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Jan van der Walt, Corporate Renewal Partners 19 October 2004 Contrasting Informal Turnaround With Turnaround During Formal Insolvency Conference: Managing.

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Presentation on theme: "Jan van der Walt, Corporate Renewal Partners 19 October 2004 Contrasting Informal Turnaround With Turnaround During Formal Insolvency Conference: Managing."— Presentation transcript:

1 Jan van der Walt, Corporate Renewal Partners 19 October 2004 Contrasting Informal Turnaround With Turnaround During Formal Insolvency Conference: Managing A Turnaround, Wits Business School, 18 – 22 October 2004

2 3 The Trails, 127 Linden Rd. Sandown 2196, Sandton Contrasting informal turnaround with turnaround during formal insolvency  Conference: Managing a turnaround  Wits Business School 18 – 22 October / Let’s clear up some confusing concepts and terminology at the outset TERMINOLOGY Is Turnaround Synonomous With Corporate Recovery/Business Rescue? A sustainable turnaround has only taken place once the causes of distress have been reversed - including fixing the business - mere refinancing and selling alone provides only temporary relief. Business Rescue  Banking fraternity – distressed business has: –Switched bank, or –Been turned around  Legal definition - going concern value has been maintained – distressed business has: –Been refinanced, or –Been sold, or –Been turned around Corporate Recovery  Recovery of value for shareholders i.e. turnaround, or  Recovery of amounts owing to creditors by other means? In practice it means liquidation i.e the latter! Under UK insolvency law, the winding up of a company with 100% claimholder recovery rate is regarded as a successful “business rescue”

3 Contrasting Informal Turnaround With Turnaround During Formal Insolvency :  Timeline Of Financial Distress  Management-led Turnaround  Informal Creditor Workout  Business Rescue

4 3 The Trails, 127 Linden Rd. Sandown 2196, Sandton Contrasting informal turnaround with turnaround during formal insolvency  Conference: Managing a turnaround  Wits Business School 18 – 22 October / What is the significance of the timeline of financial distress model? TIMELINE OF FINANCIAL DISTRESS Where we found the model  Used by the G10’s Contact Group on the Legal and Institutional Underpinnings of the International Financial System …  … to describe insolvency arrangements and contract enforceability The Timeline Of Financial Distress Model Boasts An Impeccable Pedigree: Where the model originated from 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 How we used the model in South Africa  Employed by the Task Group for Organising the Turnaround and Business Rescue Industries (See Themba September’s presentation: “Developments in the SA Turnaround Industry)…  … to spawn two industry associations: –Turnaround Management Association (South Africa Chapter) –ABASA (Association of Business Administrators of South Africa)

5 3 The Trails, 127 Linden Rd. Sandown 2196, Sandton Contrasting informal turnaround with turnaround during formal insolvency  Conference: Managing a turnaround  Wits Business School 18 – 22 October / A troubled business not eventually turned around follows a timeline through four stages TIMELINE OF FINANCIAL DISTRESS The Timeline Of Financial Distress: Informal Processes Insolvency Processes Management-led correction Informal creditor workout Business rescueLiquidation Emerging problemsAcute 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 Compromises 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 But new business rescue legislation should deliver a higher success rate.

6 3 The Trails, 127 Linden Rd. Sandown 2196, Sandton Contrasting informal turnaround with turnaround during formal insolvency  Conference: Managing a turnaround  Wits Business School 18 – 22 October / Costs increase, but the success rate and management power decrease as a distressed business moves along the timeline TIMELINE OF FINANCIAL DISTRESS

7 3 The Trails, 127 Linden Rd. Sandown 2196, Sandton Contrasting informal turnaround with turnaround during formal insolvency  Conference: Managing a turnaround  Wits Business School 18 – 22 October / 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 – more in the spirit of the new business rescue culture  Job retention – we would like to see this measure too TIMELINE OF FINANCIAL DISTRESS

8 3 The Trails, 127 Linden Rd. Sandown 2196, Sandton Contrasting informal turnaround with turnaround during formal insolvency  Conference: Managing a turnaround  Wits Business School 18 – 22 October / To which stages does turnaround apply? TIMELINE OF FINANCIAL DISTRESS Turnaround And The Timeline Of Financial Distress: Informal Processes Insolvency Processes Management-led correction Informal creditor workout Business rescueLiquidation Turnaround applies by definition  Applies to workout 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! –But a distressed business can be “rescued” by refinancing or selling it too Hardly ever

