Corporate Restructuring, Divestment, Purpose of divestment, Buyouts, Types of buyouts, Financial distress

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Corporate Finance FIN 622

Lesson 36

CORPORATE RESTRUCTURING

This handout will take care of following topics:

Corporate Restructuring

Divestment

Purpose of divestment

Buyouts

Types of buyouts

Financial distress introduction

Corporate Restructuring

Corporate restructuring and improved corporate governance are essential parts of economic reform

programs under way in many countries. How can corporations be restructured to promote growth and

reduce excessive debt without placing undue burdens on taxpayers? What framework is needed to promote

better corporate governance?

CORPORATE Restructuring involves restructuring the assets and liabilities of corporations, including their

debt-to-equity structures, in line with their cash flow needs to promote efficiency, restore growth, and

minimize the cost to taxpayers. Corporate governance refers to the framework of rules and regulations that

enable the stakeholders to exercise appropriate oversight of a company to maximize its value and to obtain

a return on their holdings. Both corporate and financial sector restructuring are central to ongoing reform

programs in East Asia. This article focuses on reform efforts in Indonesia and Korea, as well as Malaysia

and Thailand.

Corporations, government, and banks have close relationships in many East Asian countries.

Conglomerates controlled by a small group, nontransparent accounting, interlocking ownership between the

corporate and financial sectors, and weak minority shareholder rights dominate many sectors of their

economies. It is estimated that the top 10 families in Indonesia in 1997 controlled corporations worth more

than half the country's market capitalization. Comparable figures are one-half in Thailand, one-fourth in

Korea and Malaysia, but only 23 percent in Japan. Fundamental cultural and institutional changes are

required if a new corporate governance structure is to be established with arm's-length, transparent relations

between corporations, government, and banks. Changing corporate governance, however, is a long-term

process. In East Asia, the immediate task is to deal with the present crisis by undertaking integrated

restructuring of the assets and liabilities of highly indebted firms, external debt restructuring, and financial

sector reform. Integrated restructuring of both corporate assets and liabilities is required if competitive

enterprise and financial sectors are to be developed, the risk of crises recurring is to be reduced, and the

cost to taxpayers of accomplishing these goals is to be minimized.

Build up of vulnerabilities in the corporate sector. Before the crisis hit, many East Asian corporations

expanded into sprawling conglomerates making extensive use of debt, because equity markets were

undeveloped and, in many cases, owners preferred to retain control of firms with concentrated holdings.

There were also structural weaknesses in these countries' banking supervision systems and internal bank

management. Much of the debt owed to banks and corporations was unheeded and short term, which led to

extreme over indebtedness following the devaluations and high interest rates of 1997 and 1998. Two factors

that make financial crises in East Asia difficult to manage are the large, short-term internal and external

debts and openness of many East Asian economies, both of which constrain their monetary and exchange

rate policies.

Need for a comprehensive approach. Resolving corporate sector, financial sector, and external debt

problems requires a comprehensive and integrated approach. Since good firms are necessary if an economy

is to have good banks, corporate restructuring must be linked to bank restructuring, which, in turn, must be

linked to the settlement of external debt problems. Perverse incentives and inequitable burden sharing can

result if obligations to short-term external creditors are met and losses are concentrated on the government,

labor, and, ultimately, the taxpayers. The costs to the government of bank recapitalization are high--we

estimate that they range between 15 and 35 percent of GDP for the four countries discussed in this article.

Financing these costs domestically is likely to increase government borrowing, thus increasing interest rates

and further slowing recovery of the corporate sector.

In the short term, there is an urgent need to restructure the corporate and financial sectors. It is important

to manage the crisis in such a way as to start the process of satisfying longer-term reform goals in each

country, including making the fundamental changes necessary to create arm's-length relations between the

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government, corporations, and banks. Necessary steps include broadening the ownership of corporations

by liberalizing foreign entry and expanding the role of capital markets. Protecting shareholder rights and

developing improved accounting standards and bank regulations are essential. Just as the Great Depression

led to legislation and reforms in the United States that diminished "relation-based" finance and laid the

foundation for a modern financial structure, so the crisis in East Asia offers a rare opportunity for countries

in that region to lay the foundation for a new, arm's-length system that is likely to be more efficient and

sustainable.

