Considerations for creditors, shareholders, and private equity firms.

According to Statistics South Africa, 216 businesses were liquidated in March 2021, 50% higher than the number recorded just a year ago. It is against this backdrop that the Southern African Venture Capital and Private Equity Association (SAVCA) recently hosted a panel of experts to discuss the critical role of business rescue during this crucial time, keeping its members abreast of the changing landscape.

“Prior to 2011, distressed businesses would have been left with little option but to close, and be placed into liquidation, however, thanks to the newly introduced business rescue legislation, they now have another, more hopeful avenue. The legislation now gives us (for the first time in South Africa) the opportunity to rescue businesses and keep jobs. The potential of a turnaround and restructuring outcome makes us passionate about what we do.” Those were the opening remarks of Eric Levenstein, Director at Werksmans Attorneys and SAVCA panellist. He then touched briefly on the responsibility of directors who find themselves faced with solvency issues.

“Directors, both executive and non-executive, can be held personally liable if they don’t take meaningful steps to deal with financial distress. Directors who don’t take action when they are privy to reckless trading practices also open themselves up to personal liability.”    

Cathy Goddard, SAVCA board member and CEO of FyreFem Fund Managers, and panel moderator then shifted the focus of the discussion to the options available to South African businesses when insolvency looms. A wealth of insight was shared by her second panellist, Alison Timme, an Associate Director at EY. 

“In short, the earlier one acts, the more options will be available.” She reiterated the legal requirement to act when faced with either balance sheet or cashflow insolvency, with the latter being the most important determinant of optionality. She says there are well-documented insolvency warning signs that board members should watch out for.

“Creditor stretch or informal creditor finance, delays or non-payment of tax returns, late supplier payments, and covenant breaches should all be looked at closely. Overreliance on customers and suppliers (and their own health) is also something the board should be attuned to.”

To spot solvency issues early on, Timme recommends that the ability to forecast cashflows be enhanced. Scenario planning that maps out the magnitude of potential upside and downside; the isolation of key drivers of cashflow; and the identification of levers the business can pull to bring relief should the need arise; will all improve line of sight of potential liquidity problems. Once the threat of insolvency has been acknowledged, financial/balance sheet or operational restructuring both enter the fray. On the latter, Timme quoted the following from the EY 2020 Global Corporate Divestment Study: “96% of shareholder activists, up from 64% in 2019, recommend that post COVID-19, a target company divest of their non-core assets.”

Regarding shareholder rights in the context of a business rescue plan being implemented, Levenstein made their standing clear: “Unless there is a share transaction on the table, shareholders tend to take a back seat in business rescue proceedings.” Where shareholders are also creditors (through shareholder loans), their classification as ‘independent creditors’ determines whether their vote counts towards the 50% needed to put the business rescue plan into action. Before the vote, the business practitioner will make it clear who qualifies as independent and who does not. 

Goddard then asked Timme how shareholders could possibly improve their position during a business rescue process. One of the simplest ways, she said, is to buy the debt. But in practice that can be very complicated.

“First you’d need to establish whether the creditors are willing to sell their debt. If they are, at what price? Shareholders often sign guarantees for bank debt, which aren’t extinguished by business rescue procedures and therefore remain callable, buying the debt is most often a very expensive exercise. It’s also important to understand the voting interest landscape, and whether the cost of obtaining a ‘seat at the table’ aligns with the overall strategy and required returns going forward.  Lastly, if there’s a failure to adopt the business rescue plan, understand that a new set of creditors may enter the fray that could undermine your voting rights.”

In wrapping up the webinar, Levenstein was asked to share his views on post commencement finance (PCF) in the business rescue process, and how it works as a mechanism for private equity firms to successfully invest in distressed assets.

“PCF is the lifeblood of any business rescue plan, without it, liquidation is almost a certainty. Those who provide the finance are immediately elevated to the top of the payment waterfall in the business rescue proceedings and are also ranked higher in the case of liquidation. PCF providers will also have   some influence over how the business rescue plan is carried out, but most importantly, providing PCF gives the financier a foot in the door to acquire the asset outright. They can offer the existing creditors slightly more than they would get in liquidation, buy the asset, and exit the business rescue plan as the new owners. Until private equity and venture capital firms understand that mechanism, many attractive distressed investing opportunities will go to waste,” Levenstein explained.   

“The reality we find ourselves in is that many businesses simply cannot withstand the lasting impact of the COVID-19 pandemic. However, business rescue offers good South African businesses an opportunity to keep operating, save jobs and continue contributing to the economy. We therefore felt it was an important topic to explore in the first of a two-part webinar series,” concludes Tanya van Lill, SAVCA CEO.