Restructuring and insolvency developments in Australia’s commodity and mining sectors
July 2015 | TALKINGPOINT | BANKRUPTCY & RESTRUCTURING
FW moderates a discussion on restructuring and insolvency developments in Australia’s commodity and mining sectors between Cameron Belyea, a partner at Clayton Utz, Michael Ryan, a senior managing director at FTI Consulting, and Beau Deleuil, a partner at Quinn Emanuel Urquhart & Sullivan.
FW: How would you characterise the challenges and issues currently facing Australia’s commodity and mining sectors? What factors are driving rising levels of distress and insolvency?
Belyea: The challenges faced today are much the same as those faced by the mining sector after the 1997 Asian crisis – falling commodity prices and adverse currency movements are placing pressure on high cost models, particularly mid-capped enterprises with leveraged balance sheets. Those boards with inadequate planning to rebalance leverage, chase down costs or improve productivity have quickly lost the confidence of financial counterparties. As counterparties and customers demand better cash support, the enterprise comes under financial covenant, cash flow and performance pressure. For some boards, these pressures are exacerbated by activity from short sellers. The issues break down the same way they did in the post 1997 period – poor board planning around capital management and productivity, and management unwillingness to accept guidance from external capital and professional advisers with experience in turnaround and workout planning. Board and management teams with strong growth credentials are often poor stewards in recognising, planning for, or dealing with distress conditions.
Ryan: The challenge is that there is a lack of confidence. Notwithstanding that fundamentally, the output of the mining industry is as critical to economic growth as it has always been, with the bulk of the investor community for the moment having abandoned ship. Until the investors come back to the industry, we will continue to see tough times ahead. The key issue is the lack of liquidity. Specifically, we are seeing a temporary misalignment of supply and demand in the coal and iron space and as a result, there has been a rapid fall in prices. The other key issue is the move from construction to production and the impact that this, together with a squeeze in margins, has had on the mining services sector.
Deleuil: Australia’s rich endowment with natural resources has successfully driven its economy for many years. In the middle of the last decade, off the back of a growing Chinese economy, commodity prices increased sharply and caused an unprecedented mining investment boom. However, as the Chinese economy cooled, and increased supply came on line, commodity prices fell and so did mining investment. Many of those investments are now distressed. In the iron ore sector alone, billions of dollars were invested by companies on an optimistic assumption that the iron ore price would be sustained above their average cost of production. In some notable cases that assumption proved to be very optimistic. Long term take or pay contracts were also commonly executed in the coal sector to secure critical access to constrained transport infrastructure, on the assumption that coal prices would remain high enough to justify production. In most cases they did not. When prices fell, investment stopped and producers that were cash flow negative started shutting down mines to preserve cash. Capital became harder to find and distressed financing became very expensive.
FW: What kinds of funding options are available to distressed firms in Australia’s market? To what extent are banks and alternative lenders supporting struggling commodity and mining companies?
Ryan: We are seeing some hedge fund and private equity money, however, this is generally only for in development or near development cash positive operations that have managed to right size, but in doing so have reduced their cash reserves. In the case where lenders are already exposed to a situation, we are seeing a strong workout mentality and some willingness to convert debt to equity. Otherwise, there is not a lot of appetite to fund loss making mining or mining services businesses.
Deleuil: In terms of conventional funding, the effect of Basel III and the associated liquidity reforms on large banks has caused a significant exodus of these players from the distressed market. Secondary debt markets now routinely provide the exit strategies for conventional financiers instead of traditional work outs, and there is little or no appetite for distressed lending, as it is seen as non-performing and capital intensive. In terms of alternative lenders, while the emergence of hedge funds is not necessarily new in Australia, there was a notable increase in participation from non-traditional financers and syndicated lenders. Perhaps the greatest example of this was the very significant increase in US participation over the last five years, through Term Loan B arrangements. However, as conditions (and yields) continue to improve in the US market, we will likely see a decrease in the level of foreign activity, or at least a decrease in the competitive terms traditionally offered to Australian commodity and mining companies.
Belyea: Australian inbound investment remains strong across a range of debt and equity products. A number of investment banks, special situations funds, institutional money with bonds or Term Loan B experience, and some private equity out of Asia with high yield based hybrid products, are investing in mining. Traders based in Hong Kong and elsewhere are active commodity offtakers. Australian trading banks are still willing to write hedging instruments, engage in asset financing and provide merchant or some international trade facilities, supported by a range of large receivable financing businesses. Investment into equity by private clients, investment funds and, for large capitalised entities, state enterprises and sovereign funds, also remains strong. Yield investors structure coupons to risk, so the later in the distress cycle management leave approaches to capital, the pricier and greater the security coverage demanded, or the deeper the discount and the more restrictive the terms required by equity. It is apparent from a number of ongoing turnarounds in the market that capital supports management teams engaged with counterparties in an open and transparent manner, with proper advisory support and planning.
