Problems to be addressed by the deleveraging model
When potentially viable firms are selected for in-court or out-of-court restructuring in Slovenia the capital of the firm after restructuring is too small to assure long term viability and firms are not “bankable” under the commercial terms. Banks are still reluctant to extend new credit to partially restructured firms at competitive interest rates, the old creditors are still facing potential increases in NPLs on their balance sheets and the undercapitalized debtors might well need to repeat the financial restructuring in the near future.
In addition, after partial financial restructuring most of the firms are not easy to be sold to the new owners. It is very unclear ex-ante who is the actual seller when the firm is only partially restructured and still financially distressed: creditors or owners? Who was selling Mercator at 221 EUR per share in 2011 and who eventually sold Mercator two years later at 86 EUR per share? How much time was wasted to establish that creditors and not the owners are to restructure and prepare Cimos Group for a sale to strategic investors? What is the role of creditors and owners in the proposed capital increase for Pivovarna Laško Group and how is the role of both groups changing in time? Who is the key decision maker in the sale of Elan Group: owners or creditors or state aid providers?
There is always a strong conflict of interest between creditors and owners when the undercapitalized firm is sold. Creditors, when staying with the firm, are mostly concerned with the size of the capital increase after the transaction while owners are mostly concerned with the price of the shares and dilution of control. This conflict of interest is often ignored at the start of the sale process in Slovenia and both sides are trying to improve their relative positions during the process. Such strategic behavior of owners and creditors (often both state controlled) is destructive to the value of the firm and above all to the price paid for the firm by the new investors. In short, the important focus of creditors and owners in the sale process is on distribution of the value and not on maximizing the value to be distributed to both stake-holding groups.
Some domestic experts are promoting the idea of the government guarantees on new financing and the government sponsored mezzanine financing to solve the problem of too small capital in partially restructured firms. In short, the government financed bail-out of banks should be complemented by the government financed bail-out of viable companies. Is this a realistic general solution given the size of the excessive debt problem in the real economy and the current fiscal situation of the country? Our proposal is based on the reversed logic: first, the existing creditors should provide initial equity and mezzanine financing for viable troubled debtors and second, under clearly defined preconditions the exit of old creditors should be supported by purchases of their exposures on commercial terms by new lenders and mezzanine investors.
Given the increased liquidity on the financial markets many experts are proposing that the wholesale approach in selling NPLs to large private equity funds (PE funds) might be the most effective way to speed up restructuring of companies on a large scale in Slovenia. Financial claims on related or even unrelated companies are to be bundled together in large portfolios and sold to the foreign specialized investors as soon as possible with practically no prior restructuring. The main advantages of these investors are their international expertize, financial strength, political and commercial independence from the local stakeholders, while the main disadvantage is their limited understanding of the local institutional and legal framework. As always, foreign buyers apply discounts on the purchase price for the uncertainties they do not understand and for the risks they can not control. Our proposal for deleveraging is a bit different from such wholesale and “do nothing” approach: the existing creditors and owners in any particular company should implement some basic financial and legal restructuring measures, eliminate some of the domestic risks and uncertainties, and prepare reliable information on the business opportunities before these exposures are sold in the competitive and transparent process to the new investors.
Therefore, our model is designed to add value in the restructuring process in Slovenia by providing the “bankable” and “ready to be privatized” deleveraging solutions for large potentially viable companies, by providing opportunities for the cooperation of existing creditors and owners to get a better price in selling their exposures to the new “smart money” and by relieving the government budget from any additional non-commercial funding for corporate restructuring.
Temporary debt-to-equity conversions followed by sale and privatization
In the absence of external equity investors only debt to equity conversions by existing creditors can provide the stable capital structure in the short run. The valuation of company with implied distribution of control between owners and creditors after conversion is something that the opposing parties find very difficult to agree unless the value of equity is clearly negative. But in many troubled companies the equity is not yet negative. How to handle this complex valuation and control issues in a way to secure long term viability of the company?
The postponed market test for valuation is proposed as owners and creditors have very different opinion on the value of equity at the start of the process. After the sale of the company in the next few years the value of the company is to be known with certainty. Distribution of proceeds at that time is to be done according to the basic principle: the old creditors are paid in full before any proceeds go to the old owners. This is an application of basic absolute priority rule (APR rule) for residual payments to owners in the insolvency situation. In addition, strong motivation of all parties involved is needed to put the company on sale at the best price in the next few years to pay off the initial creditors, while potential proceeds above these obligations belongs to owners.
