How to restructure Kuwait’s investment companies: Why facing financial reality is critical
The debt dilemma facing many of Kuwait’s investment companies can be addressed through a three-step restructuring process that enables stakeholders to identify investment companies that are worth saving and those that should be wound up.
How to restructure Kuwait’s investment companies Why facing financial reality is critical
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About the authors
Beirut Fadi Majdalani Partner +961-1-985-655 fadi.majdalani @strategyand.pwc.com Marc-Albert Hamalian Principal +961-1-985-655 marc-albert.hamalian @strategyand.pwc.com
Fadi Majdalani is a partner with Strategy& in Beirut and leader of the firm’s Middle East investment practice. He has founded a private equity management company, and has provided consulting services to a number of investment companies and multibusiness holding companies on topics ranging from strategy, operations, and organization and change. Marc-Albert Hamalian is a principal with Strategy& in Beirut, in the firm’s Middle East investment practice. He has experience in a broad range of corporate finance assignments. He specializes in strategy-based transformational change, debt restructuring, due diligence, portfolio restructuring, and financial modeling. Ronald Maalouf was formerly a senior associate with Strategy&. Georges Al Feghali is a senior associate with Strategy& in Beirut, in the firm’s Middle East investment practice. He specializes in strategy-based transformations and portfolio restructuring for investment companies, banks, and diversified conglomerates.
This report was originally published by Booz & Company in 2013.
Marielle Sarkis, Sabine El Najjar, Nay Abiramia, and Saleh AlSaleh also contributed to this report
After the financial crisis began in 2008, many of Kuwait’s investment companies and their creditors were in considerable distress. The investment companies’ business model relied on short-term debt to fund illiquid assets. Once banks cut off this funding this business model was no longer viable. Instead of directly confronting these asset–liability mismatches and unprofitable business models, the investment companies resisted accepting their losses. The banks, with their own capital issues, agreed to “extend and pretend” agreements in which credit lines remained open and losses were not recognized. These agreements staved off bankruptcy for many zombie companies, but they also hoarded and depleted capital that could have been invested more productively elsewhere. The result has been a drag on economic growth. Many of these debt agreements are expiring, which provides banks, regulators, and shareholders with an opportunity and an obligation to structure improved debt work-outs. A new approach is needed to distinguish between investment companies with viable long-term businesses and those that are nonviable. For those with viable businesses, new restructuring plans must allow them to settle debt obligations and reduce leverage. Nonviable investment companies should leave the market expeditiously through asset liquidations. Stakeholders need to confront the depth of the problems in the investment companies. By doing so they will free up capital and thereby allow Kuwait to put the financial crisis behind it and the financial sector to play its proper role in the economy.
• Many of Kuwait’s investment companies have suffered enormous losses since the financial crisis but thanks to extend and pretend loan agreements with creditors they continue to exist as zombie companies — investment vehicles that tie up or destroy capital (estimated at around US$40 billion) that could be productively deployed elsewhere. • A legal and regulatory environment that favors debtors has helped to keep these zombies going. Laws recently enacted to strengthen the financial sector have actually made debt restructuring more difficult. • As loan agreements between investment companies and creditors expire, stakeholders need to resolve the investment company debt dilemma by separating viable from nonviable businesses, restructuring debt sustainably, and facilitating managed liquidations and market exits.
Extend and pretend
The financial crisis hit Kuwait’s investment companies particularly hard. Their business model depended on using cheap, short-term debt to finance operations, the purchase of illiquid assets, and dividend payments to shareholders. When the global financial crisis broke in 2008, and the worldwide recession worsened, the banks cut off any new short-term, low-cost funding. This squeezed, or froze, all operations that were expecting, and that required, continuous funding. Many investment companies invested in such assets as nonlisted equity and direct ownership in real estate, which are tricky to unload at short notice. As the value of these difficult-to-monetize assets started to drop, Kuwait’s investment companies struggled to meet their debt obligations. The banks were also in a tight spot. They faced investment companies that could rely on a Kuwaiti legal system that favors debtors, which meant investment companies could refuse to accept the severity of the problem. Unsurprisingly, the investment companies pushed to reschedule their debts without acknowledging or writing down their losses. At the same time, the banks were coping with their own diminished capital positions, making them similarly reluctant to book losses. Consequently, many of the debt work-outs agreed at that time were extend and pretend arrangements that papered over the problem without addressing the investment companies’ insolvency and weak business model.
