Distressed debt in Australia
October 2010 | TALKINGPOINT | FINANCE & INVESTMENT
FW moderates a discussion between Clint Hinchen at Allens Arthur Robinson, Nicholas Dunstone at Henry Davis York, and Michael McCreadie at PricewaterhouseCoopers, on trends in distressed debt trading in Australia.
FW: Can you outline the reasons behind the recent pick up in debt trading in Australia?
Hinchen: Unrestricted assignability in loan documentation, coupled with the fact that many more international financial institutions are lending to Australian corporates than was the case during the last downturn, are both factors leading to lenders treating the Australian debt market in a similar fashion to its European and US counterparts in respect of debt trading. International players see the Australian marketplace as a strong credit when compared to other developed nations and, with low legal risk (loan documentation containing terms similar to what lenders would expect to see in UK deals) and low political risk, debt traders are entering the Australian distressed debt market in droves – especially in larger distressed situations with highly structured debt profiles.
Dunstone: There are probably three main reasons for the increase in debt liquidity in Australia. First, and most obviously, the supply of large cap distressed situations (both LBOs and complex structures) has increased. Second, many hedge funds and investment banks have been knocking on the doors of Australian Banks who are the holders of distressed positions for some time, and the trading over the last 12 months might be regarded as the fruits of those efforts. Thirdly, Australia remains a very attractive jurisdiction for offshore distressed funds to make investments – given both the strong regulatory environment (and therefore downside protection) and also as high yielding opportunities in many of their home jurisdictions have reduced in recent times.
McCreadie: Just to be clear Australia is not a debt trader’s paradise just yet. The debt that is trading is generally a handful of large corporate exposures that were heavily syndicated and are facing a major restructuring. Essentially, once the large local banks have sold down their positions, many of the other syndicate members have looked to exit their positions. There are a number of factors that have influenced this pick up in sales activity, including a significant level of interest from buyers which has meant pricing has held up. The lack of many alternatives in Asia has meant that for funds looking for geographic expansion beyond the US and Europe, Australia becomes a desirable investment destination. Add to this the fact that the banks are coming under pressure to deal with their growing NPL issues and many of the names that are currently trading have been around for quite some time and banks are just now addressing the issues. Australian banks have gone through the GFC relatively unscathed, however they do have a growing NPL exposure which from a capital perspective is eating up significant amounts of capital. Sales make an obvious early exit option where the capital can then be reapplied to revenue generating causes.
FW: Which parties are interested in buying debt in Australia and what is their motivation?
Dunstone: A range of different global funds are acquiring debt – from international PE funds, to credit hedge funds, trading desks and investment banks. Their motivations are varied – but until recently it has been mainly on the trading/credit side rather than a private equity style motivation – although that is presently changing. Their interest in Australia as opposed to other Asian jurisdictions has also been motivated by a desire to invest where there is a strong insolvency framework to protect downside.
McCreadie: Australia is an attractive investment option as compared to the rest of Asia because of the robust legal and regulatory framework. Hence a number of offshore funds from around the world are interested in buying debt in Australia. For those funds looking for geographic expansion, Australia is an obvious choice from an Asian perspective. Over the past two years we have seen a number of US investors buying debt in Australian exposures together with a couple of European funds. Some buyers buy from secondary traders such as the investment banks who tend to source the debt based on established relationships with banks whereas others, particularly on bigger trades, have been buying direct, sometimes at informal auctions where the banks hold limited participation auctions for debt to a few buyers they trust but who may have very different levels of knowledge in relation to a credit. The investment bank trading desks then on-sell the positions to many of the distressed funds. To date there are very few locally based buyers and holders of distressed debt.
Hinchen: A variety of players are buying debt in the Australian secondary market, however, in my experience, the US based hedge and distressed debt funds are the most active. Motivations are proving to be mixed – some funds are entering the market with a view to obtaining a quick return by on-selling their position prior to completion of a restructure or deleveraging event, while others are acquiring a more traditional ‘take and hold’ position and are proving more willing to be part of a restructure with all that entails, including often taking an equity position as part of their exposure post-restructure.
FW: In your opinion, how have hedge funds and distressed debt funds influenced recent restructuring efforts?
