Fin management materials / P4AFM-Session09_j08

SESSION 09 – CORPORATE RECONSTRUCTION & RE-ORGANISATION

OVERVIEW

Objective

¾To be familiar with methods of predicting bankruptcy.

¾To formulate plans for rescuing a firm from financial distress.

¾To be familiar with methods of divestment such as sell-off, spin-off and MBO.

RECONSTRUCTION &

RE-ORGANISATION

PREDICTING

CORPORATE RE-ORGANISATION

FAILURE

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SESSION 09 – CORPORATE RECONSTRUCTION & RE-ORGANISATION

1PREDICTING CORPORATE FAILURE

1.1The Z-Score Model

¾A predictive model created by Edward Altman of Stern Institute of Business (New York) in 1968. It is a multivariate model combining five different financial ratios to determine the likelihood of financial distress i.e. bankruptcy.

¾The original model was developed for US public manufacturing firms and uses the following equation::

Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 +X5

Where

X1 = working capital/total assets X2 = retained earnings/total assets

X3 = earnings before interest and taxes/total assets X4 = market value equity/book value of total liabilities X5 = sales/total assets

Z = overall index

¾Generally speaking, the lower the score, the higher the probability of bankruptcy. Companies with Z-Scores above 3 are considered to be healthy and, therefore, unlikely to enter bankruptcy. Scores between 1.8 and 3 lie in a grey area.

¾This is a relatively accurate model -- real world application of the Z-Score successfully predicted 72% of US corporate bankruptcies two years prior to these companies filing for “Chapter 7”( bankruptcy proceedings in which a company stops all operations and goes completely out of business. A trustee is appointed to liquidate the company's assets, and the money is used to pay off debt).

¾Later versions include Model A for private manufacturers, Model B for private nonmanufacturers and the EMS model (Emerging Markets Scoring).

1.2The ZETA® Credit Risk Model

¾In 1977, Altman, Haldeman and Narayanan constructed a second generation model with several enhancements to the original Z-Score approach.

¾The new model, ZETA, was effective in classifying bankrupt companies up to five years prior to failure on a sample of corporations consisting of manufacturers and retailers.

¾The parameters of the model are property of Zeta Services Inc.

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SESSION 09 – CORPORATE RECONSTRUCTION & RE-ORGANISATION

2CAPITAL RECONSTRUCTIONS

2.1Background

¾A capital reconstruction may be required when a company has experienced financial difficulties which have weakened its statement of financial position/balance sheet and drained its resources.

¾The company may have good prospects in the future but is currently unable to exploit the opportunities available because of lack of cash.

¾Often the firm’s balance sheet will be characterised by:

a debit balance on retained earnings due to accumulated loses;

low NAPS (net assets per share);

expensive and risky use of overdraft facilities which are technically repayable on demand.

¾Existing shareholders may at present be unwilling to inject more cash due to the debit balance on retained earnings preventing the payment of dividends.

¾A reconstruction scheme is therefore suggested by the directors (or another stakeholder).

2.2Types of capital reconstruction

¾UK company law allows two types of capital reconstruction:

Simple reconstruction (Section 135 Companies Act 1985) - write-off debit balance on retained earnings. This allows dividends to be paid in the near future and helps to attract new equity finance.

Complex reconstruction (Section 425 Companies Act 1985) - arrangements that affect the rights of creditors and other stakeholders e.g. cancellation of debt in exchange for shares. Requires court approval. US law has similar legislation known as “Chapter 11” bankruptcy protection.

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SESSION 09 – CORPORATE RECONSTRUCTION & RE-ORGANISATION

2.3Formulating a scheme

¾Elements may include:

Write-off retained earnings debit balance;

write off any fictitious assets, e.g., goodwill, development expenditure;

revalue other assets;

reorganise capital structure e.g. write off debt in exchange for equity;

raise new capital.

¾In formulating a scheme consider the interests of the various existing suppliers of capital:

secured creditors have power to apply for the company to be liquidated. Therefore they should be given incentives not to do so e.g. an offer of free equity or increased coupon rate;

preference shareholders may have to forego arrears of preference dividend in return for a promise of higher coupon rate in future;

ordinary shareholders have most to lose in liquidation therefore it will not normally be necessary to be too generous to them in reorganisation.

2.4Factors affecting success of scheme

Exam questions may present you with a draft scheme and ask you to evaluate its chance of success. The steps to take are:

¾Identify the position of each class of investor if the company goes into liquidation.

¾Identify the position of each class of investor post-reconstruction i.e. if the company is saved.

¾Is each investor no worse off under reconstruction than under liquidation i.e. will investors vote to accept the scheme? (75% agreement is needed from creditors for a complex reconstruction to receive court approval)

¾Is the refinancing package sufficient i.e. do the cash inflows upon reconstruction at least equal the outflows?

