distressed investing in australia from turnaround
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A guide or buyers and sellers
Distressed Investing in Australia
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About Blake DawsonOur focus is getting to the heart of your legal needs and delivering you commercially astute and practical
solutions. We have a proud history, long standing client relationships, a passion for challenging conventionsand thrive on cutting edge work.
We provide legal services to Australias leading companies and institutions as well as global corporations and
government. We are privileged to work with many of the organisations that are shaping tomorrows industries.
Blake Dawson delivers more than just the law. We value our relationships with our clients and look forward
to working with you.
Our Distressed Investing Practice
Our Distressed Investing practice has an established track record of assisting clients to successfully executethe restructuring, sale or purchase of distressed assets, companies and non-performing loan portfolios.
Our expertise spans all sectors including real estate, energy and resources, manufacturing and financialservices and we cover all geographic areas. We bring together a multi-disciplinary team of leading advisers
from our banking, restructuring and insolvency, corporate, property and tax teams to best structure yourdistressed deals. For further information, please visit our website at www.blakedawson.com
About PricewaterhouseCoopersPricewaterhouseCoopers provides industry-focused Assurance, Tax & Legal and Advisory services
for public and private clients in four areas:
corporate accountability
risk management
structuring and mergers and acquisitions
performance and process improvement
We use our network, experience, industry knowledge and business understanding to build trust
and create value for our clients.
Distressed Debt Group
Over the past decade, PricewaterhouseCoopers Distressed Debt Group has managed more than150 sell-side and buy-side engagements in over 25 countries. Overall the group has acted for more
than 30 international clients, 60 local buyers and various government agencies.
With dedicated staff located in Australia as well as Asia, Europe and Latin America we bring together
global experience with local capability, no matter where the deal is, to ensure a smooth and seamlessexperience. We are also uniquely positioned through our extensive relationships with the pool of global
investors, to ensure any deal is marketed to the widest possible audience of buyers.
The Distressed Debt group is an integral part of PricewaterhouseCoopers Corporate Advisory
and Restructuring practice which has a local presence in over 60 countries in the world.
2009. Blake Dawson and PricewaterhouseCoopers. All rights reserved.
This work is copyright. Reproduction of any part is welcome with prior permission from Blake Dawson and
PricewaterhouseCoopers. Requests and enquiries may be emailed to [email protected] [email protected].
Australian laws and regulations are constantly changing. This publication is intended only to provide a summary ofthe subject matter covered. It does not purport to be comprehensive or to render legal advice. No reader should act
on the basis of any matter contained in this publication without first obtaining specific professional advice. We invite
you to contact us for any further information or assistance.
PricewaterhouseCoopers refers to PricewaterhouseCoopers, a Partnership formed in Australia or, as the context
requires, the PricewaterhouseCoopers global network or other member firms of the network, each of which is aseparate and independent legal entity.
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Foreword Blake Dawson 2
Foreword PricewaterhouseCoopers 3
Overview Distressed investing in Australia 4
1. The who, the how and the why of buying distressed debt/assets 12
Who buys and sells distressed assets, and why? How big is the global market? What is Australias
place in this market, and what do potential investors think of Australia? What is the secondary debtmarket, and how does it operate in Australia and offshore?
2. Portfolio debt sales the key considerations in value 18
What determines the value of a portfolio of an individual credit or a portfolio of distressed debt?What are the key steps in the administration of distressed assets? How do debtholders recover
assets in Australia?
3. Using secured debt to control outcomes and obtain ownership of the assets 28
What are the legal boundaries within which distressed asset investors must move? What are the
rights and responsibilities of secured debtholders? How can debtholders best protect the valueof their assets?
4. Recapitalising distressed listed/unlisted companies 32
How can distressed asset investors recapitalise their assets? What are the differences betweenlisted and unlisted firms? How does the administration regime in Australia provide for companies
to be reorganised?
5. Why should an Australian bank sell debt? 36
If Australian banks have felt no need to sell distressed assets until now, why should they consider
it? Reasons include an increased number of buyers of distressed assets, the increasing drainon management time and focus on workout, the constraints on capital created by Basel II,and liquidity constraints brought on by the global financial crisis.
6. How does a non-performing loan portfolio sale work? 40
What are the steps in selling a non-performing loan, or a portfolio of loans? How are they pricedand how do sellers achieve the best price. What are the mechanics of servicing the portfolio
during and after the sale process? How can sellers best protect their interests?
7. Structuring options for sellers of debt/assets 46
How should banks and other sellers of debt structure their transactions? Options include outright
sale, a joint venture arrangement, or securitisation.
8. Tax implications of selling and buying debt 50
Tax issues are complex both for the buy side and sell side. What features of the Australian tax systemare relevant for distressed asset investment? What tax issues should sellers and buyers take into
account at the planning stage?
Appendix A Economic outlook 62
Appendix B Summary of Australian Big 4 Banks Basel II disclosures 64
Useful websites 66
Contributing authors 68
Contact information Back cover
able o contents
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Foreword Blake Dawson
The emergence and continued growth of a secondary market in Australia for
distressed debts and assets is a sign of the increasing depth and sophistication
of Australias financial markets.
Such a market is beneficial to the Australian economy for at least two key reasons.
Firstly, it adds much needed liquidity into the system, permitting parties with existing
positions to trade out those positions. Secondly, it creates a floor for distressed assets,
meaning that any business that is capable of being restructured is restructured.
Ultimately, by providing opportunities for new investors, the chances of preserving
stakeholder value and continuity of employment in Australian businesses are maximised.
For lenders and investors with existing positions, there is the option of selling
down their positions into the market. For potential investors with a knowledge
of distressed investing techniques, there is the opportunity to invest.
Australia is an attractive place to invest. The rule of law prevails and the legislative and
judicial processes are justifiably held in high regard. A number of the historical legal
impediments to secondary market trading have now been removed and the Australian
market is becoming more comfortable with the distressed investing techniques that arecommon features of other markets; these include loan to own strategies; pre-pack
formal appointments; and convertible note investing. By utilising these techniques,
an investor can look to minimise the risks associated with investing in distressed
companies or their assets.
Of course there still remain issues that lenders and investors must confront. The
Sons of Gwalia decision, for example, has not done much for Australias reputation
in other financial markets where shareholders are expressly excluded from competing
with creditors upon insolvency. These issues aside however, distressed debt and
asset trading is a market not to be ignored. In a time of uncertainty, it presents
significant opportunity for those who have the appetite.
As market leaders in restructuring and distressed investing, we are committed
to shaping this emerging market. For this reason we have partnered with
PricewaterhouseCoopers to produce this guide. Covering the key legal and
accounting issues, we hope this guide will arm you with the requisite knowledge
and understanding to participate in and take advantage of this exciting market.
James Marshall
Partner, Blake Dawson
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Foreword PricewaterhouseCoopers
When one door closes another door opens; but we so often look so long and so
regretfully upon the closed door, that we do not see the ones which open for us
When Alexander Graham Bell wrote this world famous quote it is doubtful that he
had in mind the financial crisis of 2008/09.
The Australian market is today facing a period of uncertainty like it has not facedsince the early 90s. Like then, globally banks today are facing a rapid build up
in non-performing loans and companies are facing unprecedented pressure on
their top and bottom lines. However the market is also a very different one today
to those uncertain days. In todays market there are so many more options open
to both distressed companies as well as lenders.
There exists a very real opportunity for banks to unlock the hidden value tied up in
non-performing loans. From freeing up management time to focus on newer more
pressing problems to releasing capital that needs to be set aside against all NPLs,
debt sales have a very real place in todays market as has been highlighted by the
American, European and Asian markets experience.
This is why, together with Blake Dawson, we have invested in this publication to further
develop the Australian market and to highlight some of the issues around the buying
and selling of distressed debt and assets and thereby encouraging the evolution
of this fledgling market in Australia.