It is only fair for the existing owners to be paid the residual value after the sale if the price covers all claims of existing creditors. The owners as residual claimants are the most interested that the final sale is made in a competitive and transparent way. In addition, the cooperation of current management (and owners) might well be important in some cases to restructure and operate successfully the company till privatization. Therefore, it makes a lot of economic sense in many situations that the initial owners (and managers) stay involved in the company restructuring even after the effective control is transferred to creditors.
Existing owners should always have the first right to recapitalize the company or to find the new owners for the company. Due to the severe financial distress in many companies this fundamental ownership right is only theoretical at present. Therefore, existing owners might find such an ex-ante agreement with creditors on sharing the value after the joint sale to new investors as an attractive practical alternative to the insolvency procedure which is destructive for the value of the company. The main advantage of this consensual privatization approach is that the final valuation of companies might be postponed when (i) creditors and owners are fully committed to the sale of the company in the near future and (ii) control over restructuring till privatization can be shared among creditors and owners as their cooperation is needed for successful restructuring and privatization.
The ex-ante agreement of owners and creditors to sustain from destructive actions in pre- privatization period, to avoid administrative insolvency procedures, to cooperate in maximizing the value of the company before sale and share the largest possible proceeds according to pre-agreed formulas is also fair to both parties: creditors as priority claimants and owners as residual claimants.
New sustainable level of financing on commercial terms
How much debt can the firm have and at what price to operate normally while it is preparing for privatization should not be decided by the current creditors who are motivated to minimize the “haircuts” and to preserve the status quo in their balance sheets. The economic consequence of this minimalistic approach by creditors is that most companies with signed Master Restructuring Agreement (MRA) are today still “bleeding” due to excessive financial burdens and bad financial reputation with their suppliers and customers. In addition, some partial restructuring measures by creditors might be later even penalized in the formal insolvency procedures due to changed priority in the order of claims.
Financially distressed companies usually need, in addition to restructuring of old debts, new financing for operations and investments. Bank Asset Management Company (BAMC), being many times the largest creditor, is not operating as a bank, while the other existing creditor banks are not willing to increase their exposure to the problematic debtor. Similarly, new creditors are not interested in financing partially restructured companies.
The market test for the appropriate level of debt and costs of debt is proposed to replace these difficult and long lasting negotiations between the debtor and the reluctant old creditors. The proposal is to simulate the behavior of PE funds in financing the payment of the purchase price for the troubled company. The old debts are usually replaced by new debts at the start. PE funds go on the market to borrow on behalf of the target company on commercial terms up to the level of debt which maintains the investment grade of the target company (at present, for example 3 times EBITDA of debt with the interest rate of 2,5 % per year). The rest of the purchase price is paid in cash by PE funds directly. The first part pays all potentially unsettled old financial credit claims and the residual part pays the old owners for 100% of their shares. The direct cash payment of the PE funds is adjusted downwards till the expected return at the time of exit is around 20% per year. Here again the downward adjustment is made at expense of owners, while old creditors are repaid as the priority. This is the way how PE funds are creating the sound financial preconditions for comprehensive corporate restructuring process at the time of entry. It is proposed that the existing creditors and owners simulate this sound financial logic when they start preparing the troubled company for sale and privatization.
New Credit Consortium is proposed as a third party providing the appropriate level of new debt for the company under the assumption that all existing debt is to be removed (paid off or converted to equity). New financing is to provide working capital and investment financing as priority, while partial repayment of the old debt is possible as well. This refinancing represents the only cash payment that troubled firm can pay to existing creditors before privatization. The rest of the financial claims are to be converted to equity and paid when the company is to be sold in the next step. The old creditors get some cash immediately and some equity with positive value.
This approach is a simple and fair recognition of the business reality of the financially distressed debtor: the level of sustainable debt and the cost of debt are determined by new borrowing on the market. As priority new financing is used to run and restructure business as going concern. The rest of the new financing can be used to repay old creditors (cash repayment tranche) but most of the repayment for creditors is to come from privatization proceeds (equity repayment tranche). Initial owners, not being able to recapitalize the firm on time, receive only the residual proceeds after converted claims are fully satisfied. There is an additional flexibility for old creditors as well. Instead of taking the cash repayment tranche they can join the New Credit Consortium and stay with the company under the new commercial terms.
