Corporate reconstructions

Corporate reconstruction of a failing company

Companies in financial distress often undergo corporate reconstructions to enable them to remain in business rather than go into liquidation. Corporate reconstruction in a failing company often involves raising some new capital and persuading creditors / lenders to accept some alternative to the repayment of their debts. This will ensure that the business continues in the short term.

Longer term, the management need to consider whether the reconstruction will help the company develop a sustainable competitive advantage, and provide opportunities for raising further finance.

Corporate reconstruction of a solvent company

Corporate reconstructions can also be undertaken by successful companies. The specific objectives of the reorganisation /reconstruction maybe one or more of the following:

• To reduce net of tax cost of borrowing.
• To repay borrowing sooner or later.
• To improve security of finance.
• To make security in the company more attractive.
• To improve the image of the company to third parties.
• To tidy up the balance sheet.

Options open to failing companies

Options open to failing companies not wishing to go into liquidation, and which allow space for the development of recovery plans, usually include:

• a Company Voluntary Arrangement (CVA)
• an administration order.

A Company Voluntary Arrangement (CVA)

• An application is made to the court, asking it to call a meeting between the company and its creditors or a class of creditor, e.g. debenture holders.
• The scheme of reconstruction is put to the meeting and a vote taken.
• If there is 75% in value and including proxies vote in favour the court will be asked to sanction it.
• If the court sanctions it, the scheme is then binding on all the creditors.

Administration orders

The use of an administration order

Consider the case of a manufacturing company which has become insolvent. There are also indications of poor credit control, and production problems including long lead times, high defect rates and high levels of stock. However there is a growing market for the company's products which are well-designed.

The company was put into administration to allow for a recovery plan to be developed. Its debts were written down and creditors and the bank given equity in the business. New management was brought in which improved the production and financial management and turned round the company which is now profitable.

Options for the reconstruction of solvent companies

Conversion of debt to equity

The most likely reasons for converting debt to equity are:

• Automatically by holders of convertible debentures exercising their rights.
• In order to improve the equity base of a company. This situation is particularly likely to arise when a company has financed expansion by short-term borrowings. Sooner or later, it will run into working capital problems, and if long-term loan funds are not available (because, for example, they would make the gearing excessively high) the only solution is to issue new shares, possibly by way of a rights issue.

Conversion of equity to debt

Conversion of equity to debt usually involves the conversion of preference shares to some form of debenture. Although through the eyes of both companies and investors there is little to choose between debentures or preference shares bearing a fixed rate of return, in the eyes of both tax and company law they are very different:

• From the tax point of view, payments to preference shareholders are dividends, and are not, therefore, an allowable charge in computing taxable profits.
• From the legal point of view, conversion of preference shares into debentures constitutes a reduction of capital. Company law provisions relating to redemption of shares must therefore be followed. In accounting terms the broad effect of these provisions is to reduce distributable profits by the nominal value of the preference shares redeemed (by transferring amounts from distributable profit to capital redemption reserve).

Conversion of equity from one form to another

This includes:

• Simplifying the capital structure. It was once common to have a variety of types of share capital, designed to appeal to a variety of investors. This has now become less favoured, and the tendency is to have only one, or at most two, classes of share capital. Conversion of shares from one type to another can only be carried out in accordance with the procedures in the articles, normally approved by a prescribed majority of the class affected, subject to rights of appeal to the court.
• Making shares more attractive to investors, for example by sub-division into smaller units, or conversion into stock.     
• Eliminating reserves by issuing fully paid bonus shares. This is very much a tidying up operation, and may be especially useful to remove share premium accounts and capital redemption reserves. Additionally, in a period of inflation, it may be recognising the fact that a substantial part of the revenue reserves could never be paid out as dividends.

Conversion of debt from one form to another

This procedure might be undertaken to improve security, flexibility or cost of borrowing. For example:

• Security - Consider the example of a company financing itself out of creditors and overdraft facilities, neither of which give any security. Rather than a rights issue, converting the creditors to long-term loans, e.g. debentures, would be equally satisfactory in that it would give security as to the source of funds.     
• Flexibility - Again, a company financing itself out of short-term borrowings has little room to manoeuvre. Flexibility could be improved by arranging more permanent financing. Alternatively, a company already borrowing to the limits of its ability could reduce its borrowings and improve flexibility by using other sources of finance - leasing for example.     
• Cost - Some loan finance is cheaper than others for example secured loans compared with unsecured loans. An opportunity may arise to shift from a relatively high cost to a relatively low cost source of funds.

Devising a corporate reconstruction scheme

General principles in devising a scheme

In most cases the company is ailing:

• Losses have been incurred with the result that capital and long-term liabilities are out of line with the current value of the company's assets and their earning potential.
• New capital is normally desperately required to regenerate the business, but this will not be forthcoming without a restructuring of the existing capital and liabilities.