Please read this with the open mind that Alexander Graham Bell advocates and
help us to help you realise this opportunity and in the end maximise recovery
during these uncertain times.
Michael McCreadie
Partner, PricewaterhouseCoopers
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Overview Distressedinvesting in Australia
Australia is really attractive to us...
...says the manager of a billion dollar global fund dedicatedto investing in distressed assets, who was interviewed forthe purposes of this publication.
Worldwide, distressed investment is a
US$50 US$100 billion industry. As theconsequences of the global financial crisis work
their way through the global economy, it is oneof the few areas that is set to grow significantly
in the years to come, as increasing numbers ofcompanies find themselves in difficult financial
circumstances and are unable to meet theirdebt commitments. Distressed M&A in the
US alone is set to grow by 93% this year.
Australia will follow. The boom years have
been good to the lucky country, but the
global downturn has significant implicationsfor Australian companies. Export markets
are stressed and the domestic economicsituation has darkened. Companies are laying
off large numbers of workers, are restructuringto avoid insolvency, and in some cases
are falling into administration.
For distressed asset specialists, Australia is
an extremely attractive market. Heres why:
Opportunities will proliferate as the economic
situation unfolds. The countrys banks are
managing a larger number of underperformingloans than they have seen in 15 years.
Their workout teams are overwhelmed. In alllikelihood, the supply of non-performing loans
from Australian banks will multiply as banksstruggle with the new business conditions
and become increasingly comfortable withthe idea of bundling and selling poorly
performing assets to third parties
The legal and accounting frameworks are
clear and comprehensible, unlike a number
of markets in the Asian region
The business operating environment is well
regulated and stable, with good infrastructureand well developed services
There is a large base of sophisticatedinvestors looking for alternative investment
opportunities in this new and exciting market.
The distressed investing market in Australia
has historically been very quiet. But this is
likely to change, and change rapidly.
Between December 2008 and January 2009,PricewaterhouseCoopers and Blake Dawson
interviewed a number of high profile marketparticipants, including representatives from
Australias major banks, foreign banks active
in the market, fund managers with experiencein distressed asset investing offshore,
and domestic private equity managersconsidering distressed deals.
This overview outlines our conclusions fromthose interviews together with research into
the opportunity for the creation of a secondary
or distressed investing market in Australia.This publication outlines the mechanics ofsuch a market, from the basics of distressed
asset transfer to the structure of such deals,
its legal framework and tax implications.
Understanding how to participate in distressed
investing will be vital in the coming monthsand years for those organisations that wish
to flourish through the downturn.
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Now, we are on the verge of a new market.
A market created by the rapid change ineconomic circumstances, by investment
capital looking for opportunities in anextremely difficult environment, and by
the need for Australian banks and otherfinancial institutions to find solutions
to new problems.
Through a period of 15 years of
uninterrupted growth, Australian lendershave experienced only modest levels of
financial distress amongst their customers.
Financiers in other parts of the world havedeveloped efficient markets for transferring
distressed assets off their balance sheetsto specialist investment funds and other
investors dedicated to the sector. But
their Australian counterparts have beenunder no pressure to do so.
With the global financial crisis rolling
through the Australian economy, financialinstitutions are likely to see a sharp
increase in non-performing loans and
other distressed assets. At the same time,banks revenues are reducing because of
lower demand for credit, and there will begreater pressure from both shareholders
and regulators to hold increased amountsof capital against impaired assets.
Meanwhile, distressed asset funds
operating across international marketsare eyeing Australia carefully. The countrys
well structured financial markets, rigorous
legal frameworks and clear regulatoryenvironment give it a competitive
advantage over its regional neighbours,and a clearly imminent increase in
financial distress is attracting attentionfrom those who seek to extract value
from financially troubled companies.
Global funds with experience in distressed
markets are cashed up and poised onthe sidelines. Over the next few years,
Australia may well see the birth of a
vibrant market for these assets, but itwill take a change in approach on behalf
of the major financial institutions, and afew breakthrough deals to kick start it.
Bad news risingAt the tail end of a 15-year boom, theAustralian economy is facing numerous
challenges. Seemingly overnight, thecredit crunch and the global financial
crisis have brought the countrys longest
unbroken period of growth to a halt.
The years of relatively easy credit that
fuelled the countrys optimism and itsinvestment in the future have ended.
In 2006, companies were offeredunprecedented amounts of leverage
to finance their futures and maintainsmooth cash flows. Much of that
Australian banks have neverreally thought about debt sales.
Tey have never really had to.
Senior manager, major Australian bank
Background
Australia has had little need for a distressed asset marketuntil today. A strong economy for well over a decadehas meant there have been relatively few bankruptcies,non-performing loans on banks books have been wellwithin manageable limits, and investors have had a wealthof positive, growth oriented opportunities to focus on.
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activity came to a stop in the middle
of 2007 as banks faced serious liquiditychallenges in the flow on from the sub-
prime crisis in the US. The early stagesof the credit crunch saw the collapse
of many Australian companies whoserise had been emblematic of the boom:
Allco Finance Group, ABC Learning,
Centro and Babcock & Brown beingthe highest profile casualties to date.
The spread of bad news through thefinancial markets has infected broader
sentiment throughout the economy.Companies, for many years unable
to recruit enough good people fastenough, have been laying workers
off in their thousands. Consumers,a mainstay of Australian prosperity for
over a decade, have stopped shopping.
Despite fast and deep cuts in officialinterest rates by the Reserve Bank of
Australia, industry has stopped investingand the housing market has stalled.
China, whose economic health has beencrucial for Australia, has also faltered in
recent months, its export-led GDP growthstumbling from over 10% over the last
decade to less than 7% at the end of
2008. Chinas unprecedented demandfor commodities placed a floor under
prices for much of Australias inventoryof natural resources, and underwrote
soaring share prices for the countrysblue chip mining companies and a flurry
of investment in small and mediumsized commodity enterprises.
China also directly invested tens ofbillions of dollars in Australian resource
enterprises. Much of this investment is
under pressure to continue to perform.The collapse in Chinas export markets
is rapidly flowing through to the Australian
mining community, and that sector, just
12 months ago the source of a greatdeal of economic strength, is undergoing
swift and unpleasant adjustment.
In short, the credit crisis is having a
significant impact on Australias industriesand enterprises. Many companies with
previously sound business models
have met with unexpected difficultywhen attempting to roll over their short-
term loans, causing sudden and severecash flow issues. Many have had to
quickly and radically adapt their businessoperations. Others have simply failed.
According to the Australian Securitiesand Investments Commission, the number
of companies entering administration inAustralia jumped 10.3% between 2007
and 2008 to 8,300, and the number
of insolvency appointments jumped byover 6% to 12,770.
Bad loans in the systemWith the economy in freefall, banks andother financial institutions are bracing
themselves for a major increase indistressed assets as companies and
consumers find themselves unable to
service the loans taken on in the goodtimes. By the end of the last fiscal year,
the major banks had already seen a risein bad debt charges, up some 174% over
the year to end June 2008. The first half ofcalendar 2008 was 54% higher than the
second half of 2007. By some measuresthe increase in bad debt charges in fiscal
2008 was up 183%, representing 0.41%of total loans. The Australian banking
industry hasnt seen this level of bad
debt charges since 1994, the tail endof the last downturn.
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Our conversations with the major banksindicate that many workout desks arealready eeling the pressure.
DOMESIC CREDI GROWH(ANNUAL % GROWH)
IMPAIRED ASSES AND BAD DEB EXPENSE
Michael McCreadie, PricewaterhouseCoopers
Impaired assets / gross loans & acceptances (left axis)
Bad debt charge / gross loans & acceptances (right axis)
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
Notes: 2006 onwards based on AIFRS
0%
5%
10%
15%
20%
25%
30%
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Total Housing Personal Business
Source: PricewaterhouseCoopers Perspectives: Major Banks Analysis, October 2008
Source: PricewaterhouseCoopers Perspectives: Major Banks Analysis, October 2008
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At the same time, the banks have
witnessed a marked increase inimpaired assets, up by 137% in fiscal
2008, or 0.43% total loans. While thisis still significantly below levels experienced
during the 1990s, the banks are alsoseeing significant increases in past-due
loans. During fiscal 2008, loans that were
past due 90 days or more with adequatesecurity increased 29% in aggregate.