Early exit by bank creditors after conversion – substitute mezzanine financing
The contractual commitment of all parties to future privatization increases the market value of new shares created by debt conversion and they can be sold to other parties willing to hold and manage them till final sale of the company. The possibility for quick exit might be less important for BAMC being a special purpose government institution but it might be very attractive for banks due to new regulation on forbearances. In addition, state owned banks which are to be privatized shortly still have large amounts of NPLs. Additional transfers or sales of bad assets, government guarantees on bad portfolio or downward adjustment of the price paid for the bank will be required in privatization transaction. The secondary transactions thus provide the opportunity for some old creditors to get rid of all exposure to troubled debtor in the short run. The secondary transactions also provide opportunity for old owners to repurchase newly issued shares at the price fully covering the value of converted debts or to sell their residual rights (warrants) to other investors. The only constraint on the secondary transfers is that all shares and residual rights stay in the package to be sold or exercised in the final privatization transaction. Therefore, the current practice of solo actions by individual owner or creditor at the expense of other owners and creditors is not possible any more as new investors are bound by the same contractual rules as the original investors. This flexible framework allows that the new investors (mezzanine financing, private equity funds, restructuring funds…) enter or even take over this restructuring effort once the binding agreement among old creditors, old owners and new creditors is reached.
The value of the company after such basic financial and legal restructuring is higher than initially and the new investors are likely to take this into account in bidding for the business in need for operational restructuring. The smart sellers (existing creditors and owners) are likely to be rewarded for their coordinated action and the “smart money” is to be a bit less smart (and less paid) in Slovenia if these sound financial principles are followed.
Agreement among creditors on long term economic value of claims
Various creditors usually have very different positions in a particular debtor in terms of size, duration, interest rates and assets used to secure the loans. In addition, they use internal valuation methods and they value the same positions very differently. There should be no surprise that numerous creditors of a typical distressed company in Slovenia can hardly agree on anything above the minimum measures to keep the company alive and to maintain the status quo.
To start searching for the long term viable solution for the company these creditors are to be put first on the same metric, using Bank of Slovenia (BS) methodology approved by EC : long term economic value of claims. This is BAMC transfer price methodology with no extra charges for operation and financing. Many of non-performing loans by banks have already been transferred to BAMC using the same valuation methodology. The same consistent solution is to be used for valuation of all financial claims in any problematic debtor. In practice this implies that the same assumptions on discount rates, default risks, values of collateral and so on are used in valuation formulas by all creditors of a problematic debtor.
All creditors are to be paid proportionally to economic value of their claims in cash today and in equity to be sold in the near future. Therefore, relative positions of all financial creditors are determined ex ante and all creditors are paid at the same time pro rata based on the economic value of their claims. The cash portion of repayment is determined on the loan market today and the equity portion of repayment on the equity market when the debtor is sold in the future.
Problem of core assets pledged individually to various financial creditors
All creditors have to lift all the pledges against the core business assets of the firm, so all assets are now available to be pooled together for secured new borrowing at the market interest rates, financing the needs of the company and cash portion of repayment. Collaterals are important for economic value of claims, determining the total maximum size of the repayment for each creditor, but the actual dynamics of payments is not linked to the sale of collateral any more. In short, the complex “waterfall” solution for repayments is replaced with pro rata repayments of all financial claims in cash and in equity (with possibility to replace cash repayment with new debt instruments).
Problem of holding out by dissenting creditors (free ridding) and shareholders
For owners all decisions regarding debt conversions and control of the company has to be passed ex ante on shareholders meeting according to the company law so they become obligatory for all dissenting shareholders as well.
With a consensus of all owners (where there are only a few big owners or a single owner – BAMC, SDH, holding companies) the structure can be simplified to a great extent. No shareholders meeting for approving capital increase and debt-to-equity conversion is needed but all shares are transferred to creditors in exchange for writing off some credit claims and issuing warrants, giving the former owners the right to repurchase these shares at the price covering all liabilities to creditors at economic value. These rights are to be exercised at the time of privatization (adaptation of L. Bebscuk option model of bankruptcy for the limited liquidity of owners and non-functioning of credit markets in Slovenia at present). The striking price has to be adjusted for the cost of equity as the original creditors are assuming the ownership role during the restructuring and preparation for privatization. Therefore, the problem of reaching consensus between owners and creditors is greatly reduced as the final valuation of a company is postponed till privatization and only formulas for distribution of value are agreed upon in advance. In addition, the sustainable level of debt and the implied ratio between cash repayment and equity repayment for creditors is determined on the credit market as well.