The general procedure to follow would be:

(1) Write off fictitious assets and the debit balance on profit and loss account. Revalue assets to determine their current value to the business.

(2) Determine whether the company can continue to trade without further finance or, if further finance is required, determine the amount required, in what form (shares, loan stock) and from which persons it is obtainable (typically existing shareholders and financial institutions).

(3) Given the size of the write-off required and the amount of further finance required, determine a reasonable manner in spreading the write off (the capital loss) between the various parties that have financed the company (shareholders and creditors).

(4) Agree the scheme with the various parties involved.

The impact on stakeholders

The interests of a number of different stakeholder groups must be taken into account in a reconstruction. A reconstruction will only be successful if it manages to balance the different objectives (risk and potential return) of:

• ordinary shareholders
• preference shareholders
• creditors, including trade payables, bankers and debenture holders

  Solvent companies often enter reconstruction schemes to improve their ability to raise finance in the future by making security in the company more attractive or to improve the image of the company to third parties. The view taken of the scheme by banks and investors is therefore vital in ensuring that this aim is achieved.

Banks have been criticised in the past for being too quick to close down failing companies in order to protect their investment at the expense of others - it is important that they are initially supportive and allow time for decisions about the company's future to be made with the full co-operation of all stakeholders.

In a failing company the main burden of the losses should be borne primarily by the ordinary shareholders, as they are last in line in repayment of capital on a winding up. In many cases, the capital loss is so great that they would receive nothing upon a liquidation of the company. They must, however, be left with some remaining stake in the company if further finance is required from them.

Preference shares normally give holders a preferential right to repayment of capital on a winding up. Their loss should be less than that borne by ordinary shareholders. They may agree to forgo arrears of dividends in anticipation that the scheme will lead to a resumption of their dividends.

If preference shareholders are expected to suffer some reduction in the nominal value of their capital, they may require an increase in the rate of their dividend or a share in the equity, which will give them a stake in any future profits.

Creditors, including debenture and loan stock-holders may agree to a reduction in their claims against the company if they anticipate that full repayment would not be received on liquidation. Like preference shareholders, an incentive may be given in the form of an equity stake.

In addition trade creditors may also agree to a reduction if they wish to protect a company which will continue to be a customer to them.

Business reorganisation methods

Unbundling companies

Unbundling is the process of selling off incidental non-core businesses to release funds, reduce gearing and allow management to concentrate on their chosen core businesses. The main aim is to improve shareholder wealth. Unbundling can take a number of forms:

• Spin-offs, or demergers, in which the ownership of the business does not change, but a new company is formed with shares in the new company owned by the shareholders of the original business. This results in two or more companies instead of the original one.
• Sell-offs, which involves the sale of part of the original company to a third party, usually in return for cash.
• Management buyouts, in which the management of the business acquires a substantial stake in and control of the business which they managed.
• Liquidation, when the entire business is closed down, the assets sold and the proceeds distributed to shareholders. This is done when the owners of the business no longer want it or the business is not seen as viable.

Spin-offs or demergers

The aim of a demerger is to create separate businesses which together have a higher value than the original company. Following a demerger:

• shareholders own the same proportion of shares in the new business or businesses as they did in the previous one
• each company owns a share of the assets of the original company
• the new company or companies generally have new management who can take the individual companies in diverging directions; and each company could eventually be sold separately
• the original company may no longer exist, with all its assets distributed to the new business.

Sell-offs

A company may sell-off parts of the business for a number of reasons, such as:

• to raise cash
• to prevent a loss-making part of the business from lowering the overall performance business
• to concentrate on the core areas of the business
• to dispose of a desirable part of the business to protect the rest from the threat of a takeover.

Management buy-outs

What is a management buy-out?

Overall the distinguishing feature of an MBO is that a group of managers acquires effective control and substantial ownership and forms an independent business. Several variants of an MBO may be identified and are explained below:

• Management buy-out - where the executive managers of a business join with financing institutions to buy the business from the entity which currently owns it. The managers may put up the bulk of the finance required for the purchase.
• Leveraged buyout - where the purchase price is beyond the financial resources of the managers and the bulk of the acquisition is financed by loan capital provided by other investors.
• Employee buyout - which is similar to the above categories but all employees are offered a stake in the new business.
• Management buy-in - where a group of managers from outside the business make the acquisition.
• Spin-out - this is similar to a buyout but the parent company maintains a stake in the business.

Reasons for a management buy-out

Opportunities for MBOs may arise for several reasons:

• The existing parent company of the "victim" firm may be in financial difficulties and therefore require cash.
• The subsidiary might not fit with the parent's overall strategy, or might be too small to warrant the current management time being devoted to it.
• In the case of a loss-making part of the business, selling the subsidiary to its managers may be a cheaper alternative than putting it into liquidation, particularly when redundancy and other wind-up costs are considered.
• The victim company could be an independent firm whose private shareholders wish to sell out. This could be due to liquidity and tax factors or the lack of a family successor to fill the owner-manager role.

