May 3, 2009

Cash Squeeze for Kuwaiti Investment Companies

The impact of the recession has been severe on the investment companies of Kuwait: a mix of ‎short- and long-term strategies is needed to stabilize the situation and create sustainable growth.

Kuwaiti investment companies have been hurt much by the global economic downturn—with ‎fragmented portfolios and a sub-optimal capital structure when cash is limited. As lenders ‎retreated and limited access to new debt, investment companies have been left vulnerable and ‎have to adapt to these new conditions and make significant changes to recover, found a new ‎report by Booz & Company. ‎

In the short-term, investment companies should focus on improving cash positions by ‎rationalizing their portfolios to focus their efforts on fewer companies. They should also improve ‎cash management at their holding and investee companies, as well as work with lenders to ease ‎existing debt obligations. In the long-term, “they must develop an explicit strategy to create value, ‎and improve their governance and risk management practices to support the implementation of ‎this strategy”, explained Peter Vayanos, a partner at Booz & Company. They also need to set ‎long-term targets for their portfolios and align their corporate finance capabilities to these targets. ‎

The Financing Squeeze

In Kuwait, investment companies are prevalent; with around 100 registered investment ‎companies (46 of which are listed on the Kuwait Stock Exchange) and several other industrial ‎and real estate companies with large investment portfolios. Alone, listed investment companies ‎constituted around 20 percent of the market capitalization of listed Kuwaiti companies (end of Q3 ‎‎2008) and around 15% in early 2009, a higher share than in most industrialized economies. ‎

‎“The crisis stemmed from a belief in perpetual growth and unlimited access to liquidity. ‎Investment companies invested opportunistically in a large number of portfolio companies, with ‎no set strategy, liquidity measures or target risk-return profile” stated Ahmed Youssef, a principal ‎at Booz & Company. Two of the largest listed Kuwaiti investment companies for example have a ‎combined total of around 120 portfolio companies; this excludes investments in real estate ‎projects, companies where they have less than 20 percent ownership, and fund investments. ‎Many are comprised of small stakes—with carrying values as low as KD 5000 in some instances. ‎

Fragmented portfolios make investment companies’ access to and monetization of cash less ‎flexible; It also increases transaction and management costs. Investment companies have limited ‎ability to immediately monetize these companies; and investors have little interest in purchasing ‎minority shares in unlisted equities. Portfolio managers further reduced the flexibility of their ‎portfolio by investing in relatively illiquid investments, which will prove more difficult to monetize.‎

More importantly, investment companies had to raise additional capital, mainly debt, to meet their ‎obligations in 2008. “Companies raised new debt and equity to pay other shareholders through ‎dividends and interest charges” Youssef commented. ‎

The average debt-to-equity ratios of Kuwaiti investment companies may look adequate, but their ‎ability to cover financing charges is challenged. Finance charges for listed Kuwaiti companies ‎totaled KD 290 million in the nine-month period ending September 2008, while cash flow from ‎operations and investing activities was negative.‎

‎“Furthermore, around 75 percent of listed investment company debt is short-term, which ‎accentuates the problem given the long-term nature of their assets,” explained Youssef. More ‎than 40 percent of investment companies have a current ratio below 1 and a cash ratio below 0.1 ‎‎(excluding marketable securities). This could be dangerous if banks put pressure to recover ‎short-term debt, especially with limited opportunities to divest portfolio companies and limited ‎cash-on-hand. It could also lead to further declines in the stock market as pressured investment ‎companies seek “fire sales” to raise cash. ‎

Immediate Steps to Stabilization

Kuwaiti investment companies should act now to stabilize cash flow, right-size their capital ‎structure, and build a foundation for sustainable profit growth. Companies can take several short ‎term actions to alleviate the cash squeeze and allow them to consider longer-term fixes.‎

Rationalize the portfolio: Kuwaiti investment companies should focus human and capital ‎resources on the portfolio companies in which the investment company can create long-term ‎value, and generate cash. They must identify underachieving companies that are ripe for lower ‎levels of investment, closure, or divestiture. “Sale proceeds can be used to pay debt or support ‎more valuable investments. Companies should not be deterred by the possibility of exiting at low ‎valuations if they can put the proceeds to better use,” Vayanos stated.‎

Improve cash management: Kuwaiti investment companies have to improve cash management ‎at the holding and investee company levels. They can work directly with investee companies to ‎establish cost-cutting targets that enable them to extract more cash from operations, especially ‎where portfolio managers have specific insights. Investee companies often do not have the ‎necessary tools or incentives to effectively manage their capital.‎