Our discussions with a number ofworkout professionals in the major
banks indicate that many are facingunprecedented workloads. In many banks,
workout desks are perhaps the onlygrowing part of operations, with many
experiencing such growth in demandthey fear being overwhelmed.
While impaired assets and debt charges
are likely to increase significantly, bankmargins will be under pressure from
slowing credit growth on both theconsumer and business lending sides.
Total credit growth slowed in 2008 to10.5% from 16% in 2007, with growth
in business lending slowing to 13.7%in the year to September 2008 from
over 22% the previous year.
This points to a challenging environment
for the major banks, to say the least.
Things are likely to be worse for otherplayers in the financial services arena.
The foreign banks, second tier financialinstitutions, such as smaller banks, credit
unions and building societies, as wellas other non-bank financial institutions
are each facing their own issuesand financial strains.
A fear exists that foreign banks, underpressure to withdraw capital to support
their home markets, will pull out of the
Australian market, transferring theirAustralian loan portfolios, in aggregate
totalling some A$50 billion to A$80 billion,to other counterparties or reducing
funding lines. At the time of publication,
reports were emerging of the first ofsuch activity, with a major foreign bank
offering a portfolio of leveraged loansof up to A$100 million.
In response to the feared pullout of foreignbanks, in January 2009 the Australian
government launched a A$4 billion fund to
support commercial property developmentprojects that lose their international
financial backing due to the financialcrisis. Domestic banks will provide half
the funds capital.
Many second tier banks and other
smaller financial organisations areseeking consolidation or other forms
of partnership with larger institutions.Non-bank financial institutions have been
significantly weakened by the increase in
the cost of funding, as well as the collapsein demand for housing finance with the
fall in house prices.
Each of these issues creates new
pressures on Australias financial systemwhose most marked characteristic over
the past decade has been swift growthand fast innovation.
Distressed assetsA significant volume of distressed debt
is an unfamiliar problem for Australianlenders. Australian financial institutions
have generally adopted a much simplerbusiness model than their counterparts
offshore. While banks and other financiersin the US, Europe and Asia have actively
managed their balance sheets by sellingindividual loans or portfolios of non-
performing loans (NPLs) and otherdistressed assets to realise value and
transfer them off their books, Australian
banks have not done so, resolutelykeeping bad loans on their own books and
focusing on working them out themselves.
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Australian bankers, when interviewed about the lack of a local
market for distressed assets cite several reasons, the mostpersistent of which is that there has been no real need for one.
Australian banks have never really thought about debt sales,said one senior manager at a major Australian bank. There may
be a number of reasons for this. It may be that the structure ofAustralian loans the documentation has precluded trading
them. Secondly, banks may have had the view that they would
be foregoing too much profit were they to transfer their assets.And thirdly, because of their position in the community, banks
would be reluctant to hand their customers over to a distressedasset firm that may not have the same relationship imperative.
Other reasons given include a cultural reluctance to admitmistakes, as well as a focus on workouts as a core banking
competence that precludes the sale of NPLs.
None of these reasons would seem strong enough to dissuade
banks from entering into an active distressed debt market if thevolume of NPLs reached critical mass. As workout desks become
increasingly overwhelmed, as investors begin to offer prices thatreflect the fair value of the loans, banks will be forced to consider
the alternative to keeping all NPLs on their balance sheets.
Capital questionsOver and above the pressure banks are likely to feel fromincreasing volumes of distressed assets, regulators will have a
keen eye on banks management of capital. The introduction ofthe Basel II regulations this year will increase scrutiny of banks
NPL portfolios. There is growing concern among the bankingcommunity that both the banks and the regulators do not
yet appreciate the full impact of the new regulations as levels
of NPLs increase significantly.
Basel II requires banks to set aside up to 25% of the gross
loan value of NPLs as Tier 1 Capital, capital that could be freedup to generate income for the bank in other ways if the NPLs
were sold to another party.
According to one senior banker: If the full impact of Basel II
is applied, there is no way banks can afford to carry NPLs ontheir balance sheets during the tough times. He points out
that the Basel II regulations, if fully imposed, are extremelypro-cyclical, discouraging banks from lending during
downturns, and freeing up capital during boom times.
Te ull impact o Basel II is really unknownas yet as we have not lived through a cyclewith it. I the ull impact is applied, then there
is no way banks can aford to carry NPLs onthe balance sheets during the tough times.
We see a market waitingto come to lie.
Michael Sloan, Blake Dawson
Senior manager, major Australian bank
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Distressed corporatesThe distressed market is not just
confined to the impaired loans ofAustralian banks. Many listed and private
Australian companies and trusts areexperiencing severe liquidity problems
associated with looming refinancing datesand a lack of replacement debt capital.
To date, some larger listed corporates
have managed to reduce gearing and raiseliquidity through cut price raisings on the
equity market which, whilst dilutive, is abetter option than the other alternatives.
However, for private companies and listedcompanies with weak share prices, this
option is generally not available. A numberof off-shore and domestic funds and
lenders are now targeting distressedcorporates and offering them relatively
highly priced debt (usually with a right to
convert to equity upon agreed terms) tofund liquidity gaps. Such funds will also
consider investing equity but will seekassurances around the balance sheet
and matters such as class action risk.
Demand or distressBanks are indeed likely to consider selling
their distressed assets in the near future.At the same time, there is significant
demand for them from both global players
based in Asia and local private equityplayers looking to deploy their funds in
the distressed asset arena. The market inAsia has been active since the late 1990s,
when the number of distressed companiesshot up in the Asian financial crisis. Across
the globe, there are hundreds of entitiesthat invest in distressed assets, from
the major international players out of the
US, such as Cerberus and Lonestar, to
smaller specialist funds, many of whichhave pan-Asian funds that would consider
Australia and New Zealand part oftheir investment universe.
A survey of 100 hedge funds across Asiaby Debtwire in October 2008 found that,
after China and Indonesia, Australia is
the market where most distressed debtopportunities are expected to arise over the
coming year. At the same time, Australiasstrong legal framework and regulatory
environment give potential distressed assetinvestors security in their property rights,
an advantage over the less predictableChinese and Indonesian markets.
There are a number of things we likeabout Australia, says one manager at
an international alternative investment
fund. Firstly as a global fund we likethe language, the law and the corporate
governance framework. At the sametime, because we deal with distressed
assets we can see there are some realproblems brewing in the underlying
economy so we are likely to seesome opportunities arise there.
The country also has a greater levelof sophistication in terms of asset
management networks. We are a capital
provider, and cant service individual loansfrom a pool of them. Rather, we need to
tap into an existing infrastructure to helpus manage our assets, and that exists in
Australia, whereas it doesnt in some ofthe less developed markets in Asia.
A point made by many asset managerswas that, because many funds operate
on a global basis, any investments inAustralia would have to offer risk-adjusted
rates that were competitive with those
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attained in other parts of the world. At themoment, there is an impression that there
is something of a large spread betweenwhat sellers of distressed debt might
offer, and what buyers might pay.
My feeling, says another distressed
asset specialist operating across Asia,
is that the market in Australia is still inprice discovery mode. There is a fairly
large bid-ask differential.
At the same time, asset prices across
the globe have been falling steadily sincemid-2008, and many investors are sitting
on the sidelines waiting to see whena bottom might be found.