FW: In your opinion, what has been the impact of dwindling Chinese demand for raw materials? In retrospect, have the economic linkages between Australia and China been too close given China’s economic slowdown?
Deleuil: It has been said that ‘if China sneezes, Australian commodities contract pneumonia’. This is not surprising as Australia is now the most China-dependent economy in the world. Australian exports to China have grown from 8.5 percent of the total in 2003-04 to 32.5 percent in 2013-14 – and they continue to grow. The biggest challenge faced by Australia is the combination of cooling demand in iron ore coupled with supply growth, mainly from Australia and Brazil. Similar trends have been seen with coal. The recent slowdown in Chinese growth is not surprising given a transition from state initiated investment-driven growth to slower domestic consumption based growth. We expect to see more stable, sustained growth from China as its economy matures. None of this should amount to a criticism of the economic linkages between China and Australia. If any criticism is to be made, it is the delay in effecting this partnership. China is now the second largest economy in the world – Australia’s relationship with it, both now and in the future, will be critical to Australia’s terms of trade.
Belyea: Although we are probably seeing some mid-year pricing stabilisation, and the early signs of recovery across commodities sourced by the electronics and some manufacturing industries, overseas demand, particularly from China, remains restrained for inputs like iron ore and metallurgical coal. These commodities are used in steelmaking and developing urban infrastructure, including roads, rail, buildings, treatment plants, health and other services. While China, as benevolent paymaster for more than a decade, contributed to the opening of otherwise marginal mines, this was not done at the loss of custom from Australia’s deep and longstanding customer markets. Instead, China’s investment helped kickstart mines that would not otherwise have been developed until another boom cycle. This economic linkage has accordingly benefited Australia on a number of levels. The challenge now is to improve productivity from high cost operations, some of which will need to use a scheme of arrangement or controllership to reshape their debts. This is a fairly normal part of a long term infrastructure development cycle, akin in many respects to the post-boom railway enterprise failures in the late nineteenth century and aviation failures in the late twentieth century. The infrastructure assets remain, under fresh management, for the benefit of the community.
Ryan: The problems in price we are currently experiencing have, above all, been largely driven by the supply side of the equation, as opposed to a dwindling in demand. In gross terms, China is still making its way through a huge amount of Australia’s exports, and we expect this will continue for some time. However, effort should be directed toward developing other markets, such as India and other products, such as specialised minerals including, graphite, lithium and the platinum group metals which will be required for the move to electric and hydrogen powered motors.
FW: To what extent are the current difficulties being experienced by commodity and mining sectors leading to an upsurge in domestic and foreign investors targeting distressed assets? How will this affect capital expenditures, as well as future planning and prospects?
Belyea: Australian mining companies have not been a particularly attractive investment class for special situation funds over the past decade, mainly because of the valuation expectations of boards. In the present market, these funds are looking to invest into fulcrum assets, provide strategic asset based financing and some stabilisation capital. Yields are generally high, though because most of these loans are based on cashflow, capital expenditure is usually constrained by covenant restrictions. Although likely to be bridging in nature, this form of debt funding can limit mine expansion and productivity programs. Atlas Iron provided an alternative model, where contractors have invested in productivity by exchanging contractual – old fee – rights for equity and also in acting as a potential source of further capital replenishment. A contractor with an exposure to profitability of the principal is far more likely to help bring down costs and improve output and mining recoveries.
Ryan: We have seen a few high profile instances where distressed debt funds are pursuing loan-to-own strategies by buying into debt positions in troubled companies. However, this is not unique to the mining industry. The real driver is the inability of companies in Australia to protect themselves against temporary macroeconomic upheavals which are the result of a lack of regime, such as the US Chapter 11. Australian companies which are more prone to rapid volatility in market prices for their products may think twice about using so-called covenant-lite, long-term bond issuances as a way of minimising equity dilution. We also believe that there may well be an increased use of derivative products to protect future revenues.
Deleuil: Hedge funds have a good reason to like Australian commodities. Most notably because of the favourable and preferred treatment creditors receive under Australia’s corporate insolvency regime. But also because if you take a long term view, the uptick in pricing and resetting of production costs will deliver value down the track. There are now many examples where mining companies and mining service companies have been acquired or become controlled by hedge funds taking advantage of discounted debt, cheap equity and desperation arising from looming repayment obligations. The fall in the Australia dollar has also made these transactions look very cheap to offshore funds.
FW: What advice would you give Australian commodity and mining companies in terms of their restructuring strategies? What options do distressed firms have available to them in order to continue operations and stay afloat?
