Over the past 12 months, we have seen high profile companies going into administration. Nakumatt Holdings Limited, Deacons (East Africa) PLC and ARM Cement have all faced this public demise. So why are administrations on the rise?
By way of background, for too long there has been an enormous diminution of value and actual cost to employees, lenders, shareholders and to the Kenya’s GDP when companies went into receivership or liquidation. There was no ‘after-life’ for such companies, as at the end of the process a few would continue to trade. The entities that did continue to trade, invariably were substantially smaller than pre-receivership, and under new ownership.
The returns to lenders (who generally appoint a receiver) was poor and potentially subject to years of costly litigation.
Administrations came to the fore in the Insolvency Act, 2015. The idea, heavily based upon the UK Insolvency Law, was that companies should be ‘saved’ and continue to trade, rather than be wound up/go into liquidation.
The recent publicity around the sale of ARM Cement has shown that a company can be sold under administration and therefore be ‘saved’. The question is, however, has that company been ‘saved’ and were the returns to lenders and other stakeholders anything like those forecast? From press articles, it appears as if senior lenders may not be paid in full with the consequence with reports there will be no dividend to shareholders.
As a turnaround expert of 25 years, I support a process that allows stakeholders (the main ones being management, shareholders, lenders, suppliers and employees) to gain maximum returns and saving a company.
In my opinion, administrations, even though better than many other types of ‘enforcement’, they should be a last resort. The costs associated with administration can be large, and, thus, reduce the overall returns to creditors, lenders and shareholders. The latter often receive no value for their shares post-administration.
The better way is a turnaround outside of a court process. This is fully understood by the majority of stakeholders. However, for the turnaround culture to work, it requires directors to be proactive. If a director seeks professional assistance as soon as he/she becomes aware that the company is facing a cash tightness (loss of major contract, a large receivable not being paid, non-receipt of government payable or a general slow-down within the sector) then there is a high probability that the company can be saved.
It is clear that many Kenyan owned family businesses and SMEs have facilities with local and international lenders. Many lenders’ Offer Letters include financial covenants.
If a director is proactive, as soon as it is clear that an internal KPI or a lender’s covenant test is tight or about to be breached, the company can generally be saved if action is taken at that time. Any delay, however, can be catastrophic and result in the demise of the company.
It is known that the time lag between a breach of covenant and a payment default can be as much as 12-24 months. If, however, the director/shareholder (or indeed lenders) wait until there is a payment default, the options available to save/turnaround the company become substantially reduced. This inaction can reduce, if not entirely remove the value to the shareholder.
Lenders across the globe have shown they are supportive of global turnaround process which does not involve insolvency nor does it involve the court.
The Global Turnaround process is an out-of-court arrangement whereby stakeholders come together to save the business in a confidential manner.
It is a shame that in East Africa there are too many situations where a turnaround has been unsuccessful – the major reason is that the turnaround started too late. In other words, there was no proactive action taken by shareholders or lenders, when time and options were available to the stressed company. By waiting until after a payment default, the company will have moved into a distressed state and lenders will start to raise provision in anticipation of future losses.
Where a turnaround plan is taken forward early, say as soon as cash tightness is anticipated or a financial covenant is breached, it is far easier to gain the support of all stakeholders, including lenders.
After all, lenders and shareholders generally gain greater returns outside insolvency/administration and the costs are far less, so why would they not support?
Yes, lenders may have to assist the company with additional working capital, but the risk of providing “New Money” is often far smaller than provisions they may have to raise once a company has a payment default.
Lenders argue that they have to consider administration because the directors/shareholders will not take professional assistance or indeed take the necessary action required to turn the company around.
The claim, therefore, is that directors are often in denial. There is an element of truth in this, however. Equally, it is true that lenders in the past have encouraged (in some cases ‘threatened’) shareholders to take action, but lenders have not taken forward their ‘threat’ of enforcement despite little or no turnaround strategies being implemented by the directors.
This could have left directors with a perception that no action will be taken by the lender in the future.
Lenders are now facing the highest level of Non-Performing Loans (‘NPLs’) ever seen in the Kenyan banking sector history.
This newspaper on June 12, 2019, said the value of bad loans in the banking sector stood at Sh345 billion as at March 31.
The easiest and cheapest way of dealing with NPLs is to prevent an account becoming an NPL in the first place. Notwithstanding this, lenders know that under the new Insolvency Act, they can appoint an administrator without the hassle of defensive litigation being issued by directors.
Courts are likely to approve a request for an administrator to be appointed where it can be shown that a default has arisen and potential returns are higher under an administration than under an insolvency. Why? Because, under administration, the court will provide a stay of enforcement (normally for a 12-month period) during which, no action can be taken by any creditor.
In other words, the court by approving the appointment of an administrator, is providing a period of time during which the company can issue its own turnaround plan without the pressure of a potential winding up petition being issued.
The reality, however, is that often, unless a sale of the company under administration can be achieved, it will end up in a formal insolvency.
In short, therefore, in such situations where a company is showing signs of cash/liquidity stress, unless a director takes action early, any creditor (including lenders) can ask the court to appoint an administrator and such a request is likely to be granted if the conditions of appointment are met.
It has to be remembered that as soon as an administrator is appointed, the company is then run on a day by day basis, not by the company directors, but by the administrator.
In such situations where directors are also shareholders, one can find that not only are the directors removed, but the shareholder value falls to zero. The previously envisaged ‘paper wealth’ held by directors, in shares and income, are potentially lost.
To prevent this fall from grace, directors need to obtain professional help as soon as they see signs cash flow distress in their companies. If they do not, they should not be surprised that lenders will request the court to appoint an administrator.
Smithis an Associate Director and the Head of Debt Advisory and Restructuring at KPMG Advisory Services Limited.