Navigating choppy economic times for distressed businesses

In order to stem the risk of bankruptcy and improve deteriorating performance, distressed businesses should consider undertaking a thorough review of their finances, operations and industries in a timely manner. This will help them to identify the causes of distress and assist them to evaluate the full range of potential rescue options. With many businesses experiencing early warning signs of distress, it is important to proactively manage and effectively navigate various factors which can lead to significant distress.

By George Weru, Malvi Chavda & Danvas Mongare

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Prevailing corporate distress in various sectors of the Kenyan economy In the recent past and in the current environment, we have witnessed high levels of financial distress in various key sectors of our economy especially in the retail, real estate, construction and agriculture sectors.

This has led to a number of well-publicized bankruptcies, which begs the question as to what steps management should take to minimize or avoid adverse outcomes of corporate distress such as the risk of winding up, staff layoffs and business closings.

Financial distress is a situation where an entity is facing difficulties meeting its financial obligations. Corporate distress ought to be thought of in the same context as that of a patient. Just as it is advisable for a sick person to consult a physician at the earliest signs of illness, a distressed business should subject itself to examination by qualified experts early enough in order to identify or diagnose the root causes of the distress and propose solutions that will increase the entity’s chances of rescue.

“Diagnosing” corporate distress is usually conducted through a business review covering, inter alia, a review of an entity’s finances, operations and governance structures. Business reviews can be carried out in-house or by a third party “independent” consultant. Independent reviews usually make it easier to win the buy-in of various external stakeholders such as lenders, creditors, suppliers etc., as this avoids concerns around real or perceived conflicts of interest by management. This type of business review for a distressed entity is referred to as an “Independent Business Review (“IBR”).”

Objectives of an IBR The main objectives of an IBR are to identify the root causes of an entity’s distress, assess its viability and formulate possible practical entity-specific solutions to address the distress. IBRs can be initiated by either an entity in distress or, often, on the recommendation of its lenders. IBRs are usually initiated when an entity is struggling to meet its contractual obligations such as the payment of interest and principal or if it is already in breach of other lending covenants. Broadly, the causes of distress can be categorized into business-specific or industry- or sector-related (i.e., macroeconomic) causes or entity-specific micro causes.

Macro versus micro A key consideration in assessing an entity’s cause(s) of distress is to determine whether it is specific to a particular entity, or limited to the industry or sector in which the entity operates, or a result of general economic conditions. In most instances, distress is caused by a combination of macro and micro factors where the weaknesses in a company’s overall health are exacerbated during a downturn in the overall economy or in the sector in which the entity operates. As Warren Buffett once said, “Only when the tide goes out do you discover who's been swimming naked.”

For example, the operationalization of the Standard Gauge Railway impacts the transport and logistics sector and can cause a sharp reduction in the volume of cargo available for transport by road from the port of Mombasa to Nairobi. Media reports suggest businesses at the Coast and in the logistics sector are feeling this impact, exacerbated by some of the health and safety delays related to fighting the spread of COVID-19.

Determining the nature of distress will inform the appropriateness of proposed recommendations. Entity-specific causes of distress including poor corporate governance and overleveraged and misinformed expansions may call for entity specific solutions such as management changes, the sale of non-core assets to reduce debt and debt restructuring.

Early action allows for the best range of options; our observation and experience indicate that delays in addressing the problem and then in taking decisive action limits the options available in dealing with the distress.

Corporate governance Poor corporate governance often contributes to distress. Corporate governance speaks widely to various aspects of business oversight including board constitution and operation, company strategy, management structure and planning and the control environment. Most often, corporate governance matters are (wrongly) overlooked at the expense of day to day management activities such as financial and operational aspects of the business.

In the context of corporate distress, the importance of corporate governance has been bolstered by various initiatives such as the provisions of the Insolvency Act 2015 of Kenya holding the officers of a company responsible for engaging in wrongful trading. Other initiatives include the Capital Markets Authority (“CMA”) Code of Corporate Governance Practices for Issuers of Securities to the Public, 2015.