Ryan: Companies need to communicate early with their stakeholders. Cash is king. Reduce costs where possible and realign your focus to the current prices for your commodities – don’t assume the prices will come back because, though they will, there is no telling by how much or when. Outside of formal administration, efforts need to be made to restructure long term liabilities via term extensions or debt for equity transactions. Short-term liabilities need to be dealt with by raising cash by an aggressively priced equity raise.
Deleuil: There are now many recognised paths to effecting successful debt restructuring and distressed equity recapitalisations in Australia. Early intervention, retention of excellent advisers, forward and quick thinking, and decision making will often make the difference. Similarly, even where insolvency is unavoidable, there are now many instances where recapitalisations and restructurings are occurring at a debt and equity level, utilising transaction structures that are commonly accepted in solvent transactions. Hedge and other funds are significant players in this space, and as they have become more comfortable with the legal and commercial market here, are creating genuine alternative funding options, without the ‘vulture’ tag.
Belyea: You need to act early and engage specialist capital houses and turnaround experts to negotiate with financial counterparties, contractors, customers and other interested parties. Many junior miners have complicated balance sheets. These are capable of being restructured in the early stages of the distress cycle by negotiation, control transaction or equity transfer arrangements. At the cashflow level, short term productivity and profitability can be achieved by chasing down costs – purchasing inputs and contracting make up almost half the costs of most operations. These, together with financing costs, are usually capable of being reduced if the negotiations begin before the business comes under financial pressure. Left late in the distress cycle and restructuring options diminish, and generally require equity destructive tools, such as creditor schemes of arrangement or administrations, to compromise the debt burden.
FW: What impact might operational restructuring have on workforces in this sector? Could this process lead to employment and contract disputes, culminating in large scale layoffs across the supply chain?
Deleuil: Operational restructuring is an inevitable – and indeed essential – step to ensure that mining and mining services businesses can survive volatility in the commodities markets. At its most minor, it involves optimisation. At its extreme, it involves substantial restructuring to workforces, termination of mining contractors and putting mines and equipment into care and maintenance pending a price rebound. Inevitably, as prices fall, workforces must either downsize or accept lower conditions, particularly in the iron ore and coal markets. This has follow-on consequences for the mining services industry and also for infrastructure owners. The recent success of Aurizon in resetting its labour conditions within a new market dynamic is a very good example of what can be done when market conditions require change. There have been some union disputes resisting these changes, but the economic forces being imposed inevitably lead to restructuring on agreed terms – even in the most hostile of workplaces. These steps are an essential and predictable part of the economy’s response to price movements and their subsequent impact on cash flow and profitability. In addition, steps are already being taken for the effective automation of many traditional labour intensive roles, like truck driving.
Belyea: A more sophisticated board directs its management team to undertake productivity growth, capital restructuring and consolidation strategies in tandem with cost cutting. A good management team will understand productivity options and investment banks are generally engaged to advise on consolidation and control transactions. What is missing is the willingness of boards and management to early engage specialist advisory houses and professionals with experience in negotiating across distressed conditions to devise and deliver capital restructuring strategies.
Ryan: Where operations need to be closed down or shift rosters changed, we will see workforce reductions. We have seen, and will continue to see, reduced remuneration scales for middle and senior management. What we are seeing is a realignment of supply and demand before a new equilibrium is found, the effect of which will be felt right across the industry and in the mining states of Western Australia and Queensland. Invariably, this will have a knock on effect with regard to property prices and the general economy.
FW: For those companies that do collapse under the weight of existing pressures, what are their options and prospects under Australia’s insolvency processes?
Belyea: Australia has a very robust system that supports the asset being revived in another corporate form. Options include using the moratorium within administration, a scheme of arrangement or the control of a receivership to recapitalise the holding vehicle, or to sell out the asset to a new vehicle and recapitalise the resultant shell, which is a common method. More sophisticated forms of the model require boards to support capital and professional advisory teams in game theory modelling of value enhancing outcomes. Outcomes can even be achieved by deed of company arrangements or negotiation by down streaming debt from parent entities to revenue entities. There are numerous better outcomes achieved by advisory teams engaged by boards before distress events become endemic.
Ryan: A number of restructuring options exist in Australia, the selection of which depend on how critical a company’s financial position is. If approached early, then mechanisms such as Schemes of Arrangement aimed at restructuring the equity position may be utilised. If the creditor position is significant vis-à-vis the value of the underlying assets, then a Deed of Company Arrangement may be more appropriate resulting in a compromise or deferral of creditor claims. In the worst cases, liquidation may be the only option. Generally, Australian creditors and shareholders are relatively sophisticated and will be able to understand the purpose of a restructuring proposal and be supportive if it takes into account the relative priorities of the various stakeholders, is based on reasonable assessments of value and is aimed at putting the underlying business back on a sustainable footing.
