With the end of the mining and resources boom and China devaluing its currency, the storm clouds are gathering in the distance for the Australian economy. There are a range of possible implications for institutional investors should the storm hit.
Australia has not had a recession in 23 years but there is no doubt that key parts of the Australian economy are now in trouble. Economic growth in China is slowing, wages are growing at their slowest rate in decades and many once thriving businesses, particularly in the mining, transport and engineering sectors, are in distress and are either in default of financial covenants or are about to be.
Looming insolvency presents challenges for both equity and debt holders – which will be unfamiliar to many given Australia’s recent unprecedented prosperity.
In this article we consider the commercial and regulatory issues for institutional investors associated with impaired investments as well as identify the circumstances that can provide opportunities to deploy new capital.
It’s a revenue problem
The distress currently being experienced by parts of corporate Australia is generally due to the decline in revenue (for example, look at iron ore and coal prices) not increases in the cost of debt servicing (interest rates are at record lows).
Business has responded by slashing costs (so unemployment is on the rise) but cutting costs can only go so far. If revenues continue to fall and the cost cutting curve starts to flatten (as it invariably must) a lack of liquidity can quickly tip over into insolvency.
Insolvency creating value
In these circumstances, distressed M&A or asset acquisitions can become a good alternative investment opportunity to create value, because they can enable superior growth to be achieved through gaining additional revenue streams. At the same time, further cost reductions can be gained through implementing operational and other synergies in the target entity.
Unfortunately Australia’s restructuring regime often results in a formal insolvency process (receivership, administration or liquidation). This can be very value destructive for the insolvent entity, but savvy investors can benefit from this.
Depending upon the particular circumstances, distressed businesses and assets may come to market at a deep discount. Foreign cashed up investors in particular could see real value in these investments given the Australian dollar’s recent depreciation.
Of course, it is essential that prospective investors undertake appropriate due diligence for distressed asset acquisitions because distressed sales will not be subject to the same representation and warranty regimes as non-distressed transactions.
Distressed asset and business acquisition opportunities arise in many circumstances, especially where non-core businesses and assets are being sold to generate cash to pay down core business debt.
We are also currently seeing an increasing number of opportunities for well-placed investors to take either debt or equity positions (or both) in businesses with strong corporate narratives, but which are saddled with too much debt or the wrong debt/equity mix.
In recent years, the rise of special situation lenders looking to put money to work outside their traditional areas of investment has been pronounced.
Special situations loans usually command excellent premiums and can, depending upon the particular lend, well position the investor to take advantage of any continued decline in the business.
Debt for equity conversions (either displacing or severely diluting existing equity) implemented via a scheme of arrangement or deed of company arrangement are well entrenched in Australia.
The new controlling equity replaces management where needed and adopts a refined business model. Ideally, in due course, the company regains its competitive advantage and returns to profitability.
However, not all institutional investors are equal. Leaving aside the commercial considerations, some investors face particular hurdles when seeking to take advantage of distressed investments.
The position of superannuation funds
As the Final Report of the Financial System Inquiry (FSI) recognised the Australian superannuation system is currently the second largest part of the financial sector and superannuation fund assets have the potential to exceed those of Australia’s banking system within the next 20 years or so.
Given the size and growth of our superannuation funds, their role in funding the economy and their critical importance in delivering retirement incomes, it is therefore appropriate that they are subject to stringent regulation.
The regulatory framework for trustees of superannuation funds in Australia arises both in statute and at general law and gives rise to a range of duties for superannuation fund trustees.
Under this framework, a superannuation trustee is not expressly directed to make any particular form of investment. However, it does effectively ensure that the trustee is accountable for making investment decisions that are in the best interests of the fund’s members.
The Superannuation Industry (Supervision) Act 1993 (Cth) (SIS Act) requires that trustees invest the assets of the fund for the purpose of gaining interest, income, profit or gain pursuant to an investment strategy that has regard for matters such as:
- the risk involved in making, holding and realising, and the likely return from, the investments covered by the strategy;
- the composition of the investments covered by the strategy, including the extent to which the investments are diverse or expose the fund to risks from inadequate diversification;
- the liquidity of the investments covered by the strategy, having regard to the expected cash flow requirements in relation to the fund;
- whether reliable valuation information is available in relation to the investments covered by the strategy;
- the ability of the fund to discharge its existing and prospective liabilities;
the expected tax consequences for the fund in relation to the investments covered by the strategy; and
- the costs that might be incurred by the fund in relation to the investments covered by the strategy.