The challenge for policymakers is to undertake comprehensive reform that maintains pressure on all parties

in a way that promotes equitable burden sharing among borrowers, equity holders, the government, and

external creditors; restores credit to viable enterprises and confidence in the financial system; and leads to a

competitive corporate and financial system that minimizes the chances of recurrence of a crisis.

Sustainable reform and the resumption of growth require a fair sharing of the burdens of economic

restructuring among external participants (short-term creditors, equity holders, and bondholders) and

internal participants (shareholders, workers, and taxpayers). This burden sharing needs to be seen within the

context of creating a future structure in which arm's-length relations prevail between new private sector

owners, the government, sound financial institutions, and the broader capital market. The present

constraints of meeting external debt payments and tight capital- adequacy ratios effectively determine the

extent, pace, and costs (and, to a large extent, who bears these) of corporate and bank restructuring.

Framework for Corporate Restructuring

Corporate and financial restructuring takes time. In order to avoid an unnecessarily long period of

uncertainty and slow growth, however, a country's government needs to enhance efforts to resolve these

systemic problems. A comprehensive approach requires an active government that will eliminate obstacles

to restructuring; facilitate both formal and informal debt workouts; and establish an effective new legal,

regulatory, accounting, and institutional framework.

Obstacles to restructuring that need to be eliminated include tax policies that impede corporate

reorganizations, mergers, debt-for-equity swaps, or debt forgiveness; restrictions on foreigners' participation

as holders of domestic equity and investors in domestic banks; labor laws and other existing laws and

regulations that could hinder debt restructuring; and ineffective bankruptcy procedures.

Effective bankruptcy procedures, which can be legally enforced and serve as part of a country's debt-

restructuring process, are a very important means of ensuring that unviable firms do not continue to absorb

credit. An effective bankruptcy system also serves to maximize the value of the assets to be distributed to

creditors. Moreover, the presence of an effective bankruptcy system will create the appropriate incentives

for creditors and debtors to reach out-of-court settlements. Given the costs and risks associated with even

the most developed bankruptcy systems, a policy framework that facilitates out-of-court settlements that are

fast, fair, and acceptable is essential.

Experience in several countries demonstrates that the government can play a constructive, yet informal role

in facilitating an orderly workout of debts (sometimes referred to as the "London approach"). This

approach, used in the United Kingdom since 1989, has been designed to help bring together debtors and

creditors and facilitate negotiations. Many East Asian countries have adopted, or are adopting, a similar

framework to facilitate and encourage corporate restructuring that includes using new bankruptcy

provisions as an incentive for creditors and debtors to negotiate.

The government's policy framework should minimize costs to taxpayers. Because its primary focus is likely

to be on large and medium-sized corporations, neither direct nor should indirect subsidies be provided to

them. Small and medium-sized businesses require a different approach than large ones. Because many of the

former have only restricted access to banks and capital markets, it is important to have policies in place that

allow for rolling over their working capital and trade credit.

Policies are also needed to improve the competitiveness of the private sector. Competition policies that

reduce anticompetitive practices and stop large firms' abuses of market power need to be implemented in

parallel with corporate restructuring.

Approaches to Corporate Restructuring

Indonesia, Korea, Malaysia, and Thailand have all adopted an approach that facilitates and encourages

corporate restructuring and have moved to eliminate obstacles to restructuring. The extent of progress and

the degree of government involvement differ among countries, however, and are influenced by the share of

corporate debt held by domestic banks versus foreign banks, whether domestic banks are institutionally

strong enough to engage in active restructuring, and which sector the bad loans are concentrated in (real

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estate, commodity production, or manufacturing). In Indonesia, foreign private banks hold two-thirds, and

domestic private banks hold about one-third, of corporate debt. In Thailand, foreign private banks hold

about one-half the corporate debt. In Korea, most corporate debt is owed to domestic banks; similarly, in

Malaysia, domestic banks hold about 90 percent of corporate debt.