To avoid free ridding of non-cooperative creditors they all have to accept the economic value of their claims as the starting point for repayment in this model. For example, financial creditors vote for the package proportionally based on the economic value of claims and at least 90 % votes are needed for this restructuring model to be used. In other words, only 10% of economic value of financial claims might be excluded from restructuring to prevent the break-down of the model due to the free ride of many creditors unwilling to participate. As the repayment is partially postponed until privatization this economic value of debt has to increase in time to compensate for the assumed equity risk by creditors.
The only final decision by all stakeholders in this model is on the economic value of all financial debts, taking into account time distribution of payments, default risks and the value of collateral. This is needed to put all financial creditors on the same metric for repayment, for freeing companies from all pledges and for opening the door to new sustainable secured borrowing on commercial terms. For reasonable and business oriented creditors and owners this should be a relatively simple task if they can only accept the same EC approved BS valuation methodology on economic value of debts as the starting point.
The role of new institutions: Privatization Consortium, Credit Consortium and Substitute Mezzanine Fund
The official economic observers of Slovenia (EC, IMF, OECD) have recommended many times that the coordination on the national level among bank rehabilitation, company deleveraging and privatization processes should be improved. Our proposal is trying to fill this institutional gap on the micro level of the individual potentially viable debtor. The main bottlenecks for more efficient restructuring and privatization of companies are identified: formation of the privatization consortium, possibilities for new credit financing on commercial terms for troubled debtors and possibilities for quick exit of banks from their de facto equity exposures in troubled debtors. The main roles of the proposed new institutions are:
- Selecting the viable companies being important for economic activity in Slovenia (mainly large exporting companies, no holdings, no real estate projects).
- Mediating among creditors and owners to agree on temporary debt-to-equity conversion or to issue warrants to owners in exchange for shares, to form Privatization (Sale) Consortium for the company and to distribute proceeds of privatization in accordance with APR rule.
- Mediating among financial creditors using EC approved BS methodology on economic value of financial claims.
- Providing new debt financing for the operating needs of companies and making sure that companies do not stay with excessive and too costly debt while preparing for privatization.
- Providing possibility for banks to exit from troubled debtors and get rid of all forbearances by being paid in cash by New Credit Consortium or by Substitute Mezzanine Fund buying shares issued to banks for converted debts.
- Insisting on minimal institutional package before financing from New Credit Consortium or transfer of bank exposures to Substitute Mezzanine Fund with the objective to assure strong and transparent corporate governance during pre-privatization restructuring
- Monitoring the implementation of pre-privatization restructuring.
- Monitoring the implementation of privatization.
This deleveraging proposal has been written as the reflection on the most pressing problems in reaching business oriented out-of-court solutions for viable problematic debtors in Slovenia. The focus is on the needs of potentially viable companies and not on the needs of the balance sheets of the banks that are well capitalized at present. Instead of long-lasting negotiations among bankers, owners and debtors two market tests are proposed: for the value of the company at the time of privatization and for the sustainable level of debt at the start of restructuring process. The objective is to make companies “bankable” and “willing to be privatized” at the start of the process and to avoid destructive strategic behavior of creditors and owners in the process. Instead of government sponsored mezzanine financing this is provided directly by existing creditors but with the immediate possibility to sell their standardized new equity exposures to the “smart money” in the next step.
The proposed Privatization Consortium, New Credit Consortium and Substitute Mezzanine Fund are only synonyms for the main functions that are in our view missing or performing poorly in the current restructuring framework in Slovenia. The existing agents of restructuring (like BAMC, Ljubljana bankers club, BS, MF, SDH…) could perform these functions as well but they should be better coordinated by using the standardized approaches to deleveraging of viable companies. In addition, they need credibility for mediation among creditors, owners and debtors; professional competence for execution; financial resources for refinancing companies and, above all, proper motivation for action.