Proper corporate governance structures facilitate the proactive identification of challenges facing the company, hold management responsible for changes, provide proper oversight over an entity and guard against insolvent trading allegations. Corporate governance is crucial because no solution for a distressed business is likely to work effectively without committed, candid and qualified board and management.

Post IBR recommendations At the end of the business review exercise, actionable solutions or recommendations are usually made by the reviewer. The solutions or recommendations depend on a number of factors such as the debt of the business, the availability of assets that can be liquidated to reduce the borrower’s debt, the operational efficiency of the business and expected developments in the industry or market in which the borrower operates. Other considerations include the goodwill and proactiveness of the board and management in implementing the recommended solutions.

The solutions should be customized to the situation at hand. There is no one-size-fits-all approach. However, there are a number of tools that could be employed to seek to relieve the distress of the borrower including financial and operational or organizational restructuring, or even insolvency-based solutions such as administrations, creditors voluntary arrangements, receiverships or liquidations.

Corporate restructuring Corporate restructuring options are remedies available to distressed entities while their business(es) is still viable. These options are available outside formal insolvency proceedings and they are flexible such that they can be designed to meet the requirements of the various stakeholders involved. For a restructuring to work there needs to be commitment from all stakeholders including business owners, the board, management, senior lenders, suppliers and others.

From our experience, it is important for lenders or creditors to agree to a standstill period to provide an opportunity or breathing space to enable the business to evaluate viable restructuring options, especially where multiple lenders or creditors are involved. Corporate restructuring is categorized into management/organizational restructuring, operational restructuring and financial restructuring.

Management/organizational restructuring seeks to streamline an entity’s organizational structure, management suitability, size of the workforce etc. Operational restructuring aims to address problems related to working capital management, operational inefficiencies, cost reduction and the internal control environment. Persistent operational challenges would call into question the viability of a business in the longer term. Financial restructuring is recommended when an entity’s cashflows are insufficient to meet its debt servicing needs or an entity is over-geared. Financial restructuring therefore aims to lower an entity’s debt service to levels that can be sustained by an entity’s cashflows. Common options available in financial restructuring include changing or altering existing loan arrangements, entering into new borrowing arrangements or raising new finance such as through rights issues, conversion of debt to equity etc.

Alternative funding sources such as debt funds are gaining broader acceptance in the market due to, inter alia, traditional lenders becoming more stringent in their lending, greater flexibility from the alternative lenders than from traditional commercial banks (although often at a higher cost) and tighter lending procedures by traditional commercial banks. Borrowers should however be cautious when seeking alternative funding financing as these arrangements sometimes come with riders that may be costly to the business. From our experience, both financial and operational solutions are both often needed to address challenges facing distressed businesses.

Insolvency solutions Insolvency solutions are governed by statute, which in Kenya is the Insolvency Act 2015. The Act is geared towards the rescue of insolvent companies as opposed to the previous insolvency regime which was geared towards asset realizations for secured lenders. A salient feature of the Insolvency Act 2015 is the moratorium afforded to a company in administration against enforcement actions. This provides the entity with an opportunity to re-organise its affairs in a conducive environment without the threat of enforcement from creditors. The moratorium ringfences an entity’s assets and liability against enforcement actions giving it the opportunity to continue its main business operations with minimal interruptions. It is also possible to execute the financial and operational or organizational restructuring solutions within an administration scenario.

Under the right conditions, insolvency can be a useful remedy for stakeholders of distressed businesses. The appointment of a Licensed Insolvency Practitioner (“LIP”) provides an opportunity to focus on cash-positive business operations and eliminate cash-negative businesses. Should the rescue of a distressed business not be possible, insolvency provides for an orderly wind down process for an entity’s operations; the law provides for how any realizations are to be distributed amongst the various classes of creditors, etc. This removes the stakeholder rumble-and-tumble that can occur when an entity becomes bankrupt.

Conclusion It is critical that proposed recommendations are well thought out, take stakeholders concerns into consideration and can be implemented within feasible timelines. The cardinal objectives of a business review are that it should be practical and provide entity-specific recommendations and solutions to address an entity’s distress. An overarching requirement in addressing challenges facing distressed businesses is the need for early action as most of the adverse results of distress are due to delayed inaction by management.