McCreadie: Hedge funds are playing an increasingly important role in shaping the outcome of restructurings across the world. As returns have become thinner and risks have become a bit more challenging post-GFC, US and European hedge funds have looked to other markets, leading to an increase in interest by hedge funds in Australian assets over the past 12 months. Some large positions have traded in some of Australia’s largest companies, including Alinta and IMed to name but a few. How hedge funds influence restructuring outcomes depends greatly on the strategy they are following. At one end of the spectrum, the ‘bounce and out’ proprietary desk traders look for a quick market uplift on small positions held for as little as a few days. At the other end of the spectrum there are ‘loan to own’ players who buy into a capital class with a view to controlling the business and any upside post restructuring. Their influence can be dramatic, especially where rival approaches are proposed, and we have seen some cases of inter-class or even intra-class conflict dictating the restructuring process. These conflicts can create new ideas and approaches which are beneficial to numerous stakeholders, but in other cases lead to the restructuring process becoming protracted and (from directors’ perspective) more risky, increasing the risk of the appointment of voluntary administrators.
Hinchen: The involvement of hedge and distressed debts funds has significantly influenced a number of Australian restructurings. The traditional Australian ‘workout’ process that was common during the last downturn, and well understood by the major Australian banks, has required substantial modification given lending groups can change overnight. This has made voting on restructuring proposals more difficult and introduced a new level of negotiation into the restructuring process, as the motivations of some hedge and distressed funds can be materially different from the motivations driving a borrower’s core lending group. Having said that, the vast majority of Australian restructurings have not involved significant debt trading and, accordingly, on these deals well considered restructurings have been much easier to execute with certainty.
Dunstone: Hedge funds and distressed debt funds have influenced restructuring efforts through bringing new liquidity to the table in an insolvency process. They have also brought a greater focus on activist solutions and the debt for equity solution, often as a quasi competitor to an M&A process.
FW: Have any notable legal or structural issues emerged in distressed debt trading deals during 2010?
Hinchen: No particularly significant legal impediments have arisen in distressed debt trades, other than the obvious issues around assignability in the underlying loan documentation, KYC and associated AML checks. However, some structural issues have arisen, in that approvals from a fractured lender group that is constantly in a state of flux can be difficult to obtain. Of course, the extent such structural issues arise on a deal will turn on a number of factors, including the number of active debt traders taking positions across the borrower’s debt structure, and the number of steps and approvals required to action a considered restructuring.
McCreadie: Distressed debt trading, particularly for domestic portfolios, is still in its infancy in Australia relative to markets in Europe, the Americas and even Asia. There have been few portfolio deals outside of the retail NPL portfolios and the number of single names trading is still down to handful of large companies with highly syndicated loan books. Whilst hedge funds like the Australian legal system’s stability and predictability, two issues have come to prominence over the last six months which could be detrimental. The first is management and directors’ capacity and willingness to trade-on, particularly in an environment where intercreditor conflict can lead to a fear that a deal of some sort may not be capable of being done. The second issue is Australia’s constrained capacity to execute ‘pre-package’ sales of an underlying business to the owners of the debt. Both of these issues are impacted by Australia’s legal structures which are designed to avoid insolvent trading and phoenix activity, albeit with a potential impact on the commerciality of the ultimate transaction. In addition their continues to be a risk that hedge funds are exposed to following the Australian Tax Office ruling in the TPG exit from Myer. Until this is cleared up there remains a significant risk regarding the tax treatment of gains in Australia.
Dunstone: A structural issue which has emerged for distressed funds adopting a private equity approach is the tax treatment of returns highlighted from the decision of the Australian Taxation Office in the Myer TPG case. There are now structural solutions as a result of recent legislative changes which make these issues manageable.
FW: When a company is approaching insolvency, the mindset in the boardroom can quickly change. To what extent are restructurings more likely in this context? What impact does this have on the debt markets?
Dunstone: In Australia, we presently have the most draconian insolvent trading laws in the world. There are very strict liability consequences for directors that continue to trade a company that is insolvent – even if continuing to trade that company whilst pursuing a restructuring may be in the best interest of the stakeholders. This can create issues for trying to successfully implement restructurings as directors can demand substantial financial accommodation from their lenders by saying that they will have no alternative but to file the company, which may entail substantial value destruction for the lenders.