¾Does the scheme treat all investors fairly?

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SESSION 09 – CORPORATE RECONSTRUCTION & RE-ORGANISATION

3DIVESTMENT

Definition

¾Divestment – the withdrawal of investment in an activity.

¾Unbundling – the process of selling off incidental businesses in order to concentrate resources on the core business.

¾A demerger/spin off – splitting a group into two or more independent units.

3.1Reasons for divestment

¾To raise significant cash – to improve liquidity or to pay off debts and reduce gearing.

¾To allow focus on core activities – which can then be expanded to produce economies of scale.

¾To dispose of operations giving poor returns/unacceptable level of risk.

¾In the case of demerger/spin-off it may be possible that shareholder wealth can be enhanced by splitting the group – for example by appointing specialist managers for each business segment.

¾“Crown Jewels” defence against hostile takeover – selling assets which predators are interested in.

3.2Divestment strategies

¾Sell–offs; where a company sells part of its operations to a third party, normally for a cash settlement. This is a common strategy for a multi-product company that wishes to raise cash by selling a division peripheral from the main business. The decision should be made on the basis of NPV appraisal.

¾Spin-offs; a pro-rata distribution of subsidiary shares to the shareholders of the parent. Effectively this is another name for a demerger i.e. one company becomes two or more companies, perhaps with new management but the same shareholders. No cash is raised but possible benefits include:

Clearer management structure and more efficient use of assets;

Removing the “conglomerate discount”. Previously investors may have undervalued certain assets which were not clearly visible as part of a large group. Once spun-off these assets stand alone and may become fully valued by the market.

¾ Management Buyout (MBO) - the purchase of part or all of a business from its parent company, by the existing management.

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¾Management Buy-In (MBI) - an external management team purchases the business together with a financier. Alternatively, a financier may purchase a company and then find a suitable management team. Riskier than the management buy out, since the incoming team have far less knowledge of the company.

¾Institutional Buyout (IBO) - where an institution identifies a target company, arranges the finance and then approaches a potential management team. This approach has become far more common in recent years with the rise of Private Equity funds.

4MANAGEMENT BUYOUTS

4.1 Introduction

¾ An MBO is the purchase of part or all of a business by the existing management. As the management team usually have limited resources, a substantial amount of external capital will be required.

4.2 Reasons for the development of the MBO

¾The MBO developed in the UK as an accepted from of transaction in the early 1980s. At the time, a number of companies were severely affected by economic recession. When faced with an unprofitable subsidiary, the options were to put it into receivership or sell to the only available purchaser i.e. the management. Often the sales were made at distress prices and existence of security in the form of land and buildings made borrowing to finance the transaction very easy.

¾Although these advantages largely disappeared for subsequent deals, the early transactions gave an impetus to the market and ensured familiarity with the concepts involved.

¾Other reasons which led to the growth of the MBO market include:

US banks

The arrival of US banks in the UK with their familiarity with highly leveraged transactions in their home market meant that many deals which would not have been possible in the past could now be accepted.

Legislation permitting financial assistance for purchase of own shares

Changes in legislation in the UK made it easier in the 1980s for companies to assist in the purchase of their own shares. For example, loans in MBO’s are often secured on the assets of the company. Previously such assistance by the company would have been illegal.

Repayment of national debt by the UK government in the late 1980s

The government’s reduction in borrowing requirements led to a surplus of institutional funds in the UK, which partly found a home in MBO’s.

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SESSION 09 – CORPORATE RECONSTRUCTION & RE-ORGANISATION

Government policy

Government policy has been to encourage private share ownership and privatisations have often favoured MBO’s e.g. privatisation of regional bus companies.

Disposal of non-core subsidiaries

The tendency of groups to focus on core activities and dispose of non-core subsidiaries has led to a supply of companies for MBO’s.

Management desire

The desire of management teams to be liberated from the chains of a large organisation (and to get rich) has meant that there is no shortage of aspiring risk takers.

4.3The ideal MBO candidate

¾The ideal MBO candidate is a company in a relatively low risk environment. This will enable the providers of finance e.g. venture capitalists, to realise a satisfactory return without substantial risk that the company will fail. Desirable characteristics for a company to have are:

a stable or growing market;

stable cash flows;

large asset backing as security for loans;

the ability to restrict fixed asset expenditure over the years subsequent to the buyout to minimise cash outflow;

the ability to squeeze working capital in the early years to generate additional cash to pay back loan finance;

the existence of surplus assets which can be sold to pay down debt;

a strong well balanced management team;

an “exit route” e.g. the company should be of sufficient size for an IPO or should be an attractive purchase for other acquisitive companies.