The picture is one of a market waiting tocome to life. On the supply side sit the
banks, with a growing pool of distressed
assets that will need to be managed forvalue, but constrained in their ability to
expand workout operations by supply ofexperience. They are also limited in their
capacity to hold NPLs by the need to setaside significant amounts of regulatory
capital against them. On the demand side,there are a large number of funds with
considerable amounts of capital available
ready and willing to invest in these assets.
With a change in approach from Australias
major banks, an adjustment in priceexpectations from both sellers and buyers,
and a detailed understanding of the legaland business issues discussed in the
rest of this publication, we anticipate thecreation and growth of a real market for
distressed investing in Australia over the
next few years. This growth will benefitbanks, investment funds, and, in the end,
companies experiencing financial distressto have an efficient market focused on the
ownership and management of their debt.
Tere are a number o things we like aboutAustralia. Firstly as a global und we like thelanguage, the law and the corporate governanceramework. At the same time, because we dealwith distressed assets we can see there aresome real problems brewing in the underlyingeconomy so we are likely to see someopportunities arise there.
Manager, international alternative investment und
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1. The who, the howand the why ofbuying distresseddebt/assets
The distressed debt market in Asia matured during the late1990s as numerous countries in the region went through aperiod of economic turmoil. The Asian financial crisis threwup many distressed opportunities offering alternativeinvestors above average returns. These opportunities,combined with a flattening of returns in the US/LatinAmerican distressed markets focused investorsattention on the Asian markets.
The initial influx of buyers came primarilyout of the US and included larger players/
funds such as Cerberus and Lonestar,
and finance houses such as GE. Targetacquisitions included large secured NPLportfolios, real estate and large corporate
debt. As the economic crisis worsenedmore opportunities arose across Asia and
especially in countries such as Taiwan,
Japan, Korea, Thailand, Philippines,India, China and Malaysia. With early
deals reportedly generating significantreturns, the market for distressed
debt quickly grew and the numberof players expanded exponentially.
While statistics vary, in todays marketthere is estimated to be hundreds
of investors involved in the distresseddebt market. The major distressed debt
investors have been around since the
early 1980s and have developed uniqueskills and expertise in valuing, buying and
managing distressed debt acquisitions.Initially the majority of distressed debt
investors originated in the US andEurope, but the growth of opportunities
in Asian markets in the last 10 yearshas seen the emergence of numerous
Asian-based buyers focusing solely
on Asian opportunities.
The current global economic turmoil hasseen a number of funds pull out of the
market and others take a very cautious
approach to investing. To quote a commonphrase, no one wants to catch a fallingknife. Our discussions with investors
have indicated that while this was thegeneral consensus in 2008, most expect
to revisit these views in 2009. Also it
would seem that established buyers arelooking to raise new funds and capitalise
on the movement of capital away fromtraditional areas to distressed investing.
The chart on page 36 indicates the extentof raisings by distressed funds over the
past couple of years.
A unique characteristic of the current
economic turmoil is the true global natureof the downturn. Previous downturns have
focused on particular regions and hence
distressed investors focused on particularmarkets. An issue for Asia Pacific sellers
is that due to the state of markets in theUS and Europe, the big global distressed
investors who work with a global pool ofcapital will focus their attention wherever
the best returns can be achieved.Currently this is in Europe and the US.
For the market in distressed debt to grow
in Australia, pricing and returns will haveto be comparable with global valuations.
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How are investors classied?
Distressed investors can generally be classifiedinto the following three categories:
1. Distressed debt unds(Hedge unds, private equity unds)
This category is made up of those buyers that have a
primary focus on distressed debt or assets. Many ofthe early players in the distressed market were funds
established by ex-investment bankers with wealthyclientele looking for above average returns. Historically
these funds have been subject to minimal regulatory
control and have therefore been able to preserve high
levels of confidentiality. In Asia at present there is alarge number of these types of funds ranging in sizefrom the small with more than US$50 million to invest
to the large with over US$1 billion available to invest.
In the current climate these funds are typically looking
for opportunities where they can bring to bear theirfinancial skills, such as restructuring a company to
maximise their returns. Typical investment size acrossAsia is US$10 to 25 million while some of the larger
funds will look at US$100 million plus opportunities.
Return requirements are generally in the 25% plusInternal Rate of Return (IRR) range. While usually
distressed funds prefer to invest on their own rather
than in a joint venture structure, in the current climatestructuring deals including joint ventures are becomingmore popular as a means to mitigate exposure and
enhance value to both the buyer and the seller.
New entrants into the market have been the
traditional Private Equity firms. As the number oftraditional private equity deals have slowed or the
risks and rewards have become relatively unattractive,
alternative forms of investment are being investigated.Traditionally private equity has purchased equity as
a means to assume control; however the distressedinvesting model of using the debt structure to secure
control with added security is becoming increasinglyattractive for those funds that still have cash.
The majority of these funds are offshore, but a numberof new funds are setting up in Australia.
2. Financial institutions(including investment banks,commercial banks and fnancial houses)
Many financial institutions have special situation
groups focusing on distressed debt investing.
Typically these operations form part of the bankand often focus both internally and externally.
For example, a special situations group can help theirparent institution with their own non-performing loans,
can help expand customer bases by purchasing non-performing loans from other financial institutions or
can invest their own funds.
Some of the more consistent investors here include
Morgan Stanley, JP Morgan, UBS, Goldman Sachs,Merrill Lynch, Standard Chartered, Standard Bank,
Deutsche Bank, HSBC, Citibank and GE.
These investors tend to have higher investment size
preferences in the range of US$15 to 20 million plus.
3. Local buyers
Both categories 1. and 2. are generally foreigninvestors, as typically their focus is cross border,
i.e. they will look to invest in multiple countries
within a region.
Given the growth in distressed debt opportunities
in Asia over the last 10 years, a number of localoperators have been established to focus on specific
country based opportunities. A good example ofthese are government supported entities established
to resolve local bank non-performing loan problemssuch as the Asset Management Companies (AMCs)
established in China, Thailand, India and Vietnam.
In Australia a number of local servicing companies
have also looked to purchase NPLs mainly focused
on the consumer credit card space and generallyon a forward flow basis.
Established buyers are looking toraise new unds and capitalise on
the movement o capital away romtraditional areas to distressed investing.
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Investors ocus on AustraliaThe attractiveness of the Australian market
to distressed investors is highlighted by thechart above 60% of the 100 investors
surveyed throughout Asia had significantor very high potential for distressed debt
opportunities in 2009. The same surveyfound China and Indonesia (the only two
countries rated more highly for distressed
opportunities than Australia) to be thecountries where it is most difficult for
creditors to exercise or enforce their rightsover security or to enforce their rights in
court. As a result, Australia is very much
on investors radars.The added attraction of the Australianmarket is the strength of the regulatory,
legal and governance environments.As one investor mentioned, when we
walk into an Australian court the chances
of us getting subjugated to a lower assetclass is pretty unlikely. In comparison to
other Asian markets, Australias stronglegal and regulatory framework provides
a relatively high level of comfort andsecurity for investors.
ypes o investments
Deal types
Most distressed debt investors
will look at a range of deal types
including the following:
NPL portfolios sold by banks (either
secured or unsecured, although securedportfolios tend to attract more interest)
High yield lending
Equity investments, often coupled
with high yield lending, particularlyin the real estate sector
Equity investments and/or highyield lending, in private companies
or State Owned Enterprises (SOEs)often combined with management
influence (e.g. seats on the board)
Distressed real estate or real estateseized by financial institutions and
subsequently offered for sale
Single credits of distressed debtors
Credit card portfolios or othertypes of receivable portfolios
(such as utility debts)
NPLs or NPL portfolios on
the secondary market.
COUNRIES RAED ON HEIR DISRESSED DEB OPPORUNIIES IN 2009
Source Debtwire: Asia-Pacific Distressed Debt Outlook 2009, December 2008. Survey canvassed 100 hedge fundmanagers and proprietary trading bankers.
