Government Bailout: Distressed Companies Should Utilize the Capital Markets

Several indigenous Ugandan companies and businesses are on the verge of losing, or have already lost, tangible assets which they used as collateral for securing bank financing. These companies are now reportedly seeking for bailouts from the government to stabilize their financing structure. A myriad of factors including inter alia , high commercial bank interest rates, Government’s failure to pay suppliers, political instability in key regional export markets like South Sudan, and the weakening economy have been suggested as causes of the companies’ poor performance.

All financially distressed
[1] companies move through the cycle of distress as shown in the figure below. The key is to move through efficiently,minimizing the loss in going concern value.

Source: Houlihan Lokey (2009). The Great Unwind and Its Impact on China

The majority of the distressed Ugandan companies have now moved into stage 2(Crisis and Catastrophe). However, not all is lost for these Ugandan companies given that if the situation is handled well, Relief and Recuperation can occur in stage 3 ultimately leading to Recovery and Obscurity in stage 4. In a study of post-bailout performance of 104 corporate bailouts in 21 countries between1987 and 2005, Zhan et al (2010) [2] found that in certain circumstances, bailed-out firms eventually recover to a point where their post-bailout performance is at least as good as before the bailout. Examples of firms that have been through stage 3 and 4 are presented later in this write-up.

To get through stage 3 as depicted above, distressed companies would have several options including re-structuring their debt obligations to longer maturities,re-negotiation of interest rates with the commercial banks, change of senior management if initially found wanting, re-thinking their business strategies, mergers and acquisitions, and new equity investments.

Government bailouts should only be limited to a few companies that contribute significantly to the national treasury by paying taxes and employ a high number of people. However, even these should be thoroughly audited to ascertain the causes of business failure and the subsequent ability of repayment of the bailout funds by the recipient company. Government bailouts should only be used when evidence has been adduced indicating that there’s value in keeping floundering companies afloat. Zhan et al (2010) found that firms recovered more fully from nongovernmental bailouts. They offer three explanations for this finding. First, governments don’t monitor firms post-bailout as closely as large shareholders and banks. Second, governments may bail out a firm to keep people employed or to keep the economy going,regardless of the firm’s performance. And third, governments are more inclined to bail out firms with government connections.

How much long term finance is available in Uganda’s capital markets?

This article introduces the option of re-financing these distressed firms through the capital markets. The financing can be accessed by way of issuing shares to the public (equity financing) or corporate bond issuance. The major long term investors in Uganda’s capital markets include the National Social Security Fund, Life Insurance Companies, and Asset Managers as depicted below.

Long term financier
Assets under Management (billion Shillings)
Source
Pension schemes (including NSSF)
6,500
Pension Sector Report (2015)
Life Insurance Gross Premiums held by insurance firms in Uganda 74 Insurance Regulatory Authority of Uganda Annual Report 2014 Funds held by Asset Managers 1,424 CMA figures as at 31/03/2016

7,998

The untapped long term finance in Uganda’s capital market of close to eight trillion shillings as shown above is in excess of the 1.2 trillion shillings that the distressed Ugandan firms want in form of a bailout from the government.

How can companies access these funds through the capital markets?

Presently,issuing of company shares and company bonds to the public is done at the Uganda Securities Exchange (USE), which has both the main market segment and the growth enterprise market segment, and Altx East Africa which offers structured as well as unstructured securities and derivatives.

Companies that intend to list on any of these market segments must comply with the listing rules of the exchange, the Capital Markets Authority (CMA) Act, the Companies Act, and any other statutory requirements. Approvals have to besought from the regulator (CMA) after submission of the prerequisite documentation. This normally includes a prospectus which will contain information about the directors, audited financial statements, memorandum and article of association, and share ownership structure. To boost investor confidence in listed firms, periodic reporting is also required for all listed firms. This greatly improves on the firm’s corporate governance – a factor that has been attributed to the distress in some of these companies.

The growth enterprise market segment would be ideal for most of these distressed firms as it has less stringent listing requirements than the main market. This segment was set up to encourage the growth of small to medium sized businesses and companies which are not able to list on the main market. The criteria to be met are less onerous than the main market criteria, though quality and stability of the company are still seriously assessed.

One of the major advantages of undertaking financing by offering shares to the public is that the company will have no obligation to repay shareholders at a future date; as opposed to a bank loan that entails monthly interest repayments and principal to be paid upon maturity. This greatly reduces the constraints on the company’s cash flows. The equity finance raised can be used to clear pressing debt and offer the company the urgently needed cash flows for business operations. The shareholders who invest in the company can sell their shares in future to other investors via the stock exchange. As the distressed company posts recovery, it can buy back some of its shares from the investors and increase on its ownership to levels close to the pre-crisis period (stage 1). Furthermore, if the investors buying the company shares include sophisticated investors and private equity firms, the companies may benefit from their valuable business expertise in fields like company restructuring, financial reporting,and good corporate governance. This will ultimately make them more competitive and improve on their public image.