In Indonesia, most corporate debt is owed directly by the borrowing firms to foreign banks. The weak

domestic banks and their small share of total corporate debt imply that foreign banks will be an important

player in the process. The authorities have adopted a three-pronged restructuring approach that consists of

a framework to facilitate workouts on a voluntary basis, an improved bankruptcy system, and provision of

foreign exchange risk protection once a restructuring agreement is reached. To support this process, the

authorities are also eliminating regulatory obstacles to corporate restructuring.

Divestment

In finance and economics, divestment or divestiture is the reduction of some kind of asset, for either

financial or social goals. A divestment is the opposite of an investment.

Divestment for Financial Goals

Often the term is used as a means to grow financially in which a company sells off a business unit in order

to focus their resources on a market it judges to be more profitable, or promising. Sometimes, such an

action can be a spin-off. A company can divest assets to wholly owned subsidiaries.

Either the prime objective for divestment may be the assets being sold does not conform to the overall

business strategy or they fail to meet the group hurdle rate. They are often a cheaper and cleaner alternative

than closure of the unit.

It is very important to calculate the financial effect of divestment before any final decision is made based on

the two aspects stated above. The evaluation will take the form of a comparison of the potential price

available for the relevant business unit and the financial effect on the remainder of the group, against the

financial return available from the business unit if it were retained. The divestment decision should only be

made if the returns of the business unit as retained as compared with the disinvestment opportunity cost.

For example, if a division of a group is earning 12% as compared to group return of 18%, then it should be

disposed off.

However, the cost of asset and price available for sale must be compared and evaluated before the decision

to sell.

For example, if an asset or group of assets costing Rs 100,000 is earning 12% or 12000 and could be sold

for 60,000/-. The group hurdle rate is 18%. Comparing 12,000 with 80,000, then ROCE is 15%

(12,000/80,000) and is under group hurdle rate of 18%, therefore, it can be disposed off.

However, if the offer price of asset in question is 50,000, the ROCE is 24%, which is well above the group's

rate of return of 18% and the asset in question should not be disposed off.

Divestment for Social Goals:

Although these types of divestments are for social purposes, yet they have financial repercussions. The term

also refers to the reduction of investment in firms, industries or countries for reasons of political or social

policy.

Examples

Examples of divestment for social reasons have included:

· The withdrawal of firms from South Africa during the 1980s due to Apartheid

· Discussion over whether it is ethical to invest in companies that sell tobacco

Definition of buyout

Buyout is defined as the purchase of a company or a controlling interest of a corporation's shares or

product line or some business. A leveraged buyout is accomplished with borrowed money or by issuing

more stock.

The purchase of a company or a controlling interest of a corporation's shares.

Management Buyouts

Management buyouts are similar in all major legal aspects to any other acquisition of a company. The

particular nature of the MBO lies in the position of the buyers as managers of the company and the

practical consequences that follow from that. In particular, the due diligence process is likely to be limited as

the buyers already have full knowledge of the company available to them. The seller is also unlikely to give

any but the most basic warranties to the management, on the basis that the management knows more about

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the company than the sellers do and therefore the sellers should not have to warrant the state of the

company.

In many cases, the company will already be a private company, but if it is public then the management will

take it private.

Reasons for Buyouts:

The existing parent company of the victim firm may wish to dispose of it. The parent company may be

caught up in financial distress and is in acute need of cash and liquidity. The subsidiary on the other hand, is

not strategically fit with parent's overall business strategy.

In case of loss making, selling the unit to its management may be the better option than to dispose or

putting into liquidation, which has it own costs.

The purpose of such a buyout from the managers' point of view may be to save their jobs, either if the

business has been scheduled for closure or if an outside purchaser would bring in its own management

team. They may also want to maximize the financial benefits they receive from the success they bring to the

company by taking the profits for themselves.