McCreadie: Corporate boards in Australia are slowly recognising that, as their company becomes distressed, they need to be proactive in addressing the causes immediately rather than taking a ‘wait and see’ approach. Boards are also beginning to seek legal and restructuring practitioner advice sooner. Where bank facilities are a (or the) key factor in the distress, having the ‘elephant in the room’ of an administration appointment for fear of insolvent trading can focus both the company’s and banks’ attention on obtaining a resolution. That said, the legislative framework in Australia regarding insolvent trading can be onerous on directors unless it is carefully navigated with the help of strong financial and legal advice. This not only leads to companies which could potentially be restructured ending up in administration and liquidation, but this risk also serves to depress the market for and prices for distressed debt, detracting from the risk reward equation.
Hinchen: Potential solvency concerns are dealt with differently board to board. However, the triggering of a Potential Event of Default (or Event of Default) with respect to a financial covenant under loan documentation typically remains the first external signal from most borrowers of a potential concern. The occurrence of such an event usually leads to the appointment of an investigating accountant and ultimately some sort of workout or restructuring process. Boards in Australia typically seek assurances from lenders that they will remain supportive of the company while a restructuring is contemplated and actioned. Any sign of this support dissipating can encourage a board to move to a formal appointment.
FW: In the current climate, have companies been able to achieve meaningful turnarounds, or are they merely papering over cracks and delaying the inevitable?
McCreadie: There are many examples of companies of all sizes who have achieved meaningful turnarounds, with large corporates leading the way. This has been illustrated in the current earnings season, which has shown general improvements in balance sheet health (reductions in leverage and working capital improvements) as well as real and sustainable cost structure improvements at many companies. Companies that did just ‘paper over cracks’ – riding the short term benefit of stimulus spending and a reduced Australian dollar – are now being exposed as both of these impacts have wound back. This is driving the second round of restructurings and insolvencies we are seeing now and expect to see over the coming months Note, however, the best turnaround is the one you never read about.
Dunstone: There has certainly been a trend towards avoiding substantive restructurings and adopting band-aid solutions where possible – and given the previous state of the markets that was probably the right alternative at the time. We are now seeing a move towards more meaningful restructuring both as a consequence of necessity – that is, band-aids washing off – and also a more normalised market to support asset pricing.
Hinchen: We have seen a mix of stories in this downturn, with a number of very successful turnaround stories on one hand, and a number of others that have not succeeded (leading to formal appointments) on the other. There are also a number of other transactions that remain in a restructuring process, where the success or otherwise of the process remains unclear. Australian insolvency law does not allow for the ‘papering over cracks’ in that directors, when incurring a debt, must have a reasonable expectation that the company can repay that debt as and when it falls due. Without the genuine ongoing support of its lenders, the board of a company will find it difficult to form such an expectation.
FW: As you see it, what needs to happen to encourage more restructurings and turnarounds in Australia?
Hinchen: The Australian legal framework in the insolvency area is well established and understood and, while Australia does not have a statute imposed moratorium on enforcement – as is the case in the US and is currently being debated again in the UK – the informal restructuring and workout process undertaken by the Australian banks and others has a track record of leading to positive, quick and successful turnarounds. That said, if we continue to see more secondary debt trading in the Australian market there may be a renewed interest in introducing a statutory moratorium period to allow distressed borrowers time to bed down a restructuring process with their lenders without the added pressure of dealing with secondary lenders looking to leverage the distressed situation for a quick gain.
Dunstone: Proposed legislative reform to enable directors to continue to trade a company that might be insolvent when it is in the best interest of stakeholders to do so is absolutely critical. Premature filings, or the risk of premature filings, creates a difficult dynamic for achieving a successful restructuring and turnaround in Australia. In addition, in a listed company context, the proposed reforms to the Sons of Gwalia issue (where shareholders can bring litigation claims against the company that rank pari passu with unsecured creditors) will also greatly assist in achieving turnaround. The threat of large scale litigation claims from shareholders has materially impacted restructuring to the detriment of creditors.