Thanks to these arrangements, many investment companies now continue as zombies — investment vehicles that are dead in all but name and that tie up or destroy capital that could be productively used elsewhere. For example, some companies extended their credit lines to fund their operating expenses rather than to create value and develop a viable restructuring plan. However, many of the original extend and pretend agreements are starting to expire, presenting the banks and regulators with the chance to fulfill their obligations and push for a resolution of the investment company debt problem. They can force Kuwait’s investment companies to accept meaningful agreements that restructure debt sustainably for viable companies and isolate nonviable investment companies to facilitate their managed liquidation and market exit. Addressing this problem will not cause too much pain to the banks because it is of manageable scale. Most investment companies in need of debt work-outs are small. At least individually, they are not a threat to the banks. Only two investment companies have a debt balance of more than KWD 500 million ($1.77 billion), a level that would significantly affect numerous banks.
The ineffectiveness of the current agreements and the impact of the pro-debtor environment are clear five years after the onset of the financial crisis. The debt obligations among Kuwait’s 55 publicly listed investment companies have not been appreciably reduced. At the end of the third quarter of 2012, investment companies’ total liabilities were equivalent to 63 percent of total assets, compared with 65 percent in 2008 (although in absolute terms total liabilities decreased), according to consolidated financial data from the Central Bank of Kuwait (CBK). Furthermore, only about 55 percent of total debt has been worked out — and even that figure flatters the investment companies as most workouts involved postponing the debt problem and not settling it definitively. (That 55 percent of total debt is held by nine companies, five of which are still listed.) At best, a second round of work-outs is required. This means that 45 percent of investment companies’ debt still needs a first-time work-out. Most investment companies owing this debt remain overleveraged, albeit at a misleadingly lower level than companies that have already had a first round of debt work-out. The five listed companies with ongoing work-out arrangements have an 80 percent ratio of debt to assets, compared with 70 percent for the listed companies without workout arrangements. (One reason the ratio is lower for those without ongoing work-out arrangements is that not all listed investment companies require a work-out.) In either case, the level of debt is unsustainable. It poses a problem for the banks, the most important institutional creditors, and for the investment companies’ shareholders, whose accumulated returns on initial equity are close to just 1 percent. Another aspect of the worrisome financial picture is that only 29 of the 55 listed investment companies in Kuwait had published half-year financials by November 2012. Of those, 21 reported losses, mainly because they did not generate enough income to cover operating expenses and financing costs. In addition, 10 investment companies offer limited visibility for investors and creditors into their financial situation as they have either not reported financials in one year or they have been delisted from the stock exchange. These investment companies are almost certainly in significant financial distress, although the lack of transparency makes it difficult to evaluate with precision.
The debt obligations among Kuwait’s 55 publicly listed investment companies have not been appreciably reduced.
Further evidence of the depth of the investment companies’ problems is revealed by their noncompliance with CBK regulations announced in 2010. These regulations came into force in 2012 and cover leverage, liquidity, and foreign exposure ratios. As of November 2012, seven companies out of the 29 listed investment firms that published half-year financials reported leverage ratios that were noncompliant with the CBK’s regulations.
How extend and pretend work-outs fail
To better understand why the earliest extend and pretend agreements failed, consider a fictional but typical investment company. This typical Kuwaiti investment company relied on short-term debt to finance the acquisition of real estate and minority equity stakes in companies. After 2008, its bank creditors restricted the typical investment company’s access to new financing. Given the typical investment company’s limited operating cash flow, the company soon defaulted on its debt payments. The value of the typical investment company’s assets continued to decline and its liabilities soon exceeded the realizable value of those assets. The typical investment company’s problems derived from more than just weak liquidity; its business model was fundamentally flawed (see Exhibit 1, page 9). Debt work-out negotiations between the typical investment company and its creditors lasted for more than a year, during which time the financial situation continued to deteriorate. After each round of failed negotiations the typical investment company’s board replaced the firm’s decision makers to try and resolve the issue. The final work-out included haircuts (a reduction in the market value of assets to provide collateral), loan-toasset and loan-to-equity swaps, and rescheduling remaining debt. Unfortunately, the work-out agreement was not grounded in financial reality. Assets were swapped at inflated book value, and creditors obtained overvalued equity shares in the typical investment company. This led to a lower recovery ratio than claimed. The stated recovery rate of the principal debt was 95 percent, but the actual ratio was 83 percent (see Exhibit 2, page 9). Instead of resolving the typical investment company’s problems, the work-out prolonged its zombie status. The typical investment company does not have a sustainable equity cushion (the leverage ratio remains at 90 percent), nor a strong source of cash inflow, and no financial maneuverability to restart the business. As a result, the typical investment company’s creditors remain vulnerable to further losses on assets, equity ownership, and rescheduled debt obligations.