Relevantly, in the context of making investment decisions as to how to deploy the assets of superannuation funds, a superannuation fund trustee is also required to: “exercise, in relation to all matters affecting the entity, the same degree of care, skill and diligence as a prudent superannuation trustee would exercise in relation to an entity of which it is trustee and on behalf of the beneficiaries of which it makes investments” and “perform the trustee’s duties and exercise the trustee’s powers in the best interests of the beneficiaries”.
In light of these various obligations, it is critical that superannuation fund trustees understand what they are invested in, including how that investment is likely to behave in a range of market conditions (i.e. what drives risk and performance).
Moreover, any distressed investment made by the trustee of a superannuation fund must have an anticipated rate of return commensurate with the anticipated risk of that investment.
Insolvency can destroy value for the investor
Like most other jurisdictions, equity ranks behind debt in an Australian insolvency. If value breaks in debt, i.e. not all creditors would receive payment in full, ordinarily equity will in turn receive no return on investment.
Often, the key to preserving the value of an impaired debt or equity investment is to move swiftly. While the merits of providing good money after bad needs to be assessed carefully at an early stage, the provision of additional capital by institutional investors can help preserve enterprise value (and hence the value of their existing investment).
There are many ways to implement such a strategy. It is not common for super-priority secured debt to be put in place in Australian restructurings, but mezzanine financing and convertible debt are commonly used to provide additional working capital or otherwise reorganise the debt servicing profile of a distressed business.
For example, an investor may hold a significant position in the issued capital of a business that is experiencing a temporary lack of liquidity. If existing creditors are no longer willing to support that business, the current position, if left unchecked, could develop into insolvency.
The provision of “rescue financing” in the form of a debt or equity injection by the investor (or both), can assist the company return to profitability, thereby preserving the original investment.
At a practical level, management must have the confidence of key stakeholders and be able to articulate a cogent business plan that validates the long-term merits of the business continuing as a going concern, i.e. it justifies an investor taking the additional risk of recycling capital through the existing enterprise rather than committing capital to a new venture.
The ability of an impaired stakeholder to influence the outcome of a restructuring will often be determined by its ability to influence the holder of the fulcrum security, i.e. the holder of the security (usually debt, not equity) in which value breaks. Sometimes this means obtaining the fulcrum security (market conditions will determine the discount) and working with the company and its advisors to devise and implement a balance sheet or operational restructuring.
Passive investors that are attuned to setting and forgetting investments will have little experience with distress. However, as the business cycle continues to turn, it is anticipated that the Australian economy will face more challenges. There will be a need to reassess once profitable investments in successful businesses.
To preserve value, some passive investors may need to become more proactive and inject additional capital, if commercial and regulatory considerations are conducive.
For example, in the case of structured distressed investments, a superannuation fund trustee needs to assess the ability of the investment manager to evaluate and monitor the underlying entity. It is also important that there are the necessary systems and processes in place to take action as needed; there needs to be a clear management process to address issues that arise when investments are not meeting expectations.
Following the global financial crisis, institutional investors have undoubtedly learned the critical importance of understanding where their money is actually invested and the underlying exposures and risks.
Of course, this is equally important to all investment types, not just distressed investments: whether they are a structured investment (e.g. a collateralised debt obligation), a direct property investment, an investment in a traditional investment fund or an alternative investment (e.g. in a hedge fund).
It is also critical that institutional investors such as superannuation fund trustees actively monitor investments: trustees have an obligation to understand how funds are being invested and also need a clear process for acting effectively on information received. In particular, effective action needs to be taken when responses are not forthcoming or when performance cannot be explained adequately.
Key industries to watch
The junior (and not so junior) miners and mining services industries, such as transport and engineering, are experiencing significant distress as fluctuating resource prices make it difficult to plan with certainty. Investors in this space are bearish, with a number of planned projects recently being sidelined.
The general view is there is excess capacity, but clearly much depends on the growing economies of China and India. The falling Australian dollar has helped cushion the market’s fall but investors in this area will need to take robust views not only on the asset itself, but the market’s medium- to long-term outlook.