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
China
Indonesia
Australia
South Korea
India
Thailand
Vietnam
Philippines
Japan
Malaysia
Taiwan
Hong Kong
New Zealand
Singapore
Percentage of respondents
Significant Very High High Low None
65
49
38
36
25
16
21
17
12
14
9
12
3
8
17
23
22
16
25
27
18
24
21
17
21
20
14
13
8
15
22
31
29
36
41
37
43
43
47
32
54
36
4
11
16
13
17
16
15
17
19
19
18
34
26
28
4
2
2
4
4
5
5
5
5
7
5
2
3
15
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Assessment approaches
While each of the above investmenttypes will require a different assessment
approach, typically investors will consider
the following issues in relation to eachpotential transaction:
Determining an exit strategy depending on the nature of the
investment, exit strategies mayrange from regular debt repayments,
foreclosure actions, sale of assets orrealisation of equity holdings
Estimating future cashflow what arethe timings and total expected gross
cashflow amounts generated by the
proposed exit strategy, for examplethe timing and amount of forecast debt
repayments or the realisation of assets
Estimating costs to be incurred
in relation to the adopted exit strategysuch as outsourced collection costs or
the cost of establishing a local presence
Agreeing on the desired required return
factoring in the cost of debt/equity andestimated risk to the investment.
Key elements
While each investor has a specificinvestment decision matrix and
a preferred investment type, the
key elements that they all look forin any transaction include:
Reasonable transaction size relative tothe fund size, i.e. the effort to be put
into a deal needs to be justified througha meaningful investment amount.
Typically the average investor is lookingat deal sizes (across Asia) of between
US$10 to 25 million with larger investorslooking to allocate up US$100 million
on a deal by deal basis
Access to reliable and current data withwhich to make the investment decision
Certainty of a transaction taking place,especially in the case of a NPL sale
by a bank
A clear exit strategy including a relatively
predictable t imeframe. In this regardsome investors look for a relatively short
turn around such as less than 1 yearwhile others prefer longer timeframes.
It is not uncommon for distressed debtinvestments to have an average life
of 2 to 4 years
Above average return requirements while return requirements vary between
investors and for each investment type,all distressed investors are looking
for above average returns.
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Traded distressed debt includes secured andunsecured bank debt, trade debts, liquidated
and unliquidated damages claims and otherchoses in action.
The transfer of economic risk associated with a debtmay be achieved either by transferring the debt itself
so that the purchaser of the debt enters into a directrelationship with the debtor or by sub-participation
of the debt in which case the purchaser assumes
the economic risk associated with the debt pursuantto a contractual relationship with the seller only.
Debt transfers are normally carried out by legal
novation or assignment and the mechanism for
transfer is likely to be set out in the relevant loandocumentation. Any such transfer must be carried
out in accordance with the terms of the loandocumentation which may include restrictions on
the minimum amount of debt that can be transferredor the nature of transferees. For instance, it is
common for loan agreements to include provisionsproviding that the debt may only be transferred
to another financial institution.
Sub-participation is more flexible because thedebtor is not party to the arrangement and
has no influence on the terms. For this reason,portfolio sales are likely to be carried out by
sub-participation. Sub-participations can be funded(the purchaser makes payment upfront) or unfunded
(the purchaser indemnifies the vendor in theevent of a payment default).
A funded sub-participant assumes a credit riskon the seller whereas in the case of an unfunded
sub-participation the seller assumes a credit risk
on the purchaser.
Sub-participants are also exposed to increased
cost risk and withholding tax risk as they do notreceive the benefit of the protections under the loan
agreement. Similarly a sub-participant will not be ableto access market disruption provisions.
Where only part of a particular debt is sub-participateda key issue will be how voting rights under the relevant
loan are executed. Generally, the lender of recordwill not be able to split its vote so voting rights will
generally go to the institution with the largest exposuresubject to consultation. However, in some instances
where the lender of record is keen to protect a clientrelationship it may be reluctant to cede voting control
even to a sub-participant of the majority of its debt.
Other important considerations in distressed debttrades are whether the sub-participant has the ability
to force a transfer of the debt to it and whether itreceives an interest in ancillary rights to the debt
(e.g. claims against advisors in respect of reportsprovided to the vendor).
In distressed debt trading a central issue of focus iswhether the purchaser is taking the risk only on the
level of return or on the risk of the validity of the claim.Often the vendor will retain the risk that the claim
is rejected by a liquidator.
The Asian secondary debt markets (including
Australia) have not yet developed their own
standard documentation or terms for distresseddebt trading, but the Asia Pacific Loan Markets
Association is seeking to progress standardiseddocumentation for Australia. For most trades within
these markets, parties typically adapt local par debttrading documents using distressed debt terms
from the US market (Loan Syndication and TradingAssociation (LSTA) terms) or the European market
(the Loan Marketing Association (LMA) distresseddebt trading terms). Standard documentation
available includes risk transfer documentation and
associated documents for carrying out a debttrade such as confidentiality arrangements.
Secondary debt trading terms
16
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Perspective
17
The unique characteristic of the current economic turmoil is the global
nature of the downturn. Major global distressed investors will focus
their attention wherever the best returns can be achieved. Australias
advantage is the strength of our regulatory, legal and governance
environments, which offer security for investors.
Sellers of distressed debt need to know about likely buyers (who
generally fall into three main categories: foreign distressed debt
funds, foreign financial institutions and local buyers), their returnrequirements, their preferred investment types and approaches,
how they make their investment decisions and the key elements
of what they look for in a transaction.
Important considerations for both buyers and sellers are the
secondary debt trading terms and the transfer of economic
risk associated with a debt. Any transfer must be carried out
with the terms of the relevant loan documentation.
The Asia Pacific Loan Markets Association is seeking toprogress standardised documentation or terms for distressed
debt trading for Australia. Currently parties typically adapt local
debt trading documents from the US or the European standard
terms. Standard documentation available includes risk transfer
documentation and associated documents for carrying out a
debt trade such as confidentiality arrangements.
In comparison to other Asian markets,Australias strong legal and regulatoryramework provides a relatively high level
o comort and security or investors.
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2. Portfolio debt sales the key considerationsin value
The factors that will impact pricing include:
The credit approval process
The quality of the portfolio
The type of sale
The quality of information
The timing of the sale.
The risks posed by each of these factorscan be minimised by ensuring a robust
and transparent process.
The main variables that will be considered
by the buyers include the following:
How much of the individual debt
will be recovered?
How long will it take to collect?
How much will it cost to collect?
What is the risk associated with thedebt recovery process?
The key considerations are summarisedin the diagram below.
How much o the individualdebt will be recovered?The key determinant of value will be
the proportion of the outstanding debtthat can be realistically recovered
from the borrower.
Corporate loansFor corporate loans the first question
is whether or not the loan is secured,and if so, what is the realisable value
of the underlying security. The key issue
here is how current is the appraisal.
Once a floor has been set on the loan
value the next question to be addressedis whether the borrower is likely to seek
to restructure the loan. Issues that needto be taken in to account include:
Are there personal guarantees?
Are there director liability issues?
Who has provided the guarantees?
Is the company still trading?
A BUYER'S KEY CONSIDERAIONS
How much
will I collect
and from
what sources?
When will
I collect?
Servicing
and
Management
Costs
Discounted
for return
requirements
(incorporating
leverage)
Valuation
There are many interlocking factors that will determinethe value for the transfer of a loan portfolio.
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Addressing each of these questions will
assist in determining if a restructuringor renegotiation of the debt will be
possible. If a restructuring or discountedpay out is not possible then how
much of the loan over and above thesecurity is recoverable? Some of the
issues here include whether there are
guarantees in place, what assets arebehind the guarantors and where are
the guarantors located?
Consumer loansFor consumer loans the questions
are similar:
Are the loans secured, and if so,
what is the realisable value of theunderlying security?