McCreadie: There are two main aspects to this. Firstly, there is an education piece for directors of companies of all sizes. Boards need to be proactive and recognise that the earlier underperformance or financing strain is recognised, the more options are available to address them. Particularly under the current legislative framework, the window of opportunity between problems arising and it being too late to address them outside of insolvency can close quickly and directors need robust financial and legal advice – preferably from a firm with a positive attitude and nothing to gain from a collapse. Which leads to the second aspect: the legislative environment needs to be addressed and amended to provide companies with a better framework to restructure without falling down the administration-liquidation slippery slope. Recent ASIC guidance on insolvent trading has provided a little more clarity, but has not addressed the underlying issue. There are currently some interesting discussions taking place regarding alternative regulatory structures.
FW: What trends have you seen in the Australian insolvency market over the past two years, and where do you believe it is headed?
McCreadie: A clear trend over the GFC period relative to previous recessions has been the banks’ willingness to provide companies with time to turn around rather than forcing them into receivership or other insolvency appointment. Banks have clearly recognised that formal insolvency is generally a value destructive progress, particularly at the height of a crisis, when the options are few. In terms of the near future, hopefully credit markets will continue to loosen providing greater scope for refinancing and M&A transactions and other markets will remain stable, increasing the scope for sustainable turnarounds rather than just temporary balance sheet solutions. This will serve the interests of both financial institutions and corporate Australia. More serious discussions regarding the insolvency and restructuring regulatory environment is also likely, hopefully leading to a regulatory framework which is more supportive of corporate restructuring.
Hinchen: The active secondary trading of distressed debt has been the most significant change to the Australian market in this downturn, and I expect that these trading levels will only increase. The availability of this secondary trading market, coupled with suppressed asset prices, have led to lenders being more willing in this downturn to support distressed borrowers through a restructuring or workout process. Shareholder class actions have also become more prevalent, however, as at the time of writing no significant actions have appeared before Australian courts, with out-of-court settlements being agreed in all cases. Until these actions are tested before a court it is difficult to comment on the extent such actions are likely to be a key factor in insolvencies across Australia moving forward.
Dunstone: One trend is that many advisers, both accounting and legal, have rebranded themselves as restructuring rather than insolvency lawyers or accountants. At the same time, there are many front end deal makers, who are likewise branding themselves as restructuring advisers. This change in nomenclature might seem superficial, however it also reflects a cultural shift towards a desire to achieve genuine restructurings (although people are still working out exactly what that means). The same occurred in the UK in the late 90s. All financiers and advisers are now acutely aware of the needless value destruction of formal insolvency processes.
Clint Hinchen is a senior partner at Allens Arthur Robinson. He is the co-leader of the firm's national Corporate Insolvency and Restructuring Group and practises in restructuring, corporate insolvency, security enforcement, , the management of non-performing assets and banking litigation, and advises on directors’ duties (particularly insolvent trading). He has advised leading Australian insolvency practitioners, financial institutions, unsecured creditors, shareholders, directors and parties purchasing assets from companies under insolvency administrations. He can be contacted on +61 3 9613 8924 or by email: Clint.Hinchen@aar.com.au.
Nick Dunstone is a partner in Henry Davis York’s Banking Restructuring and Insolvency Group. He acts for funds which specialise in the acquisition and restructuring of distressed companies. His clients include leading hedge funds, private equity funds and the special situations groups of investment banks. Prior to joining HDY in 2002, Mr Dunstone worked in the London office of Cadwalader Wickersham & Taft working on major European and US restructurings and insolvencies for hedge funds based in Europe and the US. Capitalising on his experience in London and the US, he has established a market leading practice in distressed debt and turnaround investment at HDY. He can be contacted on +61 2 9947 6063 or by email: firstname.lastname@example.org.
Michael McCreadie is a partner in PricewaterhouseCoopers Corporate Advisory and Restructuring practice in Australia. He leads the distressed debt group at PricewaterhouseCoopers. He has had over 20 years experience in restructuring and nonperforming loans in Australia, Asia, Europe and the America. Mr McCreadie has extensive experience representing debtors and creditors in and outside of formal bankruptcy proceedings and assisting companies and financial institutions in buying and selling of portfolios of loans. He was a regular guest lecturer on corporate reorganisation at Georgetown University in America and is a qualified Certified Turnaround Practitioner. He can be contacted on +61 (0) 3 8603 3083 or by email: email@example.com.
© Financier Worldwide
Allens Arthur Robinson
Henry Davis York