Ideas & Debate

Resuscitating viable firms as pandemic wreaks havoc

idea

Summary

  • If creditors are going to invest the time, effort and cost in supporting a business to recover its health and ultimately repay its debts, they need to be convinced that they are not wasting their resources.
  • A common culprit in this regard is ‘zombie’ businesses, which have decent and consistent cash inflows that they use to pay minimum amounts to creditors, but which are so excessively leveraged that they will never manage to repay the principal sums that they owe.
  • As zombies have positive vital signs, they can be mistaken for viable patients when in actual fact, they ought to be taken off life-support and delivered to the ministrations of the morticians forthwith.

As the global pandemic continues to wreak havoc on economies and businesses, an inevitable succession of profit warnings and bankruptcy notices have peppered the news reports. In the US, we have seen household names such as JCPenney and Hertz filing for bankruptcy under the infamous Chapter 11 provisions. And in the UK, behemoth retailer brands such as Debenhams and the Arcadia group have been severely hit and are undergoing surgical procedures, including deep headcount cuts.

In such precarious times, administrators have been unfairly synonymised with liquidators despite their roles being quite different. An administrator is more like a doctor, who should be able to salvage matters if the patient has the right profile for recovery and accesses medical services sufficiently early to commence a course of treatment which has a chance of success.

What do we mean by the right profile? Well, there are certain indicators which point to a more positive prognosis for a business that is struggling financially.

Firstly, does the business have reliable inflows of cash – is it able to generate and collect revenue and can that revenue grow e.g. through penetrating new markets or offering new products? If the answers are in the affirmative, then such business would be a prime candidate for effective treatment. Another issue to consider is whether the creditors of the business are willing to give it some breathing room while it undergoes treatment. Again, an affirmative response raises the survival chances of the business a few notches higher. It is also helpful if the business has a handful of deep pocketed creditors with whom it has good relationships.

If creditors are going to invest the time, effort and cost in supporting a business to recover its health and ultimately repay its debts, they need to be convinced that they are not wasting their resources.

A common culprit in this regard is ‘zombie’ businesses, which have decent and consistent cash inflows that they use to pay minimum amounts to creditors, but which are so excessively leveraged that they will never manage to repay the principal sums that they owe. As zombies have positive vital signs, they can be mistaken for viable patients when in actual fact, they ought to be taken off life-support and delivered to the ministrations of the morticians forthwith.

Little wonder then that the World Bank Group’s publication on Covid-19 and solvency dated April 2020 advises that care should be taken to avoid proliferation of zombie firms, as they starve more deserving firms of credit in the post-crisis environment.

Distinguishing between the ‘could-be-saved’ firms and the ‘doomed-to-die’ firms is no easy task. As in the world of medicine, some diagnostic tests are required to determine the severity of the patient’s case.

The business equivalent of triage involves viability testing to ascertain how far gone the entity is and what can be done to restore it to health. Viability testing assumes that accurate and reliable financial information is available for analysis, and where such records are either deficient or incomplete, this would exclude that particular business from the possibility of preventive restructuring.

Restructuring frameworks anticipate that a struggling business will require bridge financing or new monies — a transfusion of funds to keep it alive before it bleeds out completely.

However, as is patently manifest with both blood banks and regular banks, the availability of capital is limited. It is therefore crucial to ensure that the limited funding is directed to the most viable candidate.

Turning to the issue of timing, in medicine, the earlier that a serious illness is detected and treated, the better the chances for a full recovery. In business, the same adage holds true and that is why paying attention to early warning signs is crucial.

In July 2019, the EU issued a directive on restructuring and insolvency which contained an imperative for member countries to develop insolvency provisions on early warning and to make early warning tools available online.

Early warning tools are alert mechanisms which indicate when debtors are sliding into potential insolvency for example where they miss certain payments like taxes and social security contributions. Early warning mechanisms can also include making it mandatory for accountants to report on companies whose financial position becomes precarious.

There are instances where a patient does not seek medical assistance because they are able to self-medicate successfully. However, this approach only works where the condition is mild, the patient has access to reliable information/ knowledge and the cure is easily available.

For a distressed company, more often than not, this trifecta is missing. The management of the company may not have the knowledge required or easy access to the cure. And we all know what we need to do when symptoms persist - call in the professionals.

Understandably, a financially handicapped business may want the benefit of professional advice without drawing unnecessary attention to the ailments bedevilling it.

This is where an informal restructuring comes in handy – it provides an opportunity for a company to quietly negotiate some breathing room with creditors, while engaging the services of professional legal and financial advisors to develop and implement a restructuring plan for a successful turnaround.

There are also options for statutory rescue plans such as schemes of arrangement and company voluntary arrangements but due to the requirement to summon all creditors and file the rescue proposals in court, these statutory mechanisms are less discreet than an informal restructuring.

In any event, it is advisable to start exploring options early, before drastic measures like amputation, transplants and life support are the only options left on the table.

Beatrice is a partner and head of the projects, energy & restructuring practice of DLA Piper Africa, IKM Advocates; Muigai is a director in the same team.