Business rescue: two words that no equity investor wants to read. To be fair, creditors don’t want to see it happen either. The biggest winner in this process is usually the business rescue practitioner. If things go well, the staff (or most of them) hang onto their jobs and the business doesn’t disappear from the market altogether.
The latest example is Tongaat Hulett, the embattled sugar company that has been a victim of alleged accounting misstatements, a once-in-a-lifetime pandemic (touch wood) and a province that appears to have angered all the gods, ancestors and, quite frankly, every mysterious being you can think of. The KwaZulu-Natal economy has suffered huge setbacks in the past couple of years and Tongaat Hulett is headquartered in the region with most of its operations there.
By no means the only broken balance sheet on the JSE, Tongaat Hulett is just an example of how badly things can go. Examples of other balance sheets facing major question marks include EOH, Nampak and Steinhoff. I’ve been saying for months that a rights issue at EOH is inevitable and we seem to have finally reached that point.
The share prices of these companies have collapsed this year. EOH is down 37%, Nampak is down 50% and Steinhoff has lost more than 60% of its value. With Tongaat Hulett suspended from trading and in business rescue, it’s unclear whether there will be any equity value left whatsoever.
It’s worth unpacking how overleveraged companies typically fail, or at least end up doing highly dilutive rights offers that wipe out existing shareholders.
When companies have too much debt, control (and value) slowly slips away from equity investors to the bankers instead. The power shift accelerates as debt covenants come into play, with banks carefully designing these agreements as an early-warning system. The covenants inevitably cover debt affordability (interest cover ratios) and overall solvency (gearing ratios).
Profits barely cover interest repayments, leaving little or no room for error (or rising interest rates). The share price plummets as savvy equity investors get out of the way. Speculators join the shareholder register, hoping to make a quick buck if things improve. It’s a high-risk strategy that often ends in tears, as evidenced by the share price crashes highlighted above.
As the balance sheet becomes an increasingly daunting prospect, companies realise that they can’t grow their way out of their mess. US Federal Reserve chair Jerome Powell’s money printer is sadly not available to private companies, so they don’t have the option to just inflate their way out of debt.
As the balance sheet becomes an increasingly daunting prospect, companies realise that they can’t grow their way out of their mess
Out come the pitchforks
This leaves only a few options, most of which are ugly. To kick the equity capital raise can down the road, companies start by selling off noncore assets. Of course, managing the balance sheet properly and avoiding noncore assets in the first place is often a good way to avoid this kind of trouble.
By this stage, the pitchforks have come out and management has usually been replaced. Those pesky noncore assets are “previous management’s fault”, so they must go. Such assets usually aren’t the belles of the ball, so selling them is easier said than done. This is especially true during times of economic stress, which is typically when broken companies are forced to hold a garage sale.
Long before the business rescue practitioners make their fees, the bankers and lawyers get a solid bite at the withering cherry. Advisory fees when selling difficult assets can be juicy. Again, companies that don’t want to be at the mercy of advisers should take the radical step of not playing risky games in the first place. Very few companies have gone bankrupt by focusing on core operations with a modestly leveraged balance sheet.
If shareholders are lucky, offers will come in quickly enough that the asset sales might make a dent in the capital balance of the outstanding debt. Getting offers is one thing, of course; regulatory approvals are quite another.
Competition approvals take months to achieve. It’s even worse when African subsidiaries are involved, as the sale of an entire business can be held up by a regulator in a country with a smaller GDP than Joburg weighing in on the matter. By the time it goes through, the balance sheet has deteriorated so significantly that the asset proceeds are mainly used to reduce interest. There’s very little left to reduce the capital amount.
With those assets gone, there are only two options left: an equity capital raise or business rescue. Both suck.
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