Exhibit 1 The financial distress of a typical investment company
Realizable Asset Value and Liabilities (in KWD millions)
90 40 45 Realizable asset value1 Cash Minority equity investments Real estate
Liabilities and future value of equity Future value of equity
Realizable asset value = value after applying minority/ illiquidity discounts.
Exhibit 2 Proposed restructuring, and realizable asset values after restructuring
Typical Investment Company Debt Work-Out
Stated value Actual value Description (KWD millions) (KWD millions) Haircut Loan-toasset swap Loan-toequity swap 15.0 10.0 5.0 11.0 1.4 Banks aimed to reduce haircut to avoid adverse market signals and accounting provisions Assets were mostly swapped at close to book value as the typical investment company was unable to absorb further losses due to low capitalization Regulations in Kuwait stipulate that shares can be issued only at par (i.e., 100 Fils or 0.1 KWD). As such, the typical investment company’s debtors obtained 100,000,000 shares; value of each share is around 14 Fils. Five years, including two years’ grace period and a reduced ﬁnance costs rate. The amount of rescheduled typical investment company debt had a security ratio of 100%; however, the typical investment company, lenders, and restructuring advisors were implicitly aware that a default remained imminent.
A debtor-friendly environment
Despite weak fundamentals and poor performance, investment companies have successfully resisted change in part because Kuwait’s legal environment favors debtors over creditors. Bankruptcy proceedings are often protracted because the courts are unwilling to grant bankruptcy orders without giving debtors an extended period of time to remedy their financial problems. This leeway gives debtors the opportunity to conduct discretionary bilateral negotiations and extract more concessions from their creditors. Moreover, limited transparency in the market means that debtors can mislead creditors about the value of assets when exchanging them. This “information asymmetry” between debtors and creditors is a serious barrier to long-term debt work-outs. The Financial Stability Law (FSL) gives companies even more protections from creditors and less incentive to agree to work-outs, even though it was introduced in 2009 after the financial crisis began. The FSL is also vague on key issues, such as the cram-down mechanism. This mechanism — which imposes a restructuring agreement despite the objection of some creditors — is essential for a swift restructuring process because it prevents a minority of dissenting creditors from blocking the refinancing. Thus far, the FSL has been used in only a few restructuring plans, such as the Investment Dar and A’ayan Leasing and Investment Company cases. Even for these the outcome has yet to be seen.
The creation of the Capital Markets Authority (CMA) in 2010 has also failed to accelerate the debt restructuring process. The CMA needed to ramp up its regulatory capabilities quickly in the face of complex financial market transactions. Instead, the CMA created new uncertainties affecting debt restructuring, such as requiring a buyer of more than 30 percent of a listed company to make a tender offer for the entire company — a rule that could discourage potential buyers of distressed assets. The CMA is also stricter on the legal liabilities of board members, making board members even more reluctant to make tough decisions that could prove wrong. Along with a legal and regulatory framework that favors debtors, the government created programs designed to help investment companies to the detriment of creditors. For instance, the government agreed to settle in full investment companies’ debts to foreign banks. This was done by shifting the debt to the local banking sector. The government deposited funds in local banks as a guarantee to allow them to initiate new loans to the investment companies. The result was that debt work-outs were postponed and local banks increased their exposure to investment companies.
Along with a legal and regulatory framework that favors debtors, the government created programs designed to help investment companies to the detriment of creditors.