9 3 The Trails, 127 Linden Rd. Sandown 2196, Sandton Contrasting informal turnaround with turnaround during formal insolvency  Conference: Managing a turnaround  Wits Business School 18 – 22 October / The financial health of a distressed business can be accurately determined in any stage of financial distress TIMELINE OF FINANCIAL DISTRESS 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 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

10 3 The Trails, 127 Linden Rd. Sandown 2196, Sandton Contrasting informal turnaround with turnaround during formal insolvency  Conference: Managing a turnaround  Wits Business School 18 – 22 October / The most daunting task faced by turnaround practitioners is turnarounds that are triggered to late – the rule rather than the exception  A management-led turnaround should ideally commence at the latest when a company enters the Danger Zone  In practice, however, management-led correction and informal creditor workouts: –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  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 TIMELINE OF FINANCIAL DISTRESS “It is far easier to tread on an acorn than on an oak tree” – Neil Harvey.

11 3 The Trails, 127 Linden Rd. Sandown 2196, Sandton Contrasting informal turnaround with turnaround during formal insolvency  Conference: Managing a turnaround  Wits Business School 18 – 22 October / Let’s look at an example of how the Z-Score was used to forecast turnaround results at a distressed company TIMELINE OF FINANCIAL DISTRESS Outcome  Turnaround plan agreed with bank (informal creditor workout)  Board restructured  Turnaround plan attracted R20m private equity investment  Share price increased from R0-35 to R2-00 during first few months  Company has been adhering to bank debt repayment plan to date

12 Contrasting Informal Turnaround With Turnaround During Formal Insolvency :  Timeline Of Financial Distress  Management-led Turnaround  Informal Creditor Workout  Business Rescue

13 3 The Trails, 127 Linden Rd. Sandown 2196, Sandton Contrasting informal turnaround with turnaround during formal insolvency  Conference: Managing a turnaround  Wits Business School 18 – 22 October / 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 Benefits MANAGEMENT-LED CORRECTION  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 Correction:  Triggering normally by a concerned Board of Directors  Most turnarounds take place in the form of management correction  Highest success rate and the lowest cost of all processes applied to troubled companies  Examples:  SA Post Office (Maanda Manyetshe)  Edgars (Stephen Ross) Further Characteristics Failure of management to react timeously and successfully to early warning signals of distress normally leads to intervention by creditors.

14 Contrasting Informal Turnaround With Turnaround During Formal Insolvency :  Timeline Of Financial Distress  Management-led Turnaround  Informal Creditor Workout  Business Rescue

15 3 The Trails, 127 Linden Rd. Sandown 2196, Sandton Contrasting informal turnaround with turnaround during formal insolvency  Conference: Managing a turnaround  Wits Business School 18 – 22 October / 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

16 3 The Trails, 127 Linden Rd. Sandown 2196, Sandton Contrasting informal turnaround with turnaround during formal insolvency  Conference: Managing a turnaround  Wits Business School 18 – 22 October / 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  Creditors have to rely on management's promises and capabilities 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

17 Contrasting Informal Turnaround With Turnaround During Formal Insolvency :  Timeline Of Financial Distress  Management-led Turnaround  Informal Creditor Workout  Business Rescue

18 3 The Trails, 127 Linden Rd. Sandown 2196, Sandton Contrasting informal turnaround with turnaround during formal insolvency  Conference: Managing a turnaround  Wits Business School 18 – 22 October / 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, or –Refinancing, or –Keeping it afloat and selling it a going concern  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 –Preserve jobs and create employment –Pay taxes However, SA’s business rescue legislation is antiquated - judicial management and Section 311 Compromises are not effective. BUSINESS RESCUE

19 3 The Trails, 127 Linden Rd. Sandown 2196, Sandton Contrasting informal turnaround with turnaround during formal insolvency  Conference: Managing a turnaround  Wits Business School 18 – 22 October / 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 “Business Rescue Options Available in South Africa” –Refer to Themba September’s presentation on “Developments in the South African Turnaround Industry”  The Business Administrator will 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 in 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 envisaged that new business rescue legislation will task a turnaround practitioner as Business Administrator to: –Determine turnaround viability –Conduct a turnaround if viable BUSINESS RESCUE Turnaround practitioners will, as Business Administrators, be able to operate within a turnaround-friendly formal insolvency process for the first time.