Deleuil: Some foreign lenders have begun to appreciate the value that can be extracted from a formal insolvent reorganisation. Such reorganisations include, for example, Deeds of Company Arrangement (DOCA) and Schemes of Arrangement. Under a DOCA, a company and its creditors can reach a formal compromise of all claims against the company, which compromise will result in a better return to those creditors than through a formal winding up. The DOCA is negotiated during a voluntary administration process and it only requires the support of a majority of creditors. A Schemes of Arrangement is a more cumbersome and formal process for reorganising a company, and requires the approval of a Court. However, once effected, a Scheme can be more tailored than a DOCA and can frame a compromise with any particular ‘class of creditors’ and also with equity. Used properly, it is a very effective tool for restructuring a business burdened by debt and onerous contracts.
FW: What is the outlook for the Australian commodity and mining sectors over the year ahead? Does the drop in global demand and prices constitute a blip, or do you believe the boom over for the foreseeable future?
Ryan: We believe that we will see an increase in M&A activity among the junior and mid-tier mining companies, a consolidation in the mining services space and a rationalisation or collapse of a number of businesses that have hung on too long. This current down cycle is particularly harsh given the high base the industry has come off and the speed at which certain commodity prices have fallen recently. However, the industry has an extremely strong foundation in terms of infrastructure, technical expertise, and experienced support professionals within the finance and legal sectors. The underlying demand for its products remains undeniable, so we see renewed growth in this sector for many years ahead, perhaps not at boom rates but certainly heading upwards. Finally, I think there will be certain sectors of the industry that will experience boom-like conditions in the medium term, such as the exploration sector which has been languishing for some time.
Deleuil: A review of the long term forecasts of the large mining houses, the reserve banks and economists alike, all point toward sustained and growing demand for commodities in the longer term. While the price spikes are probably behind us, we strongly believe that there is a rosy future ahead for Australia’s resources industry. This is even true for coal and iron ore, which are notably experiencing historic lows. What is over for the foreseeable future is the level of mining investment that Australia has seen over the past decade. That has implications for the resources industry, as operational optimisation has now become the main focus, instead of greenfield developments and expansions, with the associated race to production.
Belyea: There seems to be no slackening in demand for inputs into mobile electronic devices, nor many manufacturing or processed products. Commodities such as nickel remain in demand; others like iron ore are recovering from pricing lows. Aspects of energy, such as uranium and oil, are steady or rising. Precious metals remain volatile in price, though they do not seem to be dropping any further at present. More abstract commodities such as rare earths may take longer to fully recover. Leveraged balance sheets will need to be cleaned up or debt extended through compromises, forced or negotiated. Companies with the right advisory teams will survive and prosper, much like they did following the 1997 crisis. Those that do not will sell assets, which will be recycled through new business structures. As global demand stabilises and inventories run down, prices will stabilise or increase. In the absence of some massive geopolitical disaster, the next boom is only a cycle away.
Cameron Belyea is a longstanding partner of Clayton Utz and has more than 25 years of experience as a leading lawyer in contested debt and capital restructuring, complex insolvencies, corporate litigation (especially takeovers, contested corporate, shareholder/oppression disputes and contested shareholder and director meetings) and tax controversy disputes. Mr Belyea is engaged on most major ongoing restructures and strategic advisory roles in Western Australia, for the borrower/reference entity, financier, noteholder, other credit originator or major stakeholders across most minerals, commodities, transmission infrastructure, associated transport & logistics and downstream businesses. He can be contacted on +61 8 9426 8510 or by email: firstname.lastname@example.org.
Michael Ryan is a senior managing director in the Corporate Finance/Restructuring practice of FTI Consulting and is based out of Perth, Australia. Mr Ryan has expertise working on a wide range of high profile and complex corporate assignments in Australia and overseas, and has particular expertise in the mining and resources industries. Mr Ryan’s international experience includes appointments as administrator of companies with operations in New Zealand, Chile, Uruguay and Papua New Guinea. He has led negotiations with entities in the US, Canada and Malaysia. He can be contacted on +61 8 9321 8533 or by email: email@example.com.
Beau Deleuil is a partner in the Quinn Emanuel Australia office. Before joining the firm in early 2014, he was a managing partner at King & Wood Mallesons, responsible for leading the firm’s global dispute resolution practice. Mr Deleuil has been the lead lawyer on some of Australia’s largest litigation and insolvency disputes, including acting for Tap Oil and Kufpec in the $1bn Burrup Fertilisers gas contract dispute, and representing CBA and BOSI in defending multiple claims made by the Saraceni group (funded by Bentham IMF). He can be contacted on +61 2 9146 3500 or by email: firstname.lastname@example.org.
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