Reducing or halting dividend payments in the short term is another viable option—especially now. ‎‎“More understanding investors will likely see such a move as a responsible and necessary step to ‎fortify the company’s financial position in a difficult economic environment,” said Youssef.‎

Ease debt burdens: Investment companies should try to ease their debt obligations, either ‎through renegotiation with lenders or by shifting their debt burden closer to operating subsidiaries. ‎

Currently, banks realize they stand a greater chance of recovering loans by working with ‎companies to restructure their debt—especially with Kuwaiti investment companies, which ‎represent around 40 percent of the total debt held by all Kuwaiti listed companies (excluding debt ‎taken by listed financials institutions). The cash generated can be used to repay selected debt ‎obligations. ‎

‎“Investment companies can give banks greater confidence by providing more transparency on ‎how the debt is used and showing a clear action plan to improve their cash position,” Youssef ‎said. Banks gain greater insight into the company’s ability to repay by being able to more closely ‎track cash flows. ‎

Steps for Long-term Sustainability

Once these short-term fixes are in place, investment companies need to focus on long-term ‎sustainability to reduce the impact of future cash squeezes. ‎

Develop long-term strategy: A clear definition of the strategy and its impact on the value ‎creation strategy, operating model, and performance-management approach is critical. Strategy ‎needs to be tailored to each organization’s specific makeup—from conglomerates to managed ‎investment funds.‎

Set portfolio targets: Based on the set strategy, Kuwaiti investment companies should define ‎long-term targets for their portfolio mix to avoid being overwhelmed by the multitude of investment ‎opportunities. Targets could be defined across multiple parameters and should be continuously ‎challenged and reviewed with respect to both internal and external measures. ‎

The investment company’s level of influence on portfolio companies should be addressed. “Many ‎Kuwaiti investment companies have made minority equity investments in private companies in the ‎hopes of listing them in the future. But when buyers’ interest wanes, they are trapped: They ‎cannot liquidate the assets or influence company strategy,” explained Youssef. ‎

Develop appropriate corporate finance capabilities: Portfolio changes mean a change in the ‎corporate finance strategy and capabilities at the holding level. Companies need to provide more ‎transparency to lenders in the use of financing, and isolate the cost of debt and the risks faced by ‎individual companies. In addition, they need to match the maturity of their liabilities with that of ‎their assets by shifting from a focus on short-term loans to the use of financing strategy and often ‎to individual investments. Holding companies with a high percentage of unearned income should ‎avoid having excessive debt at the holding level. ‎

Companies need to develop a long-term dividend strategy beyond the short-term. “A decrease in ‎dividends could have negative effects on holding companies’ share price. Kuwaiti companies ‎should slowly educate investors about total shareholder return and reduce the pressure on ‎holding companies to pay regular dividends,” commented Youssef. Such changes require strong ‎talent and systems in corporate finance at the holding level, complementing the mainly ‎accounting-focused capabilities present in many investment companies. ‎

Improve governance and risk management: Good governance is intrinsic—particularly for ‎investment companies: Large and frequent investment decisions, conflicts of interest, cross-‎ownership, and subsidization among portfolio companies are a few of the issues that need to be ‎addressed. Clarifying the role of the board and ensuring that directors have the right combination ‎of financial skills and industry knowledge will set an effective and realistic strategic course. ‎Communications with the CFO and C-suite should be improved to strengthen the quality of ‎information board members use to make decisions and manage risks. “The board should enforce ‎the adoption of appropriate risk-management practices, forcing executives to evaluate decisions ‎and monitor the portfolio within a predefined risk-return framework”, explained Vayanos. ‎

Regulators should ensure investment companies are active in driving the change given their ‎weight on the Kuwaiti economy. Listed Kuwaiti investment companies alone had around KD6.9 ‎billion in debt (including consolidated debt of subsidiaries) as of September 2008, the equivalent ‎of around 30 percent of the Kuwaiti domestic credit portfolio (as reported by the CBK). Around ‎‎30% of this debt is taken from local banks making a more acute crisis with investment companies ‎dangerous for the Kuwaiti banking sector and economy as a whole.‎

In this context, regulators should continue to take a proactive role, starting by quantifying the ‎depth of the problem and prioritizing the challenges to be addressed. In the short-term, they ‎should work closely with the relevant investment companies to stabilize the situation and address ‎the current cash squeeze. For the long-term, the regulator should formulate a long-term strategy ‎for the sector defining its role within the Kuwaiti economy. More importantly, regulators should ‎enhance their policies and supervisory capabilities to avoid a repeat of the problem.‎