20 3 The Trails, 127 Linden Rd. Sandown 2196, Sandton Contrasting informal turnaround with turnaround during formal insolvency  Conference: Managing a turnaround  Wits Business School 18 – 22 October / 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

21 3 The Trails, 127 Linden Rd. Sandown 2196, Sandton Contrasting informal turnaround with turnaround during formal insolvency  Conference: Managing a turnaround  Wits Business School 18 – 22 October / The success rate of business rescue is low because it is deemed to be a measure of last resort Why A Low Success Rate:  The cost of formal business rescue is prohibitive: –Management-led correction and informal credit workout are attempted first  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  Our new legislation is hostile to directors and management: –It is expected that directors and managers will resist business rescue since they will lose control when a business administrator takes over, and they fear the negative impact on the business of the stigma of bankruptcy –In contrast to Chapter 11 in the USA where directors and managers remain in charge, and where bankruptcy carries less of a stigma 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.

22 3 The Trails, 127 Linden Rd. Sandown 2196, Sandton Contrasting informal turnaround with turnaround during formal insolvency  Conference: Managing a turnaround  Wits Business School 18 – 22 October / We identified a number of key success factors for business rescue in South Africa BUSINESS RESCUE Business Rescue Key Success Factors Expediting Business Rescue  Promoting timeous and effective reaction to early warning signals of distress through educating business by a turnaround industry association  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 Industry Associations  Turnaround Management Association (South 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

23 3 The Trails, 127 Linden Rd. Sandown 2196, Sandton Contrasting informal turnaround with turnaround during formal insolvency  Conference: Managing a turnaround  Wits Business School 18 – 22 October / TMA (SA Chapter) and ABASA have different roles BUSINESS RESCUE

24 3 The Trails, 127 Linden Rd. Sandown 2196, Sandton Contrasting informal turnaround with turnaround during formal insolvency  Conference: Managing a turnaround  Wits Business School 18 – 22 October / Business rescue key success factors (continued - 1) BUSINESS RESCUE Business Rescue Key Success Factors Education  Education of industry and government through TMA and ABASA  Education of turnaround practitioners/Business Administrators: –Certified Turnaround Practitioner (TMA) – exam plus proven track record and experience –Admission exam for ABASA (after the interim period) – could be the same as the CTP exam –In advanced stage of negotiations to obtain the body of knowledge (9 000 pages) for the CTP exam to make it available to SA universities –University of Pretoria is already planning turnaround course in 2005 with 3 modules (turnaround management, accounting and law) Turnaround Finance  Need for a turnaround private equity industry in South Africa  Some banks strengthening their distressed debt capability and preparing for turnaround private equity in anticipation of new business rescue legislation  Government’s R2bn turnaround fund?

25 3 The Trails, 127 Linden Rd. Sandown 2196, Sandton Contrasting informal turnaround with turnaround during formal insolvency  Conference: Managing a turnaround  Wits Business School 18 – 22 October / Business rescue key success factors (continued - 2) BUSINESS RESCUE Business Rescue Key Success Factors Turnaround, Not Mere Restructuring  The components for a sustainable turnaround are (1) the enablers - leadership, stakeholder and project management, and (2) stabilising, (3) funding and (4) fixing the business  Business rescue often amounts to stabilisation and restructuring of a business  While these actions are necessary components of a turnaround, they are seldom sufficient for a permanent solution to maintaining the business as a going concern  The business may have been "rescued" through these actions e.g. a new lease on life through restructuring or having been sold, but if the underlying causes of distress are not fixed, the required turnaround is in effect postponed or left to a buyer to address Unless the business is fixed, "business rescue" has a temporary outcome.

26 3 The Trails, 127 Linden Rd. Sandown 2196, Sandton Contrasting informal turnaround with turnaround during formal insolvency  Conference: Managing a turnaround  Wits Business School 18 – 22 October / Business rescue key success factors (continued - 3) BUSINESS RESCUE Business Rescue Key Success Factors Business 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  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 –Restructuring, sale or turnaround Avoiding Type 2 Error  The purpose of business rescue is to avoid making a Type 1 error i.e. to liquidate businesses that should be rescued  Conversely, Type 2 error refers to attempting to rescue businesses that should be liquidated  Type 2 error has major cost implications  The total cost consist of the cost associated with the unsuccessful rescue attempt plus the cost of subsequent liquidation

27 3 The Trails, 127 Linden Rd. Sandown 2196, Sandton Contrasting informal turnaround with turnaround during formal insolvency  Conference: Managing a turnaround  Wits Business School 18 – 22 October / Jan van der Walt CEO: Corporate Renewal Partners Cell: Land line & fax: Web site: Questions?


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