Restructuring distressed corporate debt in Ukraine and the CIS Lessons for creditors from recent practice - an accountant's perspective Aaron Johnson Partner, Transaction Advisory Services 19 April, 2010
What does a typical debt restructuring process look like? Phase I Situational analysis Development and testing of financial model Independent Business Review Liquidity review Quantify funding needs Phase II Diagnosis and restructuring planning Consideration of funding options Development and review of restructuring plan Phase III Negotiation with lenders Standstill agreement with lenders Debt terms renegotiation (terms, covenants, interest rate, repayment schedule) Sign final documentation Phase IV Monitoring and implementation Post signature implementation Page 2
Complications and challenges of debt restructuring and refinancing (1) When access to liquidity was easy and credit facilities cheap, banks, as well as borrowers, performed only high level analyses of: Borrowers business models and mid-term financial projections; Borrowers financial models, current and forecast financial position. Based on our experience at EY, the main challenges and difficulties during debt restructuring are: Insufficient understanding by the banks of the borrower s liquidity in the near term (3 months No reliable, transparent and robust models for short term cash flow forecasting and day to day cash management, that would give clear visibility over the borrower s cash position and cash requirements; Unreliable or nonfunctional financial model that cannot be used as a flexible tool to model the borrower s financial performance and position in the medium-term perspective (2-5 years), and to stress test core underlying assumptions; Banks not trusting the borrower s trading forecast and underlying assumptions; Lack of transparency around the borrower s total (including hidden) liabilities (off-balance sheet liabilities, commitments to shareholders etc.); Lack of understanding of the borrower's true value in a distressed market environment Page 3
Complications and challenges of debt restructuring (refinancing) (2) Other key complicating issues arising which frequently arise during negotiations between banks and borrowers are: Different objectives and internal procedures at each bank hinder the restructuring process and delay consensus within the group of creditors; Dishonest borrowers attempt to strip the core business of its assets, or "clone" the business and transfer business operations to this "clone"; Shareholders are reluctant to or fail to provide additional collateral for the restructured debt, or to convert a part of the debt into shares, or to sell a part of the business to an external investor. In this case, we often see disagreements between creditors and borrowers regarding the value of a business; Insufficient legal protection of creditors interests during "crisis" times, e.g. rights of the bond holders; Lack of effective insolvency legislation: current legal environment does not easily allow for the use of financial recovery mechanisms common in the West Page 4
Case study (1) Debtor/borrower: Retail trade with large consumer goods; Total bank debt: USD 550 million Payments: 2009 USD 220 million, 2010 USD 190 million; 2011 USD 140 million Business value (current): USD 800 million Creditors/banks: 5 foreign banks; Not interested in debt for equity swap in borrower s business Ernst & Young was engaged due to the following: The borrower stated it was unable to make principal repayments in accordance with the payment schedule; The banks were ready to restructure the debt but required understanding of: current liquidity of the business; how reliable and efficient the financial business model was, and how well it reflected key business drivers; how robust were management's forecasts on business development for the next 3 years; what were sustainable debt principal repayments and interest payments; to what extent management controls business development scenarios. The borrower planned for a partial business disposal, however the banks required understanding of how the transaction would impact the financial position of the borrower and the banks' interests. Page 5
Case study (2) Ernst & Young's scope and mandate as a financial advisor included: Analysis of the planned transaction: Problem: The banks did not understand objectives of the deal between the borrower and its investor, the value of the transaction for the borrower in the long-term perspective and the potential impact of the transaction on the borrower's near-term cash flows; Solution: Together with borrower's lawyers and management we analyzed the commercial and financial conditions of the deal; Following our analysis of the borrower's strategic goals, we scrutinized the potential transaction for its consistency with the borrower's strategy; Financial model was adjusted for the impact from the transaction on the borrower's financial position and its cash flows; Result: The banks provided their consent to the transaction. Short term liquidity analysis: Problem: The banks did not understand the liquidity position of the borrower and when it would run out of cash if no debt restructuring was agreed; Solution: The borrower presented its own approach to the management of short term cash flow; We analysed how complete and comprehensive the model of receipts and payments was and questioned significant inconsistencies, lack of support or inflated assumptions; We monitored the borrower's cash flow management functionality through forecast vs. actual analysis for 4 weeks and scrutinized significant deviations. Result: We confirmed (1) the robustness of the borrower's cash flow management and (2) when the borrower would run out of cash under the current debt repayment schedule. Page 6
Case study (3) Ernst & Young's scope and mandate as a financial advisor included: Analysis of the borrower's business performance ( Independent business review ): Problem: The banks required confirmation that management were in control of the business, were effectively realising their strategic goals in each division, and were maintaining their competitive advantage in the marketplace. The banks also wished to understand different scenarios of the business future development, taking into account further deterioration of the economic environment, and to understand if management had performed adequate contingency planning for such scenarios; Solution: Near-term and mid-term business plans of the borrower were reviewed; We performed a review of the markets where the borrower was operating, and recent developments in these markets; Meetings and discussions with the management on the plans and scenarios of business development and the borrower's response to the challenges of economic environment; Optimistic, average (base) and pessimistic (downside) scenarios of the company s financial forecasts were analysed and challenged. Result: The banks received a report prepared by EY with an analysis of the borrower's management of its business, and risks associated with its financial foecasts. Page 7
Case study (4) The Ernst & Young's scope and mandate as a financial advisor included: Analysis of the borrower's financial model: Problem: The banks required confirmation that the financial model was (1) consistent and accurate, (2) reliably represented the company s business model, (3) allowed management and the creditors to stress test the company's financial position and performance based on the possible changes to its operational environment, (4) could quantify the required financing for the business; Solution: Our scope did not require us to create a perfect financial model. The model should simply be fit for purpose; The key factors driving the financial position of the borrower, and key underlying assumptions made by management in the preparation of the financial model were identified during our Independent business review; We adjusted certain assumptions used in the model based on our findings in the IBR; We identified additional required assumptions and related input data, which were subsequently incorporated into the model by management; Management's financial forecasts were revised to reflect revised assumptions; Changes were made to the model to eliminate functional errors which restricted the model accurately reflecting the impact of changing sensitivity factors and initial assumptions; The base case financial forecast was lowered after our review of the company s forecasts and markets development. Result: The banks received a financial model which (1) was consistent and accurate, (2) reflected the company s business model, (3) allowed the business to show the impact of changing operating environment and (4) defined a downside "banking case", which banks could present to their credit committees as a basis for drawing up revised debt levels, interest rates and repayment timetables. Page 8
Summary Project period 6weeks Project results: Using the "banking case" scenario, the banks approved refinancing of the company's debt in avery short period; Revised banking covenants of the company were set and agreed by all parties; Revised guarantees and pledges to the banks were agreed; The revised terms around the bank s financing allowed the company to continue to trade and further develop its business. Page 9
Thank you Aaron Johnson Partner, Transaction Advisory Services Tel.: +380 44 490 3000 E-mail: Aaron.Johnson@ua.ey.com