Company bonds would also be a good source of capital for these companies. These would be advantageous as interest (coupon) payments can be paid either annually or semi-annually as opposed to monthly bank loan repayments. In addition, the bonds can be structured to have longer maturities of up ten years and above as opposed to bank loans that tend to be short term in nature.

Getting companies through stage 3and stage 4 via capital markets

Ascertaining the value of a distressed company is very crucial for potential equity investors. Interested investors require this information to determine what the actual underlying value of the company is and what discounts are to be made over this value to get an accurate picture of the business value of the firm. Potential equity investors would be very interested in the likely causes of distress in order to weigh their risk. As mentioned earlier, a previously profitable firm could become distressed due to non-payment by suppliers. This would not be a problem for potential equity investors who would simply recapitalize the firm. Other possible causes of distress like lack of internal controls, obsolete business models, fraud, and external shocks would be evaluated on a case by case basis by the investors to determine if they can be solved and the companies’ fortunes turned around. In sum, when dealing with distressed firms, it is very important to understand how to evaluate such firms. If the valuations can be done accurately, then it can lead to windfall gains. Trading in distressed assets in emerging markets can at times be highly profitable given the growth prospects naturally existing in such regions. This is further illustrated in the examples hereafter.

Merchant Bank Ghana Limited is a classic example of a company that was in distress and turned to equity financing for help in November 2013. The injection of fresh capital by Fortiz Private Equity Fund Limited, a wholly owned Ghanaian equity fund, was primarily meant to address the solvency and liquidity challenges facing the bank and implement a turnaround strategy to ensure that the bank continued to operate normally (Bank of Ghana, 2013). The strategy, as spelt out by the Bank of Ghana, included a requirement for the bank to have its shares listed on the Ghana Stock Exchange within three years. The Fund’s objective, amongst others, is to strategically invest in distressed companies, restructure and revamp them in order to generate long-term value and profitability. By 30 th June 2015, the bank’s network had grown to 33branches, up from 21 when Fortiz Private Equity Fund Limited took over.

Closer to home, a case of a distressed firm using the capital markets in East Africa is Uchumi supermarket. In the early 2000s, the company encountered severe financial constraints and went into receivership in June 2006. This led to de-listing of the company from the NSE. Later on, the company resumed trading under an interim management. In January 2011, Uchumi supermarket managed to regain profitability. The company was re-listed on the NSE in 31 st May, 2011

The recovery was possible after undertaking a review of the company’s management style. Uchumi Supermarkets specialized receiver manager, Jonathan Ciano, said companies should not be wound up just because they are indebted. Mr. Ciano has been instrumental in the re-structuring of utilities such as the Kenya Power and Lighting Company (KPLC) and the Kenya Petroleum Refineries. Uchumi’s annual report (2011) revealed that the floatation of new shares had generated cash for resolutions and expansion leading to the good results. Management restructuring was also noted to have successfully reinstated the organization back to its roots. Unfortunately, the company has of late slid into decline (stage 1) with clear indications of getting into a crisis and catastrophe (stage 2).

On a more positive note,Equity Building Society (EBS), the predecessor of Equity Bank, was one of several institutions that experienced financial difficulties after the financial crisis of 1986. In 1993, EBS was declared technically insolvent. It then adopted a turnaround strategy which achieved its objectives in 1999 as EBS rose from the ashes of insolvency to national and international acclaim. In the year 2004, EBS decided to convert to a commercial bank and successfully transferred its business assets and liabilities to Equity Bank. To achieve this objective, it was necessary for the Bank to raise more capital. This was done through a successful private placement of over Kenya shillings 725 million. The Financial Times’ (FT) latest listing of the world’s Top 1,000 banks shows that Equity Bank is Africa’s lender with the highest Return on Assets (ROA). Equity Bank is the second largest bank in Kenya in terms of value of assets.

It is against this backdrop that distressed companies in Uganda should seriously consider the capital markets as an avenue for resuscitating their fortunes.

[1]
Financially distressed firms are firms that are experiencing financial difficulties in maintaining their normal operations and in most severe conditions are potential candidates to the bankruptcy proceedings (Baharin and Sentosa, 2013)

[2]
Jiang,Zhan and Kim, Kenneth and Zhang, Hao (2010). An Empirical Study of Corporate Bailouts from Around the World: 1987–2005 (October 15, 2010). Social Science Research Network.

[i]
The writer is a Research and Market Development Officer at the Capital Markets Authority (CMA). The findings,interpretations and conclusions expressed in this article are entirely those of the author and do not necessarily represent the views of the CMA.