What are the chances of renegotiating
the loans?
What are the chances of recovering
any of the shortfall after realisingthe security?
For unsecured loans what are thechances of recovering any amount
from the borrower?
What is the likely timing of any
liquidation dividend?
To determine the likelihood of recovery,
borrower characteristics such as age,sex, location and employment status
must be assessed. Other factorsinfluencing recoverability will be the
type of loan and what it was used for
and what sort of recovery process hasthe loan been through?
How long will it take to collect?
Any purchaser of debt will factor in thetime value of the investment, and discount
the future payment stream back to present
value. Assumptions regarding the timeit is likely to take to recover the debt will
have significant influence on the overallvaluation. There are a number of factors
that will be key, including:
What restructuring or discounted
payoff is to be put in place,and over what period?
How long will it take to forecloseon a property?
What are the potential impedimentsto enforcing security?
How long is the typical bankruptcy
process for corporates or individuals?
How long does it take to sell assets?
How far through the recovery processis the seller?
Australianinsolvency proceduresThe main steps in each of the majorformal recovery procedures in Australia
are outlined below.
Administration
Voluntary administration is the mostcommon formal corporate rescue process
used in Australia. It is most often initiated
by the directors of the company becausethe appointment of an administrator
will relieve the directors from any riskof personal liability for insolvent trading
in relation to debts incurred followingthe appointment of an administrator.
An administrator can be appointed bythe directors (by resolution), a liquidator
of the company, or the holder of a fully
secured charge over the company.
Te emergence and continued growth o asecondary market or distressed debts andassets is a sign o the increasing depth andsophistication o Australian nancial markets.
James Marshall, Blake Dawson
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The appointment of an administrator gives
an independent insolvency practitionerthe power to administer and conduct the
companys business. Administrators aregiven wide powers to control and manage
the company, and the directors are notpermitted to exercise any powers except
with the consent of the administrator.
The administration process underAustralian law is driven by the votes of
unsecured creditors at creditor meetings.Courts do not supervise the process
but can adjudicate on issues that ariseupon the application of interested parties,
including the administrators. Whilstin administration, statutory moratoria
prevent proceedings against the companybeing commenced, charges being
enforced against the company (subject
to a 13 day decision period for holdersof full security) or property being recovered
from the possession of the company,except in certain circumstances.
However, there is no moratorium
preventing contractors from terminatingtheir contracts on the basis of an
insolvency event c lause. In many casescontracts will contain default provisions
which allow for termination upon theappointment of an administrator.
The administrator must generally
report to the creditors, in writing,within 30 business days of appointment
specifying the options for the companysfuture. The options are either a deed
of company arrangement, liquidationor return of the company to the control
of the directors. The report will containthe administrators recommendation
as to which option is in thecreditors best interests.
Administrators are given wide powersto control and manage the company,
and the directors are not permittedto exercise any powers except withthe consent o the administrator.
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Action Timerame
Notice of appointment sent to creditors 5 business days from appointment
First meeting of creditors 8 business days from appointment (omit the first day)
Second meeting of creditors Up to 30 business days from appointment
Adjournment of second meeting of creditors Permitted for up to 45 business days with creditor approval;further extensions possible with court approval
HE KEY SEPS AND IMELINES FOR VOLUNARY ADMINISRAION
Given the extensions which may be made
to the timing of the second meeting ofcreditors, in complex administrations
it may take between 3 and 12 monthsbefore the companys fate is voted upon.
At the second meeting of creditors, thecreditors vote on whether the company
should enter into a deed of companyarrangement, be liquidated, or returned to
the control of the directors (a majority voteis counted in terms of numbers and value).
Significantly, no court approval is required.
If a deed of company arrangement
is entered into, the limited statutory
requirements allow tremendous flexibility.Deeds can be used to implement almost
whatever type of arrangement the situationrequires from a simple compromise of
debts to a complete corporate restructure,a capital raising or a continuation of the
business. Recent reforms have alsoenhanced this flexibility by facilitating
post-restructuring equity raisingand debt financing.
Where the creditors accept a proposal
that the company is to continue to trade,the execution of the deed of company
arrangement marks the end of theadministration. The terms of the deed
replace the statutory moratorium oncompany debts and the arrangement
binds all of the companys creditors,shareholders, directors, the company
and the deed administrator.
Administration andChapter 11 comparedOverseas investors are often interestedto compare Australias voluntary
administration regime with theUnited States Chapter 11 procedure.
The table on page 22 highlights the keysimilarities and differences between
Australias voluntary administration
and the United States Chapter 11regimes, based on the Australian
Governments, Corporations and MarketsAdvisory Committee, Discussion Paper,
Rehabilitating large and complexenterprises in financial difficulties,
September 2003.
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ReceivershipFinancers typically require a debtorcompany to provide security, usually a
mortgage debenture, containing a fixedand floating charge. The debenture usually
allows the financier to appoint a receiverto the debtor upon default under the
instrument. A receiver is appointed tothe company for the purposes of realising
company assets to discharge the debt
owing to the secured creditor. Receiversenjoy sweeping powers under both the
debenture and statute, including the powerto take possession of the companys
assets, realise those assets or carryon the business of the company.
The terms of the security govern theappointment. The secured creditor decides
the identity of the receiver and, in doingso, is under no obligation to consult with
the debtor company. Usually the receiver
is a professional insolvency pract itioner.
A receiver owes duties principally to the
secured creditor, not to the debtor or itsunsecured creditors. However, a receiver
is subject to statutory duties in exercisinghis or her powers, including a duty of care
in exercising a power of sale to achieve amarket price. The receiver is also subject
to the supervision of the court and thecorporate regulator, Australian Securities
and Investments Commission (ASIC).
The appointment of a receiver offers
considerable advantages in terms
of immediate control (particularly ofcommencement, which may take only
1 to 2 days), cost and flexibility. However,
it does not create a moratorium onthe initiation or commencement ofproceedings against the debtor.
In a very limited number of casesa court is given the statutory power
to appoint a receiver.
Usually a deed of indemnity is provided
by the secured creditor to the receiver.
The timeframe required for a receivershipto be completed depends on the
complexity of the receivership and thereceivers ability to recover the secured
creditors security. A company canconcurrently be under both administration
and receivership. Creditors with acharge over all or substantially all of
a companys assets can choose to
appoint a receiver over the top of anadministrator. The receiver can then deal
with the secured assets unfettered by theadministration. Accordingly a prospective
purchaser of assets would usually dealwith the receiver, and not the administrator.
Such concurrent appointments (especiallyto large companies) are common.
However, concurrent appointmentscan make balance sheet restructuring
very difficult, given that the focus of
secured creditors is usually the saleof secured assets.
Liquidation
Winding up may be initiated by courtorder (winding up in insolvency) usually
upon a creditors petition, or by thecreditors (creditors voluntary winding up).
A simple creditors voluntary winding uptakes between 6 to 8 weeks and entails
various notices and meetings. A complex
winding up, which may involve recoveryactions being pursued through the courts,
could take considerably longer.
The liquidator winds up the company
and applies the assets to satisfy theliabilities and distributes any surplus to the
shareholders. The directors powers ceaseupon the appointment of the liquidator.
There is a stay on proceedings againstthe company. Liquidators have extensive
forensic recovery powers, can recover
voidable transactions and bringclaims against directors.
Set out on page 24 is a table thatoutlines the liquidation priority regime
for secured creditors for both fixedand floating charge assets.
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LIQUIDAION PRIORIY REGIME
Realisation o fxed charge assets(e.g. property, plant, equipmentand goodwill)
Realisation o oating charge assets(e.g. stock, work in progress and debtors)
Priority waterfall Priority waterfall
Costs of realising fixed charge assets Costs of realising floating charge assets
Secured creditor debts Employee entitlements
Employee entitlements Secured creditor debts
Unsecured creditors Unsecured creditors
Shareholders Shareholders
Recovering debts romindividuals: Bankruptcyand sale under amortgage/oreclosureAn issue that frequently arises for portfoliosales of non-performing loans concerns
the ability to enforce against individualsreal property. The relevant timeframes
and operation of personal foreclosureand bankruptcy laws can be relevant
to considerations.