4.4Commercial aspects of buyouts

¾It is important to ensure that a deal is feasible from the very start. This means that all parties must be serious about making the deal work. The vendor must be willing to sell, the management willing to buy and there must a good prospect that the finance will be available. In order to make the deal easy to negotiate the management team should preferably be fairly small. This will make decisions easier and minimise the risk of members backing out at a late stage to move on to more attractive positions.

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SESSION 09 – CORPORATE RECONSTRUCTION & RE-ORGANISATION

4.4.1Financiers and advisers

¾Before making an offer and negotiating with the vendor, the management team should meet with the potential financiers who can inspect the business plan and establish whether finance is likely to be available or not.

¾It may be useful to use professional advisers at this stage, such as accountants or lawyers. The advantage of this is that they will be expert at representing the management’s interests. The risk is that heavy fees will be incurred which will may to be met by the management personally if the bid does not succeed. Accountants may make their fee contingent on a successful deal being completed, but in such instances the fee will be higher.

4.4.2Offer to the vendors

¾After meeting with the potential financiers, an offer can be made to the vendors. This will cover the following points:

details of the assets or shares to be purchased;

details of trademarks or other brand names to be included in the deal;

what employees and attached obligations (such as redundancy payments) are to be included in the deal;

pre-conditions for the sale, such as an investigation or tax clearances;

the purchase price and payment terms.

¾When setting the price, the management will have to value the company using various valuation techniques. This however will only give a base guide and the final price will be determined by a range of factors. The negotiating strength of each party will be paramount.

¾The problem for the management team here is that they have only one potential target. However, the financiers will be looking at a range of options and the vendor will possibly have a number of potential purchasers. The management team will therefore need to strengthen their own position by stressing the benefits of having a MBO and by having alternative courses of action, such as walking out and setting up a new business.

4.5Financial aspects of buyouts

4.5.1Gearing levels

¾An MBO is usually financed by a mixture of debt and equity with the MBO team putting their own money in.

¾Relatively high levels of debt finance may be required. The gearing (ratio of debt to equity) can easily be 5:1, though 10:1 is not rare and 20:1 has been known. For this reason such deals are often referred to a highly-levered MBO’s.

¾High gearing requires a strong cash-flow to enable interest payments to be met.

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¾The equity investment of the buy-out team, together with debt secured on the assets of the business and/or individual team members may not be enough, resulting in applications to banks or venture capital providers.

¾They will take usually take an equity stake in the business, have a non-executive director on the board, and require a say in its medium and long term plans.

4.5.2Equity finance

¾The equity finance will typically be split between the management team and the venture capitalist, although it may be the case that the vendor wishes to retain an interest in the company. The bulk of the finance will be supplied by the venture capitalists. They will largely be concerned to ensure that they earn a satisfactory rate of return on an IRR basis taking into account the risk being incurred. On top of this they will need to ensure that the management is motivated to succeed by owning an appropriate proportion of the equity. Key elements in the equity package may be:

Share options or convertible loan stock

These will enable the financiers to increase their percentage holding of the company at low cost. The terms can be altered depending on whether the company achieves agreed performance targets.

Redeemable preference shares

These enable the venture capitalists to obtain repayment of their investment if equity returns are inadequate. They will give a running yield which will increase overall returns. They may include a conversion option.

Mezzanine finance

This is essentially a form of high risk unsecured debt bordering on equity, with its exact nature depending on how it is structured.

Useful when there is no way of raising additional straight debt and the issue of more equity would unsatisfactorily dilute the interests of the management team and other equity investors.

4.6Exit routes

4.6.1Possibilities

¾The two main exit routes whereby investors can realise their capital gain are the flotation (IPO) or the trade sale to another company. The attractiveness of each depends to an extent on market conditions and the use of each has varied in the past but in general trade sales have been more common than floatation.

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SESSION 09 – CORPORATE RECONSTRUCTION & RE-ORGANISATION

4.6.2Exit — flotation or trade sale?

¾The factors to take into account when considering which exit route is the more suitable include the following:

Key points

The Z-score and Zeta models are widely used in practice to predict financial distress, and their accuracy is supported by strong empirical evidence.

If management (or stakeholders) identify a significant risk of bankruptcy then steps should obviously be taken to avoid this. Company law in many countries allows some form of capital reconstruction e.g. debt to equity swaps.

Even a healthy company may wish to restructure its operations, perhaps to focus on core activities or to separately quote potentially undervalued segments of the business.

Divestment can take various forms – in recent years sales to private equity funds have been very common.

FOCUS

You should now be able to:

¾discuss the main models used to predict bankruptcy;

¾formulate capital reconstructions to save a firm from financial distress;

¾discuss methods of unbundling a business.

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