Marko Simoneti and Božo Jašovič
Indebtedness of companies (non-financial corporations) is one of the main reasons for stagnation of lending activity of the banks. Slovene companies are one of the most indebted in the Eurozone, taking into account the leverage ratio. At the end of 2011, the ratio deteriorated for Slovene companies despite the deleveraging and reached 143 per cent of equity capital. This information proves that over-indebtedness of companies in the years before the crisis, when standards of indebtedness and investment criteria were loose, is not the only issue; there is also reduction of companies’ capital due to unfavourable market situation and poor operating results. To reach a more stable level of leverage ratio (ca. 100 per cent), Slovene companies would need to decrease the debt by over EUR 5 billion and, at the same time, increase the equity by the same amount. *
The other side of over-indebtedness of non-financial corporations during the risky and crisis situation shows as a deterioration of loan portfolio, which harms the capital adequacy of the banks. Banks are caught in a vicious circle: instead of cleaning their portfolios immediately and thoroughly, admitting the losses and starting to deal actively with bad debtors, the entire process is developing too late, gradually and not decisive enough from the financial aspect. This is why there was no visible success in the restructuring of companies so far.
Huge indebtedness of companies also shows in high ratio between the loans and deposits. Indebtedness of banks, which are intermediary institutions and act with high leverage, is measured by the ratio between loans and deposits of the non-banking sector. This ratio shows how much the banks are financing their intermediary activity through deposits obtained from their clients and how they depend on the wholesale financing sources. At the end of 2011, this indicator for Slovene banking system was 137 per cent and was higher than the average of banks within the Eurozone (113 per cent). To bring the level of indicator for Slovene banking system closer to the average value of the banks within the Eurozone, banks should decrease the loans to non-financial institutions by over EUR 5 billion and deleverage by the same amount at the wholesale market abroad.
Solving the high indebtedness of companies should therefore include solving the deficit of companies’ equity as well as bank deleveraging. The first stage of the latter is merely an accounting operation (instead of loan, bank shows equity investment), whereas further stages, depending on the success of management of such equity stakes, may lead to selling these investments and decreasing dependency of banks on the sources from abroad. Substituting these sources with the state’s deposits and borrowing from the ECB, which is what is going from the beginning of the crisis, is limited and only means buying time for more gradual but inevitable adjustment of our banks and companies to the new, after-crisis financing circumstances.
Possible solutions: Debt-to-equity swaps with the goal of selling
In the current situation, when over-indebted, poorly capitalised entities prevail in the sector of non-financial companies, it is possible to say that a part of companies’ debt to banks actually shows the character of capital. To put it differently, if the banks assess that certain loan receivables from companies will not be completely repaid, this means that the credit risk was materialised to the extent that the losses spread to company’s creditors. These situations are typical of companies with low capital, where the company creditors are not protected enough by the equity against the loss. In the above example, the debt of company’s creditors is worth as much as the company’s assets and what is important for the creditors (banks) is that they establish control over the company and, in this way, indirectly, over its assets.
The equity must be primarily provided by the companies’ owners (local or foreign, if there are no local). Many of the Slovene companies find themselves in the position when their owners have no assets and they are of no interest to foreign owners or investors because of their over-indebtedness or financial instability. In such situations, creditors (the banks) must provide sufficient equity in the first stage and, in this way, enable the company to survive if it has a sustainable business model, and afterwards search for a long-term owner.
Banks may provide equity for the company in a way that they replace all or a part of their debt with equity. In this way, the above described first stage is realised. It probably does not need to be emphasised that the banks are prepared to replace their credit debt with equity only when it becomes clear that the debtors will not be able to fulfil their obligations. It is also important to establish whether the debtor actually has a business potential, otherwise bankruptcy is a better solution and the assets of the dead company are liquidated. When the bank decides for a debt-to-equity swap, it faces the following issues:
- It has to evaluate the so obtained equity holding in the company and recognize losses in its credit portfolio,
- It has to establish and implement the activity of management or co- management of the company where the equity stake was obtained,
- It has to start searching for an investor and sell the equity stake individually or together with other banks or co-owners.
Managing of acquired shares or stakes demands knowledge and experience which the banks lack. This is especially true when the company needs to be actively governed, which includes at the minimum the activities related to the preparation of programmes of operational and financial restructuring, appointing the managements and their supervision. Additional activities need to be taken into account related to searching for potential investors and managing the procedures of selling the equity stakes. The bank’s goal is to sell such equity stakes or shares as soon as possible and to regain as much assets, from the loan that was granted, as possible. When the capital investments obtained by debt-to-equity swap are sold, the above described second stage is realised.
The question of valuation of capital investment seems trivial at first sight, however, it is related to the aspects of debt-to-equity swap. Firstly it is a question of efficient management team that is leading operational and financial restructuring of the company. Since the bank is not specialised in the activities of the real sector, the evaluation of these depends on the potential of the management hired and on its capability of successful supervision.
In the process of valuation it is important to know what was the percentage of debt that was replaced for equity by the bank. Banks often act opportunistic and are prepared to sacrifice only as much debt to cover the negative equity. Such practice is unsuitable from several aspects.