A lenders power of sale is heavily
regulated. Generally, a lender can enforceits power of sale over mortgaged property
1 month after the borrowers default. The
timeframe and procedures are lengthy andcomplex and they vary from State to State.
If a lender fails to recover all of its fundsfrom the sale of property, the lender
has recourse to the borrower for the
outstanding amount. This is the mostimportant distinction between Australian
real property mortgages and those ofthe United States.
To realise this amount, the lender can usethe bankruptcy procedure. This can be
quick and effective if the borrower, anxiousto avoid bankruptcy, finds funds to pay
the outstanding amount within 21 days(see page 25). However, the process
can take months if the bankruptcy runs
its course, especially if the borrowercontests the bankruptcy notice.
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BANKRUPCY IMEFRAME
Action Timerame
Creditor issues bankruptcy notice,
demanding payment
First step
If person ignores notice a creditors
petition for bankruptcy can be made
At least 21 days after the bankruptcy
notice
In all cases there is an applicationto court for a creditors petition
for bankruptcy
Within 7-14 days of the expiry ofthe bankruptcy notice, but not more
than 6 months
Court determines application (ifsuccessful, court sequesters bankrupts
assets and appoints a Trustee)
Within 4 to 8 weeks of application
Trustee notifies creditors ofthe bankruptcy
After 42 days of Trustees appointment
Trustees report to creditors on likelihoodof receiving dividends
After 3 months of Trustees appointment
Trustee may pay dividends, interim
and final
Usually after 3 months
of Trustees appointment
How much will it cost to collect?
Bankruptcy
The costs of collecting the debts caninclude a wide range of costs which willneed to be factored in to any valuation
calculation. Investors will typically factorin any of the following costs:
The cost of servicing the portfolio.This will usually be provided by a third
party servicing company. There area number of such organisations in
Australia, primarily set up to service theconsumer debt market, however some
also have corporate capabilities
Administration costs of the purchaser
Tax costs which will typically need to
take into account corporate profitstax and withholding tax on repatriating
profits if the investor is offshore.Corporate profits tax is generally around
30%, whereas interest withholding tax
in Australia is generally around 10%
Other specific costs such as legal
costs, auction costs, commissioncosts and stamp duty costs.
Recapitalising a distressed companycan be achieved either inormally orthrough a ormal insolvency procedure.
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What is the risk associated with the purchase?
There are many factors that may be taken intoaccount when determining the discount rate to be
applied to the net present value of the future cashflow. One approach is to apply a formula and calculate
the weighted average cost of capital. This takes intoaccount such variables as the risk free rate, country
risk premium, debt to equity ratio, cost of debtand the effective tax rate.
Any calculation however will need to be comparedto the investors desired internal rate of return for
distressed investments, whether they be portfoliosor single credits. A common theme that many of
the larger investors have expressed is that they areworking in a global environment and they are therefore
competing against returns in deals in Europe andthe US. If they can get similar or better returns on
deals in other markets, then it is hard to get thesepast credit committees. As such most investors have
indicated they are working on internal rates of returns
in excess of 20 25%. For more information onusing secured convertible notes see page 34.
Sons o Gwalia risk shareholders as unsecured creditorsThe Australian High Court case of Sons of Gwalia v Margaretic(Sons of Gwaliadecision) confirmed
that shareholders in publicly listed companies may prove as unsecured creditors in the administrationor liquidation of the company in respect of a successfully established claim for misleading and
deceptive conduct or non-compliance with the continuous disclosure regime by the company
prior to its insolvency. Such claims are generally founded on a companys failure to discloseits true financial state to the market.
The circumstances in which a shareholder will be able to establish a claim are limited, both in relationto the factual and legal circumstances. For example, there will usually be practical difficulties in
establishing such claims, particularly in proving the elements of reliance on the alleged misleadingand deceptive conduct and causation (there is no fraud on the market in Australia).
While these shareholder claims may be difficult to establish, the existence of such potential claims mustbe considered in valuing distressed debt since such claims may dilute the value of the unsecured debt.
Following the Sons of Gwaliadecision the Australian Federal Government commissionedthe Corporations and Markets Advisory Committee (CAMAC) to examine whether the law
should be changed. CAMAC released its report on 29 January 2009.
While its members were not in complete agreement, CAMAC recommended that legislative reform
was not required to overturn the Sons of Gwaliadecision or to postpone, cap or prohibit aggrievedshareholder claims. CAMAC considered that any move to limit the rights of recourse of aggrievedshareholders where a company is financially distressed could be seen as undermining apparent
legislative aims to provide shareholders with direct rights of action in respect of corporate misconduct.
The Australian Federal Government is considering CAMACs recommendations. Legislative reform
would be required to reverse or limit the effect of the Sons of Gwaliadecision and it is unlikely that theAustralian Federal Government will make any decision on this issue for quite awhile. Until there is any
legislative reform, shareholders will be able to make claims against an insolvent company based on thefact that they were misled into buying shares in the company and will be treated as unsecured creditors
in respect of those claims.
If investors acquire secured debt or invest in distressed companies using secured convertible notes,
this risk can be avoided.
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Perspective
27
Large oreign investors haveindicated they are workingon internal rates o returns
in excess o 20 25%.
The first step is assessing the value of the distressed debt.
Sellers of distressed debt need to be aware of the factors which determine
the value of the loan portfolio and the buyers key considerations. Pricing
depends on various factors including the credit approval process, the
quality of the portfolio, the type of sale, the timing of the sale, and the risks.
Buyers will consider the type of loans, whether they are corporate or
consumer, how much of the individual debt can be recovered, whetherthe debt is secured or unsecured, how long it will take to collect, how
much this will cost and the risks associated with the debt recovery process.
Buyers need to be aware of Australian corporate insolvency procedures,
the differences between voluntary administration, receivership and
liquidation, as well as bankruptcy procedures for individuals. The key
steps, timeframes, costs of each process, as well as the extent of power
to administer and conduct a companys business are crucial considerations.
Assessing the risks associated with the purchase is a major consideration.To determine the discount rate to be applied to the net present value of
future cash flow, one approach is to calculate the weighted average cost
of capital taking into account variables such as risk free rate, country risk
premium, debt to equity ratio, cost of debt and the effective tax rate.
In valuing distressed debt of a company, buyers also need to be aware of
the effect of the Australian High Court case of Sons of Gwalia v Margaretic,
discussed on page 26.
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3. Using secured debtto control outcomesand obtain ownershipof the assets
Thus, a secured creditor can opt out
of the voluntary administration process
and enforce its security. If the securedcreditor fails to take this step within the
13 days it will be unable to enforce itssecurity during the period of the voluntary
administration; however a practice hasdeveloped whereby administrators extend
this period in order to encourage securedcreditors to support their appointment.
In the case of a secured creditor whoseentitlement does not extend to the whole
or substantially the whole of the companysproperty, then that secured creditor will
be unable to appoint a receiver withoutthe administrators or the courts consent.
In these circumstances, the securedcreditor becomes subject to the actions
of the voluntary administrator during thecourse of the administration. An exception
to this rule arises if the secured creditor
takes steps to enforce its charge beforethe appointment of an administrator.
This enforcement power may, however,be restricted by the court on an
application by the administrator.
A secured creditor who is entitled to enforce a charge over thewhole, or substantially the whole of a companys property haswide powers of enforcement especially in relation to companiesthat may also be in administration. Such a secured creditorcan elect to appoint a receiver over the secured propertyeven during the first 13 days of an administration.
