Asset financiers' options for mitigating losses

15/02/2010

Tarun Mistry (pictured), Head of Leasing and Consumer Finance at Grant Thornton, leaves no options unturned

Introduction

The past year has been a difficult year for many lenders and specifically asset financiers.  Arrears and bad debts have increased significantly and combined with poor asset values, lenders have had to revisit their strategies for improving recovery rates from distressed clients.  There is still uncertainty with regards to the recovery of the economy and 2010 will be another tough year for those in our industry.

In this article, we discuss the different ways that lenders might respond to customer defaults in order to improve their recovery.  Our recommendations are based upon many years of experience of working in the restructuring field advising creditors (including asset financiers) and debtors on their options and managing the process through to an improved outcome.  Each default case will be different, however, below we have attempted to high light the common aspects to consider and general principles to follow.

We will focus mainly on corporate borrowers, although the same principles apply for all borrowers.  We shall consider why this approach might achieve a better outcome for lenders, and look at the main impediments to achieving success and how they might be overcome.

Initially we will set out the steps involved in the process and finally set out some of the key success factors which would enhance or impede success.

 

Why is it important to consider other options?

These are unprecedented times.  Your businesses, and indeed your customers' businesses, are encountering more difficult trading conditions than they have ever faced before, including:

- reduced trading volumes

- falling asset values

- increasing defaults

- lack of liquidity

Many asset financiers are likely to be the last to become aware of the difficulties being faced by their customers.  In addition they are unlikely to hold a debenture, therefore, are not in a controlling creditor position.  It is therefore crucial that that they keep close to their customers financial position and act quickly as soon as there is a sign of distress.

In these circumstances, recovering their assets is possibly not the ideal option since any further rental income received before having to take the asset back could represent an improvement in the net recovery position.  A time period during which the assets are held and secured by the customer could also allow an asset funder time for contingency planning.

Historically, repossession or insolvency of the borrower were the only potential outcomes if borrowers defaulted.  There are a number of reasons why other options now need to be considered.

- the competition in the lending environment over the past few years has meant that asset funders existing portfolio margins are low and LTVs are high, therefore, the fall in asset residual values has meant that many more lenders are facing shortfalls when customers default.

- the second reason is political.  Banks, and particularly those now owned by the taxpayer, are embracing a culture of finding alternative solutions.  This is not particularly new - the ethos started to develop after the last recession, but is becoming even more prevalent when insolvency is demonstrably the worst option for lenders and customers alike.

 

Other options for lenders to consider

 

The alternative options to consider prior to following an insolvency process are: 

- turnaround

- restructure

- work out

These are all variations on a theme; and that theme is negotiation with the customer and other stakeholders to re-schedule instalments to avoid repossession.  The process is broadly the same in all three cases, however, a broad definition of each would be:

- a turnaround addresses areas of operational inefficiency with a view to improving profitability, and is therefore an appropriate strategy for a solvent company which is loss-making.

- restructuring addresses balance sheet issues with a view to restoring solvency, and is therefore an appropriate strategy for a company which is profitable, at least at an operational level, but overburdened with debt.  There have been many such examples in recent months, which has been a legacy of the hugely leveraged buy-outs in the last five years.

In much of the work we do, the solution involves elements of both strategies, however, it is useful to understand the particular objective of each strategy.

- the third alternative is probably most applicable in cases where the business is no longer viable in the long term, therefore a managed exit is appropriate.  We would argue that there are many cases where the outcome for the lenders would be much better if they supported a work out in preference to an insolvency appointment.  This probably amounts to a liquidation in all but name eventually but without any loss of value which might be caused by an insolvency and without the additional layer of costs.

The options and where they are applicable is perhaps best illustrated by the Argenti curve (figure 1), which is an excellent representation of the way in which businesses deteriorate over time if problems are not addressed.

 

Figure 1 - Argenti curve

 

It is important to emphasise:

- the worsening rate of decline.  This emphasises the need for lenders to monitor their customers and address problems early.

- chances of recovery, or indeed survival, decline over time, since the number of options available to tackle the company's issues also rapidly decline.

- the appropriate strategy moves from turnaround through restructuring to workout.

Also beware, if the first warning sign of a problem is a bounced instalment, it might already be too late to save your customer and your exposure!

 

What are we hoping to achieve?

In the first instance, we would hope to restore the viability of the borrower and have a sustainable business going forward.  This is clearly in the interests of the lenders, firstly since they would suffer no loss but secondly there is a prospect of an ongoing profitable relationship.

However, if recovery is not possible, then the focus is on minimising the loss for the lenders.  This could be achieved by a consensual process which maintains an income stream for the lenders (albeit possible lower and/or stretched over a longer time than originally scheduled).

There is also the added benefit of a much better managed residual process.  Assets would be delivered up rather than the lender having to search for them and are likely to be returned in a better condition.  More importantly, the financed assets will be returned over time in bite-size chunks so that the re-marketing results in no market distortion.

This is all, of course, subject to lenders being satisfied about the on-going security of their assets.

 

What are the barriers to success?

The biggest hurdle is the management of the borrower, which we shall discuss shortly.  Other major barriers include:

- lack of information, e.g. poor/late MI

- lack of time, if it's simply been left too late

- the cost of the solution, e.g. a disproportionate cost.  The key is, if funding is required, who will provide it?