Private Equity Financing

The management of a company will not usually have the money available to buy the company outright

themselves. While they could seek to borrow from a bank if the bank accepts the risk, they will commonly

look to private equity investors to back their buyout. They will invest money in return for a proportion of

the shares in the company, and sometimes also grant a loan to the management.

Private equity backers are likely to have somewhat different goals to the management. They generally aim to

maximize their return and make an exit after 3-5 years while minimizing risk to them, whereas the

management will be taking a long-term view. While certain aims do coincide - in particular the primary aim

of profitability - certain tensions can arise. The backers will invariably impose the same warranties on the

management in relation to the company that the sellers will have refused to give the management. This

"warranty gap" means that the management will bear all the risk of any defects in the company that affects

its value.

As a condition of their investment, the backers will also impose numerous terms on the management

concerning the way that the company is run. The purpose is to ensure that the management runs the

company in a way that will maximize the returns during the term of the backers' investment, whereas the

management might have hoped to build the company for long-term gains. Though the two aims are not

always incompatible, the management may feel restricted.

Leveraged Buyout LBO

The acquisition of another company using a significant amount of borrowed money (bonds or loans) to

meet the cost of acquisition. Often, the assets of the company being acquired are used as collateral for the

loans in addition to the assets of the acquiring company. The purpose of leveraged buyouts is to allow

companies to make large acquisitions without having to commit a lot of capital.

In an LBO, there is usually a ratio of 90% debt to 10% equity. Because of this high debt/equity ratio, the

bonds usually are not investment grade and are referred to as junk bonds. Leveraged buyouts have had a

notorious history, especially in the 1980s when several prominent buyouts led to the eventual bankruptcy

of the acquired companies. This was mainly due to the fact that the leverage ratio was nearly 100% and the

interest payments were so large that the company's operating cash flows were unable to meet the obligation.

It can be considered ironic that a company's success (in the form of assets on the balance sheet) can be used

against it as collateral by a hostile company that acquires it. For this reason, some regard LBOs as an

especially ruthless, predatory tactic.

Employee Buyout EBO

A restructuring strategy in which employees buy a majority stake in their own firms. This form of buyout is

often done by firms looking for an alternative to a leveraged buyout. Companies being sold can be either

healthy companies or ones that are in significant financial distress.

For small firms, an employee buyout will often focus on the sale of the company's entire assets, while for

larger firms; the buyout may be on a subsidiary or division of the company. The official way an employee

buyout occurs is through an employee stock ownership plan (ESOP). The buyout is complete when the

ESOP owns 51% or more of the company's common shares.

Management Buy In (MBI):

Management Buy in (MBI) occurs when a manager or a management team from outside the company

raises the necessary finance buys it and becomes the company's new management. A management buy-in

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team often competes with other purchasers in the search for a suitable business. Usually, a manager will lead

the team with significant experience at managing director level.

The difference to a management buy-out is in the position of the purchaser: in the case of a buy-out, they

are already working for the company. In the case of a buy-in, however, the manager or management team is

from another source.

Some of the private equity groups and executive search firms that focus on management buy-ins.

Spin out

To rotate out of control, as a skidding car leaving a roadway.

Factors to be considered in Management Buyout

A management buyout occurs when incumbent management takes ownership of a firm by purchasing a

sufficient amount of the firm's common stock. These transactions vary due to the conditions under which

the firm is offered for sale and the method of financing employed by the managers.

Consider the conditions that may encourage managers to purchase a controlling interest in the firm's stock.

The owners of a corporation are its stockholders. These stockholders are concerned with increasing the

value of their investment, not only in one specific firm, but for all investments. Therefore, if a majority of

the firm's stockholders perceive that the value of their investment will be enhanced by agreeing to be

acquired by another firm, they will elect to sell their stock to the acquiring firm at a price they consider fair.

Managers of a firm may consider this transfer of ownership a benign event. They may also, however, be

concerned that the new owners will not manage the firm most efficiently, that they will have less control

over the management of the firm, or that their jobs will be less secure. In this situation, the current

managers of the firm may consider purchasing the firm themselves.

