt risks.
Leveraged Restructuring – How to increase corporate value
Depending on its shareholders’ interests, firms can explore some financial scenarios in which case a restructuring of the permanent capital could increase firm value. First, a firm can do a debt-for-equity swap and second, a leveraged buyout (LBO). These two leveraged restructuring strategies are seen as commonly used by many companies and institutional investors to unlock corporate values.
Debt-for-Equity Swap: This financial scenario involves a debt-for-equity swap, or exchange, which is a type of leveraged recapitalization in the corporate finance. On top of the commonly derived tax benefits inherent in a debt-for-equity swap, there is evidence that a firm’s exchange offer is usually perceived and interpreted by the market as a signal about the ability to generate future cash flows in the company. The leverage-increasing exchange offers could result in decreases in debt risk and increases in earnings, sales, and assets for the firm.
Leveraged Buyout (LBO) Restructuring: This financial scenario also covers the same initial condition, except now the swap is an extreme one with all of the equity purchased through a leveraged buyout (LBO) and the public firm becomes privately owned. Most LBO and financial restructuring advocates state that a firm will usually become more efficient in its cost management and productivity increases after it goes private as the firm implements the discipline of debt management as a good motivation for increasing firm values and not to mention the tax benefits that may be obtained.
On the other hand, those who oppose LBO restructurings debate that the enormous debt will burden new investment and puts the highly leveraged firm at a distinct long-term disadvantage. Further, optimistic forecasts of higher earnings and cash flows and successful asset sales do not always materialise and the huge amounts of debt cause good companies to falter. In these problem situations, both the new debt and equity holders could lose a significant proportion of their investment.
Firms can minimise the risks of business failuresto increase value through:
- Redesigning, redefining and implementing an overall strategic turnaround and restructuring plan for their businesses;
- Obtaining strategic consultation for the financial turnaround;
- Getting consultation services by addressing bankruptcy risks or firm failure;
- Negotiating for a debt restructuring (e.g. debt-for-equity swap, LBO);
- Injecting more equity financing (right issue, additional new share capital, etc);
- Selling assets or closing down their unprofitable business;
- Deleveraging and cutting down the financial leverage or corporate debt and
- Executing a priority timeline for corporate turnaround.
From a corporate perspective, deleveraging commonly strengthens balance sheets. It is a sound financial management strategy and commands a strategic course of action to get a corporation back on the right track.
With their experienced and strong corporate team in place, firms usuallyimplement strategic priorities and execute actions well in avoiding future bankruptcy risk situations should they are faced with the financial distress and possible bankruptcy.
How to Achieve a Successful Financial Turnaround
- Create financial turnaround strategies.
- Install an experienced and competent financial turnaround team.
- Negotiate debt restructuringstrategically and quickly: Do not wait too long to restructure and turnaround, if there are signs of trouble. The faster the better, to avoid a financial deterioration.
- Conduct accurate assessments: If firms have an accurate assessment, they can refine their strategies and execute them quickly well.
- Reduce business complexity and streamline operations and structure;
- Focus on core activities and processes and maintain critical roles;
- Align senior leaders and managers’ tasks and responsibilities;
- Manage uncertainty and resistance through regular communication; and
- Stay agile and flexible during the financial turnaround period.
No firm is immune from failure. The most important thing is that the leadership and management team must be able to execute the financial turnaround strategies, so that more time is available for managing debt, negotiating and restructuring it to avoidfinancial distress, further crises and to remain in business and stay in the game.
