Contrasting Informal Turnaround With Turnaround During Formal Insolvency 2004

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

• Timeline Of Financial Distress
• Management-led Turnaround
• Informal Creditor Workout
• Business Rescue

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What is the significance of the timeline of
financial distress model?
TIMELINE OF FINANCIAL DISTRESS
The Timeline Of Financial Distress Model Boasts
An Impeccable Pedigree
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A troubled business not eventually turned around
follows a timeline through four stages
TIMELINE OF FINANCIAL DISTRESS
The Timeline Of Financial Distress
But new business rescue legislation should
deliver a higher success rate.
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Costs increase, but the success rate and
management power decrease as a distressed
business moves along the timeline
TIMELINE OF FINANCIAL DISTRESS
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What are the costs of financial distress, and how
is the success rate defined?
TIMELINE OF FINANCIAL DISTRESS

• 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

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To which stages does turnaround apply?
TIMELINE OF FINANCIAL DISTRESS
Turnaround And The Timeline Of Financial Distress
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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

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The most daunting task faced by turnaround
practitioners is turnarounds that are triggered
to late the rule rather than the exception
TIMELINE OF FINANCIAL DISTRESS

• 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

It is far easier to tread on an acorn than on an
oak tree Neil Harvey.
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Lets 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

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Contrasting Informal Turnaround With Turnaround
During Formal Insolvency

• Timeline Of Financial Distress
• Management-led Turnaround
• Informal Creditor Workout
• Business Rescue

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Turnaround should ideally occur as management
correction
MANAGEMENT-LED CORRECTION
Management-led Correction
Failure of management to react timeously and
successfully to early warning signals of distress
normally leads to intervention by creditors.
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Contrasting Informal Turnaround With Turnaround
During Formal Insolvency

• Timeline Of Financial Distress
• Management-led Turnaround
• Informal Creditor Workout
• Business Rescue

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Should management-led correction fail, creditors
normally the bank(s) intervene
INFORMAL CREDITOR WORKOUT
Informal Creditor Workout
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Informal creditor workouts have advantages, but
serious disadvantages too
INFORMAL CREDITOR WORKOUT
Informal Creditor Workout (2)
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Contrasting Informal Turnaround With Turnaround
During Formal Insolvency

• Timeline Of Financial Distress
• Management-led Turnaround
• Informal Creditor Workout
• Business Rescue

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Business rescue has a number of objectives and
benefits
BUSINESS RESCUE

• 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, SAs business rescue legislation is
antiquated - judicial management and Section 311
Compromises are not effective.
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Promulgation of planned new business rescue
legislation will mark the most significant event
in SAs turnaround industry history
BUSINESS RESCUE

• Judicial management to be replaced by new
  business rescue legislation
• Refer to David Gewers presentation on Business
  Rescue Options Available in South Africa
• Refer to Themba Septembers 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

Turnaround practitioners will, as Business
Administrators, be able to operate within a
turnaround-friendly formal insolvency process for
the first time.
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Business rescue overseas, however, is not without
problems
BUSINESS RESCUE

• 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 companys underlying
  problems are addressed with a turnaround plan or
  sale, Chapter 11 cant 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)

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The success rate of business rescue is low
because it is deemed to be a measure of last
resort
BUSINESS RESCUE

• 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

As a result, a business tends to be in the
Failing Zone of the Z-Score by the time that
business rescue is triggered.
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We identified a number of key success factors for
business rescue in South Africa
BUSINESS RESCUE
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TMA (SA Chapter) and ABASA have different roles
BUSINESS RESCUE
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Business rescue key success factors (continued -
1)
BUSINESS RESCUE
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Business rescue key success factors (continued -
2)
BUSINESS RESCUE
Unless the business is fixed, "business rescue"
has a temporary outcome.
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Business rescue key success factors (continued -
3)
BUSINESS RESCUE
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Questions?
Jan van der Walt CEO Corporate Renewal
Partners Cell 082 853 1414 Land line fax 011
477 4414 Web site www.corprenewal.co.za Email
vanderwaltj_at_corprenewal.co.za