Advantages of buy-outs to the disposing company

There are a number of advantages to the parent company:

• If the subsidiary is loss-making, sale to the management will often be better financially than liquidation and closure costs.
• There is a known buyer.
• Better publicity can be earned by preserving employee's jobs rather than closing the business down.
• It is better for the existing management to acquire the company rather than it possibly falling into the hands of competitors.

Advantages to the acquiring management

The advantages to the acquiring management are that:

• it preserves their jobs
• it offers them the prospect of significant equity participation in their company
• it is quicker than starting a similar business from scratch
• they can carry out their own strategies, no longer having to seek approval from head office.

Issues to be addressed when preparing a buy-out proposal

MBOs are not dissimilar to other acquisitions and many of the factors to be considered will be the same:

• Do the current owners wish to sell? The whole process will be much easier (and cheaper) if the current owners wish to sell. However, some buy-outs have been concluded despite initial resistance from the current owners, or in situations of bids for the victim from other would-be purchasers.
• Will the new business be profitable? Research shows that MBOs are less likely to fail than other types of new ventures, but several have collapsed. As the new owners the management team must ensure that the business will be a long-run profit generator. This will involve analysing the performance of the business and drawing up a business plan for future operations.
• If loss-making, can the new managers return it to profitability? Many loss-making firms have been returned to profitability via management buyouts. Managers of a subsidiary are in a unique position to appreciate the potential of a business and to know where cost savings can be made by cutting out slack.
• What will be the impact of loss of head office support? On becoming an independent firm many of the support services may be lost. Provision will have to be made for support in areas such as finance, computing, and research and development. Although head office fees might be saved after the buyout these support services can involve considerable expense when purchased in the outside market.
• What is the quality of the management team? The success of any MBO will be greatly influenced by the quality of the management team. It is important to ensure that all functional areas are represented and that all managers are prepared to take the required risks. A united approach is important in all negotiations and a clear responsibility structure should be established within the team.
• What is the price? The price paid will be crucial in determining the long-term success of the acquisition. Care must be taken to ensure that all relevant aspects of the business are included in the package. For example, trademarks and patents may be as important as the physical assets of the firm. In a similar way responsibilities for costs such as redundancy costs must be clearly defined.
• Is the deal in the best interests of shareholders? Managers known to the existing owners may be able to secure the buyout at a favourable price, and the final price paid will be a matter for negotiation. However, the current directors of the firm have a responsibility to shareholders to obtain the best deal possible, which may mean a full commercial price being paid for the victim company

Evaluating the benefits of reorganisations

Concentration of growth and maximisation of shareholder value

Following the unbundling of a company the resulting value of the new businesses can exceed that of the original business. This suggests that the shares in the original business were selling for less than their potential value and can be for a number of reasons:

• The splitting-off of non-core activities from the rest of the business may increase the visibility of an under-valued asset which is then valued more highly by the market.
• Businesses may be valued more highly in the hands of the new managers than under the previous management.
• The sale of less profitable parts of the business may be viewed favourably by the market, result in an increased valuation for the remainder.
• The performance of the individual businesses may improve, also resulting in a higher valuation.

Reduction in complexity and improved managerial efficiency

Since the 1980s, increasing numbers of demergers and sell-offs have taken place in order to reduce the complexity of the organisation:

• Diversified businesses are complex to manage. As the pace of change and uncertainty facing organisations has increased, the complexity of large businesses becomes more difficult to cope with and absorbs management time and energy which is diverted from the business itself.
• Smaller companies tend to be more flexible and respond more easily to change.
• Following a demerger, the new companies have a clearer, more focused management structure.
• Improved managerial effectiveness also results from the splitting off of non-core businesses as managers are free to concentrate on what they do best.
• Changes in the market can also mean that benefits of synergy no longer exist, and there is no longer any business reason for the organisation to retain unrelated businesses.

The release of financial resources for new investment

Unbundling parts of the company can also release financial resources:

• selling a loss-making part of the business which is absorbing funds can release cash to invest in the core businesses or new activities
• a reduction in the size and complexity of the organisation can reduce the central management costs, freeing up resources
• unbundling generates a lump sum in proceeds which can be invested in a specific project

Illustration

In October 2006 GUS plc, a major UK retail and business services conglomerate, completed the process of demerger into three separate businesses. Burberry, a luxury brand, was demerged first, and the remaining company was demerged in October 2006 into Experian, a provider of analysis and information services, and Home Retail Group, a major home and general retailer.

This demerger was the culmination of a strategy to maximise shareholder wealth by focusing on a small number of high-growth businesses. Other parts of the business were sold off to raise funds for reinvestment. Among the reasons given for the demerger were:

• the lack of synergy between the businesses
• separate opportunities for investment for shareholders
• allowing the independent businesses to pursue individual strategies and benefit from a better management focus.

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