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Voting abilityIn a receivership, the receiver realises
assets for the benefit of the securedcreditor and there is no process for
unsecured creditors to vote. Thereforeunsecured creditors have limited formal
input into or influence over a receivership.
In a voluntary administration, the future
of the company is decided by a vote of
creditors. Resolutions are passed by amajority in number and value. If there
is a deadlock, the chairman of themeeting (the administrator) has a casting
vote. The casting vote may (but will
not always) be exercised in accordancewith the vote of the majority of the valueof the creditor pool. Thus, a party that
controls more than 50% of the liabilitiesof a company in administration, both
in value and number, may have control
of the outcome of voting and therebycontrol the companys destiny. Employees
typically form the majority of creditors innumber and thus are an influential voting
block. Secured creditors can vote in fullwithout valuing their security.
Duties afecting the powero sale section 420AA receiver exercising a financiers power
of sale over secured property must takereasonable care to sell the property at
no less than its market value, or if no
market value can be ascertained, at thebest price available in the circumstances.
This duty arises under section 420A ofthe Corporations Act 2001 (Cth). A similar
duty arises under common law.
These duties of care aim to ensure that
receivers do not sell assets at a discount
simply to recover secured debt quicklyand cheaply at the expense of both thesecured creditor and other creditors.
Generally, in order to fulfil these obligations
a receiver will pursue a structured andpublic sales process, including:
advertising the assets and requestingexpressions of interest
undertaking due diligence
organising tender bids
deciding on preferred bidder
selling to preferred bidder.
There is no equivalent to section 420Afor voluntary administrators, however,
the administrator has a duty to act inthe best interests of creditors and this
includes realising market value for assetssold. In certain circumstances it may be
necessary to sell a business very quickly
during an administration to preservegoodwill and avoid the termination of
contracts. While an administrator in sellingassets does not need formal creditors'
approval, usually creditors' views areconsidered before a sale is effected.
A receiver exercising a nanciers powero sale over secured property must take
reasonable care to sell the propertyat no less than its market value.
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Prepack appointmentsA pre-pack appointment occurs in
a receivership or an administration whenthe sale of an insolvent company, or its
assets, is negotiated by stakeholders(including creditors, shareholders, key
customers and key trade suppliers)and agreed before the formal
procedure is commenced.
The key advantage of a pre-pack is tomaximise the chances of a rescue for
the company while it remains a goingconcern without the loss of goodwill
usually associated with an unplanned
insolvency announcement. Pre-packsare commonly used on companies withcontract or service based businesses.
The process begins with negotiating thepre-pack arrangement. Once agreement
is reached, an administrator (or receiver)
is appointed, and the pre-ordained saleof the company or its assets is executed
expeditiously. Because the pre-packsale occurs without the business or
its assets being offered on the openmarket, the sale could be impugned as a
breach of the administrators or receivers
duty of care in selling the company orassets (discussed above). To avoid this,
administrators are required to showthat due enquiries were made regarding
the real value of the asset or businessduring the pre-pack process before the
administration, and that the sale continuesto be reasonable and in the best interests
of creditors after administration begins.
There have been few pre-pack
administrations and receiverships to datein Australia. This is due to the difficulties of
managing stakeholders and the concernsabout the duty of the administrator or
receiver in the sales processes. Althoughthis concern is legitimate, the pre-pack
sales exist to maximise the value of the
business and its assets and avoid theloss of goodwill often associated with
unplanned insolvencies.
Control strategiesA party looking to invest in a distressed
company or its assets will often seek toacquire secured debt in the company as
a first step to gain control and then drivethrough a sale or recapitalisation.
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Perspective
31
An important consideration for buyers when assessing a distressed asset is
to assess how much debt is secured because secured debt can be used to
control outcomes and obtain ownership of assets.
A secured creditor who is entitled to enforce a charge over the whole,
or substantially the whole, of a companys property has wide powers
of enforcement especially in relation to companies which may also be
in administration.
A control strategy for buyers is to acquire the secured debt and
drive through the sale or recapitalisation.
Buyers need to be aware of the duties placed on a receiver by the
Corporations Act 2001 and common law when exercising a financiers power
of sale over secured property to take reasonable care to sell the property
at no less than its market value, or the best price in the circumstances.
If a buyers strategy is to preserve value in a distressed company such as a
contract or service based business, one strategy is to enter into a pre-packarrangement, to maximise the value of the business and its assets and avoid
loss of goodwill, associated with unplanned insolvencies.
A party looking to invest in a distressedcompany or its assets will oen seek toacquire secured debt in the company asa rst step to gain control and then drive
through a sale or recapitalisation.
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4. Recapitalising distressedlisted/unlisted companies
These advantages include:
Tax advantages Asset sales can attract
significant stamp duty (although stampduties on business assets other than
land are progressively being phasedout in Australia)
Investors can retain companyspecific benefits such as the existing
infrastructure of a companys operations,including contracts and employees.
Recapitalising a distressed company can
be achieved either informally or through aformal insolvency procedure. A distressed,
though solvent, company and itslenders may decide that the company
can return to health despite its currentdifficulties with debt.
Privately-held companies can berecapitalised with relative ease. With
supportive lenders and shareholders,substantial new equity can be injected
quickly and with minimal publicity.
It may even be possible to recapitalise
a distressed company without thesupport of its existing shareholders.
Publicly listed companies face more
complex challenges, although it is equallypossible to recapitalise a distressed
listed company quickly.
The ASX Listing Rules generally limit theamount of equity that can be placed
to an investor without shareholderapproval to 15% in any 12-month period.
Australian takeover laws prevent aninvestor from subscribing more than
20% of voting shares in a companywithout shareholder approval. A significant
feature of shareholder approvals of this
nature is that an experts report as to theproposals fairness and reasonableness
is generally required, adding to thecost and complexity of the proposal.
Obtaining shareholder approval (andan experts report if one is required)
can result in considerable delay in thedistressed company getting access to new
funds, which it may not be able to afford.
However, there are various exceptionsto the shareholder approval requirement
that can be used to facilitate arecapitalisation quickly. In particular,
exceptions to both the 15% ListingRule limit and the 20% takeovers law
restriction are available for pro-rata rightsissues (including underwritten rights
issues) to shareholders. In addition,waivers from the general 15% rule can
be sought from ASX to facilitate rights
issues on an accelerated basis, whichcombine advantages to the company
of an accelerated institutional offer (quickaccess to funds) with the advantages
to retail shareholders of a rights issue(minimising dilution through participation
in the recapitalisation).
In some cases, recapitalising a distressed company canhave significant advantages over an asset sale.
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By way of example, suppose an investor
wishes to participate in a recapitalisationof a listed company in desperate need
of funds. The company could make aplacement to the investor of up to 15%
of the companys capital. The companycould then announce an accelerated
rights issue, underwritten by the investor.
Properly structured, the proposal wouldenable the company to access the funds
from the placement and the institutionalcomponent of the rights issue almost
immediately, and enable the investor toacquire a significant stake in the company
through the placement and by taking up
its entitlements and any shortfall under therights issue without the timing constraints,
cost and uncertainty associated withseeking shareholder approval for the
recapitalisation proposal.
In general, the techniques available to
listed companies are also available tomanaged investment schemes, such
as real estate investment trusts andinfrastructure vehicles, although additional
considerations arise due to their uniquestructure. In particular, amendments
to the entitys constitution may be
required to facilitate a recapitalisation.
Listed companies are also subject to
continuous disclosure obligations underthe Corporations Actand the ASX Listing
Rules, which in broad terms require themto immediately disclose information that
would be expected to have a materialeffect on price or value to the market as
soon as the company becomes awareof that information.
Any recapitalisation proposal will become
public as soon as it is agreed (or perhapseven during negotiation). This can
increase the likelihood of a competingproposal emerging, thereby placing the
investors proposal at risk, particularlywhere the proposal remains conditional
on announcement (for example, it is
conditional on shareholder approval).