A new chance to restructure
Defaults are once again looming after several years of avoiding the problem. Banks, regulators, and shareholders should use the expiry of the extend and pretend agreements to seek a comprehensive solution. The timing is propitious as the banks are now better capitalized than before, which means they can absorb the inevitable losses. Forcing the investment companies to tackle asset–liability mismatches and weak business models will push some of these investment companies into liquidation. Unpleasant though this may be, it will pave the way for healthier investment companies to emerge with sensibly restructured debt and firmly grounded businesses. Stakeholders will need to take action on three fronts for these new agreements to succeed. 1. Separate viable from nonviable businesses The CBK and the CMA should mandate an independent task force to conduct an honest inventory of assets, segregating troubled assets from viable ones. This task force is necessary because the first round of restructuring demonstrated that executives in some investment companies do not evaluate their assets accurately. The valuation and monetization potential of all assets must then be assessed and compared with the liabilities and debt maturities. Following the review of assets, the task force needs to answer three questions about each company’s finances to determine its viability. • Are solvency levels acceptable or has equity been completely wiped out? • Is recurring income from monetization, dividends, or fees adequate to sustain overhead and repay debt? • Are funds available to continue operations and fund new investments?
2. Restructure debt sustainably Investment companies that pass the viability test have two options for debt restructuring: out-of-court or through the mechanism of the FSL. Out-of-court work-outs: As a first step, the company should seek a consensual agreement among all its creditors. This will often require the assistance of an independent mediator, such as the official regulator. Therefore the regulators, as a legitimate third party, should actively participate in out-of-court restructurings. The CBK should act as a facilitator, driving the process whenever needed. For instance, the CBK might push a strong lender to swap loan exposure into illiquid but attractive assets (such as land and dividend-yielding minority equity ownerships), which allow for monetization over a longer time frame. FSL work-outs: If a restructuring agreement is not reached within an acceptable time frame of three to six months, the investment company should seek regulatory protection in the form of an FSL work-out. This will facilitate a court-approved restructuring and protect the investment company from creditors that might prefer to take the company straight into bankruptcy. To encourage such applications, the FSL must be improved. For example, the FSL needs an effective cram-down mechanism. The FSL should outline creditors’ approval thresholds and more clearly define solvency and eligibility criteria. Additionally, the FSL process should be shortened. Currently, bureaucracy and uncertainty about how to apply the law can delay the initial analysis for a restructuring proposal by up to eight months. In the case of either an out-of-court or an FSL work-out, restructuring plans need sound information, creditors’ alignment, and innovative long-term solutions. • Sound information: Investment companies must provide transparent and accurate information about their assets to all stakeholders, including regulators. In addition, financial projections should be realistic and reflect current market conditions. • Creditors’ alignment: The plan must establish credit committees with clear rules and processes (for example, decision-making mechanisms and frequency of meetings) so that creditors have a forum in which to articulate and resolve conflicts. Such committees might, for instance, agree to collateralize all assets at market values to give all creditors as much security as possible, thereby reducing conflict between secured and non-secured creditors.
• Innovative long-term solutions: Restructuring plans should balance the long-term survival of the business with its creditors’ ongoing protection. For example, management can legitimately acquire the flexibility to meet debt obligations through loan-to-equity swaps with several recovery options, grace periods, and debt relief based on agreed triggers. In addition, covenants can ensure that creditors have sufficient control over their claims. 3. Facilitate managed liquidations and market exits Nonviable investment companies need to stop hemorrhaging financially. Their shareholders must acknowledge that their equity has been wiped out. Their creditors must accept haircuts. To assist with this process, regulators should issue clear rules and guidelines to force nonviable companies toward market exits by allowing shareholders to trigger voluntary liquidations and regulators to trigger involuntary ones. Also, regulators should have the power to replace management with external liquidators to manage the process of closing the company and distributing assets to stakeholders.
All investment companies’ stakeholders, whether creditors, shareholders, regulators, or managers, must work together to seize the opportunity for realistic debt restructurings. Kuwait will reap considerable economic benefits when the almost $40 billion in capital tied up in the investment companies is liberated for productive investment. The three-step restructuring process will identify those investment companies that are worth saving and those that should be wound up. Resolving the investment company debt issue will dissipate the uncertainties about Kuwait’s financial sector as a whole, demonstrate firmness by the authorities, and allow for increased investment in the broader economy.
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This report was originally published by Booz & Company in 2013.
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