- lack of alignment and/or trust between the stakeholders, possible caused by management pursuing a "divide and rule" strategy between their creditors

- the number of stakeholders involved and varying security positions or agendas

- the extent of the crisis.  As stated earlier, early identification is vital

- the time and resource required by stakeholders to manage the problem.  Bluntly, is it worth it?

 

Ways to overcome these barriers

Each distressed client will be different, however, there are certain generic approaches which can assist in most cases:

- a credible/realistic plan

- communication/transparency

- gaining stakeholder support and confidence

- and finally, the use of restructuring and sector specialists acting independently for all the stakeholders

 

The steps in the process

A plan of action will normally include the following steps:

- getting management on board

- stabilisation of the company

- formulating a strategy acceptable to all key stakeholders which sees their exposure being reduced over time

- agreeing and documenting the plan

- implementing and monitoring the plan with regular communication with stakeholders

 

Below we consider each step

Getting management on board

The problems with management are many and varied.  The reality is that management can often be their own worst enemy in these distressed situations.  The issues we commonly include:

- do they, or are they prepared to, recognise that there is a problem

- are they prepared to change their strategy to address creditor concerns over and above shareholder interests

- are they prepared to accept help

- do they have the ability to drive change and to act decisively

- do they have sufficient resources?  In our experience, this is a major issue.  When a business gets into difficulties, the burden on management gets larger, and often they are reduced to simply fire-fighting and have stopped actually managing the business

- do they have any credibility left?

 

Figure 2 - Decline curve

 

Figure 2 plots out the emotions generally experienced by management and stakeholders in distressed circumstances.

The basic premise, is that until you reach the acceptance stage (acceptance of the fact that there's a problem and acceptance of help to deal with it), then the business will continue to decline.  Only after acceptance can there be any hope of recovery.

 

Stabilisation

Having got management on side, or having been invited to help, the real work starts.  The key initial stage is stabilising the position, which starts with establishing leadership - this might be by appointing an interim manager.

However, the heart of the matter, as always, is cash.  We normally start by maximising working capital through a combination of acceleration of cash collection and minimising cash outflows.  Alongside this, we would prepare (or validate if there's one already produced) the short term cash flow forecast.

We need to know if and when there are peak funding requirements (for example, when are salaries, or VAT/PAYE, or rent due) and how these peaks can be smoothed to generate some headroom.  Depending on the type of business, we might need to lock in key suppliers or customers into this process since effectively they may represent stakeholders too.

 

Formulating a strategy

This can be summarised briefly into two or three key areas which are essential to the whole process:

- first and foremost, engaging with the key stakeholders and developing a plan which is supported by them all.  It goes without saying that one stakeholder acting unilaterally could wreck the whole process.  In practice, this involves some poker playing, where some parties are often unreasonable in their demands or expectations.  In practice, this is one of the key areas where an independent advisor can often facilitate an agreement.  An advisor who appreciates the issues and objectives of all stakeholders and develops a strategy aligned to these or at least tries to accommodate them is crucial.

- secondly, we can't over-emphasise the need for realism and the need to look at funding needs and, more importantly, who will provide it and on what terms?  The problem in practice is that you often have to spend to save, e.g. to make redundancies or exit onerous contracts.

 

Agreeing and documenting the plan

This stage is rather more mechanical.  Apart from formalising the plan, the key issues here are firstly to make sure that actions happens.  Implementing these type of plans often takes people well outside their comfort zone and their abilities.  Accordingly, assigning responsibilities and timescales and ensuring that set tasks are actually carried out is essential.

 

Implementation and monitoring

Plans must remain "live" and kept under constant review.  The other important aspect is that there is no guarantee of success, particularly in the current economic climate, therefore it is essential to have a contingency plan.  It could costly to be committed to a failing strategy but have no cost-effective way to exit.

 

Key success factors

Things we would encourage lenders to do include:

- consider all options, you don't commit to anything by listening

- be realistic, and ensure that any plans you enter into are realistic, and are based on realistic forecasts

- lenders should use their collective bargaining power, and negotiate strongly.  Lenders should think about, for example, taking second charges, or collateral security, or setting new covenants as a quid pro quo

- solutions must be equitable.  This, however, does not mean that all lenders should be treated the same - strength of position, and particularly the extent of any security held, is the key ingredient in the equation, since security controls each lenders options

In order to be able to understand a proposal properly, you should see detailed cash flow forecasts, both for the business as a whole and evaluate the vulnerabilities within it.

The proposal should also be presented formally so that each party can fully understand what is proposed without fear of misunderstandings, and can take independent advice on how it impacts them.  There are obvious advantages to having one advisor representing a group of creditors.

Finally, as a general rule any restructuring plan should be equitable and this may include the concept of "income following the asset".  In other words, if an asset owned by Lender A is earning income for the business, the bulk of that income should be attributed to that Lender in any restructuring or workout.

 

We would suggest that you don't:

- act alone

- give up security or other remedies without taking legal advice.  As a general rule, any agreement you make should be on a without prejudice basis, with claims or security only being released once the other side of the bargain has been performed

- support stop gap measures.  That is, interim plans which do not offer a reasonable degree of probability of solving the problem.  Generally, there is only one chance at resolving these sort of problems

and finally, never allow things to drift.  Think back to the Argenti curve; the longer problems are left to fester, the harder they become to solve and fewer alternative solutions will be available.

 

Tarun Mistry

Director - Head of Leasing & Consumer Finance

E: tarun.mistry@gtuk.com

 

Bernie McAlister

Associate Director - Leasing & Consumer Finance - Restructuring

E: bernie.e.mcalister@gtuk.com

 

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