Another situation that frequently leads to management buyouts is the case of financial distress. If the firm is

having serious difficulties meeting its financial obligations, it may choose to reorganize itself. This can be

done by closing failing operations to slow the drain on financial resources and by selling profitable

operations to an outside party for the cash needed to restore financial viability to remaining operations. It is

not uncommon for firms in this situation to give managers of the divisions being divested the opportunity

to buy the assets. This makes sense for two reasons. First, management probably has the greatest expertise

in managing the subset of assets offered for sale. Second, it saves the cost of searching for an external party

with an interest in the division, for sale.

Once incumbent management has decided it is interested in purchasing the firm or a particular portion of

the firm, they must raise the capital needed to buy it. Managers in many corporations are encouraged to

become stockholders in the firm by including stock and the option to buy more stock as part of their

compensation package. The non-management stockholders, however, will expect some compensation from

this sale and the value of manager-owned stock is not likely to be sufficient to finance the purchase of the

firm or one of its divisions. This means that managers must raise cash from other sources such as personal

wealth. If managers have sufficient capital in other investments, these can be sold and used to finance the

remainder of the purchase price.

While a management buyout is relatively straightforward when managers have sufficient personal capital to

meet the purchase price, the more common scenario requires managers to borrow significant amounts. It is

not un-common for managers to mortgage homes and other personal assets to raise needed funds, but in

many transactions, these amounts are still not sufficient. In these cases, managers will borrow larger

amounts using the assets of the firm they are acquiring as collateral. This type of transaction is called a

leveraged buyout, or LBO. The LBO is a common form of financing for large transactions. It provides

the management team with the financing needed to control the assets of the firm with only a small amount

of equity. Nevertheless, the new firm that emerges from this transaction has very high financial risk. The

large amounts of debt will require large periodic payments of interest. If the firm cannot meet this

obligation during any period, it can be forced into bankruptcy by the debt holders.

This description of a management buyout can be generalized to define an employee buyout. In some

situations, it is feasible that all employees, not just a small group of managers, can collectively purchase a

controlling interest in a firm's stock. This may be the long-term result of a carefully designed employee

stock ownership plan (ESOP), that management has instituted. It may also result from the pressures of

financial distress. In 1994, United Airlines was faced with declining profits and strained relations with labor.

Management and labor eventually agreed on a swap of wage concessions for a 55 percent equity stake in the

firm. In the five following years, the firm became more profitable, the stock price rose significantly, and

employees retained a controlling interest in Unity's common stock.

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It is important to note that managers (or employee owners) are no different than other investors. They will

assess the risk and rewards associated with a buyout, leveraged or otherwise, and will act in their own best

interests. As managers, they have specialized knowledge of the firm that may prove advantageous in

charting a future course of action for the acquired firm. By assuming ownership of the acquired firm, they

will also assume a riskier position personally. If the potential rewards associated with control are perceived

as adequate compensation for this risk, then the management buyout will be source of financial distress.

Sources of Financial Distress:

A situation in which available cash is insufficient to pay supplier, vendors, employees, banks and creditors is

known as financial distress. Signs of first-stage distress include negative net cash flow and earnings and a

falling market equity value. If this situation persists, then management must take actions to rectify it. The

second-stage signs of distress include managements' attempt to reduce costs, such as employee lay off and

plant closing.

If this situation goes on, the firm enters the third and final stage of distress marked by delayed and small

payments to creditors and vendors, employees and others. This may also include of sale of assets, issuing

loan stocks and rescheduling payment with creditors and banks. If these actions do not alleviate the

financial sufferings and the firm is likely to embrace the bankruptcy the eventual result of financial

distress.

A firm incurs several costs when its financial position deteriorates, even if the firm does not declare

bankruptcy. These are called costs of financial distress. Bankruptcy involves additional fatal costs. As a

general definition, any loss of value that can be attributed to a firm's financial strength is a cost of financial

distress. These can be classified into three categories:

- In terms of favours to stakeholders to off set them for the risk of doing business with financially sick firm

- Loss of competitive edge in product market

- Loss of tax shield available

In the next hand out we shall cover the sources of financial distress in detail.

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