Replacing debt that does not provide bank’s control over the problematic company is questionable and can represent a grant to the former owners, since the possibility of selling the minority stakes is questionable. The situation is opposite when taking over the majority stake and the bank takes over the control over the management and implementation of the restructuring programme. In such situation, the bank can count on realization of positive potential upon the sale of the investment, especially if the sale is carried out transparently and in the international competition of investors.
The structure of company’s financing must be subordinated to its potential cash flow and if the company’s liabilities are still too high after the debt-to-equity swap, than all free cash flow is taken over by the creditor banks. The operations of the debtor are still at risk and we can be sure that it will not be possible to find an investor willing to invest in such a company. The owners invest in equity only because they expect future cash flow from the investment. They will not invest if it is not probable that they will receive any benefits. The banks must provide appropriate ratio between debt and equity to the company in order that the latter becomes interesting for the possible new owners.
Debt-to-equity swap in the company does not automatically mean that the company is saved. Through the swap, the bank admits that it will not receive a complete refund of its original claims and at the same time, conveys the message to the owners that they have lost the invested capital. The swap is formal acknowledgement of the situation described above and at the same time means accepting the responsibility for further restructuring of the company. In the role of the owner, the bank has a higher risk, which is why it discounts the future benefits at a higher discount rate. This seems logical, since through debt-to-equity swap it formally accepts the investment in relation to which it assumes all risks of the company’s creditors. On the other side, the bank as the owner can expect future benefits from this (upside potential) which are shown at valuation. The valuation principle that takes into account the assumptions of successful restructuring and sale of the company should be encouraged by the bank regulator if all conditions for successful investment management are met.
From this aspect, it is highly important that the banks are organized accordingly for this role. Furthermore, the regulator should consider the option of requiring from them to transfer their equity stakes or shares to the special purpose vehicle. Such measure would contribute to several goals: it would ensure professional management of stakes or shares which requires a constant supervision of managements and their implementation of recovery programmes, it would enable active search for investors for these companies and, last but not least, it would enable efficient and transparent sale of the company, which is also the ultimate goal. Valuation of capital investments acquired by the banks through the debt-to-equity swap is most definitely not a trivial question and depends a great deal on the fact of how the banks will acquire and manage such assets as well as how they will exit from these investments.
Reference to the solutions from the legislation on recovery of the banking system
Transfer of risk items (also equity stakes in companies) to a special purpose vehicle is already possible in accordance with the current solutions of the Act on Measures of the Republic of Slovenia to Strengthen the Stability of Banks, however only for the banks, which will be included in the individual recovery procedure due to insufficient equity. This Act therefore does not foresee any measures in cases of over-indebted companies, where a group of banks is included in the financing. When the participating banks decide to swap their share of debt to capital, it would be good that the equity stakes of all banks are transferred to the special purpose vehicle. If this were possible, the special purpose vehicle could obtain the majority stake in the companies and by this, become a tool to successfully lead and supervise the programme of restructuring and selling the company as the owner.
The current Act on Measures of the Republic of Slovenia to Strengthen the Stability of Banks does not enable the above described, which is why it is necessary to amend the Act in such a way that the special purpose vehicle would be able to buy equity stakes from the companies after the swap (or get to govern them in any other way) also from those banks that are not included in the individual recovery procedure if this leads to the majority equity stake in these companies. Such amendment would also motivate banks when resolving the over-indebtedness of companies to carry out the debt-to-equity swap because of the transfer to the special purpose vehicle. Special purpose vehicles would therefore be able to focus only on management of companies where they are the majority shareholders and control recovery of the companies and search for investors, whereas the banks would provide working capital for their smooth operations.
The above described division of activities between the bank and the “bad bank” is logical, since the latter would manage companies, which is what banks are not able to do. Therefore it is not a surprise that up until now, there were not a lot of debt-to-equity swaps, since the banks lack knowledge as well as equity. At the same time, encouragement by the regulator for such an active approach is limited, legislation on takeovers and insolvency has not favoured debt-to-equity swaps and the current local state and private owners do not wish to lose the control over companies. A key to break through in this area is that such measure is to be included in the legislation on bank recovery and that banks may use it in case of joint agreements on restructuring of debtors, where the majority equity stake will be transferred to a special purpose vehicle.
The proposed measure requires judgement and appropriate alignment with the rules on state aid. However, even more essential is establishment of appropriate infrastructure of special purpose vehicles for management of companies. It is almost impossible to imagine that it would be possible to establish a completely own professional system for implementation of this function in Slovenia in due time. It is definitely more logical and rational that experienced, professional teams are hired to supervise the managements in the companies undergoing restructuring, implementation of recovery programmes, search for investors and, at the end, carry out sale of the companies on the international market. Last but not least, the regulator should also clearly encourage immediate implementation of the above described infrastructure in active management of bad debts of companies, which would ensure that everything was prepared if a need of additional centralised measures by the state bad bank occurred due to providing financial stability.
Marko Simoneti is associate professor at the Ljubljana Faculty of Law and former Chairman of the Supervisory Board at NLB.
Božo Jašovič is advisor to the management and head of the Compliance Department at Gorenjska banka and a former Chairman of the Management Board at NLB.
* This article is a translation from Slovenian version that was originally published in Finance