Western-style debt restructurings are a relatively new phenomenon in the People's Republic of China (PRC). Prior to 1998, given the unique business and financing practices in the PRC, few, if any PRC entities were ever officially in financial difficulty. While there had been efforts to restructure certain debt ridden State-Owned Enterprises in the past, such offerings were largely different from what would be considered restructurings in the west and generally did not address the entities' fundamental financial and operational problems. This all changed in December 1998 when the Guangdong Provincial Government announced that its flagship international trust and investment corporation - Guangdong International Trust and Investment Corporation (GITIC)- was broke, and placed it into liquidation proceedings.
This announcement came as a surprise to GITIC 's lenders, as large-scale liquidations were unprecedented in the PRC. Initially, GITIC's foreign lenders took comfort in the knowledge that their debts were seemingly backed by the Guangdong Provincial Government, whose agencies had issued comfort letters pledging to support GITIC. The real shock came when GITIC's foreign lenders were told in no uncertain terms that their comfort letters were not legally enforceable, and therefore not worth the paper they were printed on. This changed everything. Instead of what they thought they had - quasi-sovereign debt - bankers were now simply unsecured creditors in a company being liquidated under a system they did not understand! The foreign lending community was mortified and quickly retaliated by shutting off the flow of funds to China's other trust and investment corporations and the window companies of municipal governments. Since these entities largely funded themselves with new loans that repaid old, they soon ran out of cash; their access to fresh outside capital had ended.
China's leaders decided to take measures to restore foreign lenders' confidence. When foreign lenders complained that liquidation wasn't the answer for China's ailing firms, the Guangdong Provincial Government listened, and wasted no time in announcing that its largest window company, Guangdong Enterprises (GDE), was also broke, but would embark on a restructuring process that would adhere to internationally recognized workout standards. Thus, a wave of PRC debt restructurings began that continues to this day.
Today's PRC debt restructurings follow both tried and true western models as well as new models that have emerged based on the GDE and other large PRC restructurings. Debt restructuring in the PRC certainly has its unique characteristics - from government involvement and red tape to a less-than-apparent approval process - but they seem to work, offering stakeholders significantly better deals than what could be obtained in a liquidation scenario.
Characteristics of a PRC company headed for a restructuring
PRC companies headed for restructuring all seem to have similar attributes. They are generally large and State-owned, with numerous subsidiary companies. They can have hundreds of banks and financial creditors. They are generally cash flow negative operationally, and have continual strained relations with both their foreign and domestic lenders.
Despite management's best efforts, they are often unable to keep most of their promises for repayment. Their efforts to raise new capital have fallen short, and they are usually kept alive with government support. Many of their trade creditors only ship on a COD basis and others are threatening to issue writs. Their foreign bankers are out of patience and some are considering issuing statutory demands for repayment. PRC domestic bankers are usually far more patient than foreign bankers but this is changing.
The PRC troubled company's time is definitely running out. Several of its bankers have demanded updates on the present financial position and they are not satisfied with the information provided to them. Its western bankers demand more transparency, and ask that as a condition of continued forbearance, management consents to having an independent party come in to assess and report on the company's current and prospective financial position as well as the underlying viability of its operations.
This is where the stalling begins, as PRC companies are generally loath to let anyone have a good look at their books and resist this request as long as they can. But after months of meetings and haggling with bankers and government officials, the company will see that it has no choice and will give in and retain an independent financial advisor to make this assessment via a business review report. The company's advisor arranges for a meeting of all of the company's lenders, commonly known as an All Banks meeting even though some of its lenders may not be banks, to inform lenders of their appointment as advisor and to suggest a way forward.
The PRC troubled company is now officially in a debt restructuring, also commonly referred to as a workout. For the next several months or even years, all involved will spend even more of their time in efforts aimed at resolving the situation.
The first All Banks meeting
The main goal of the first meeting of the company's banks and other possible financial creditors will be to convince than to standstill and otherwise not take any aggressive action against the company pending the findings and recommendations of the business review report.
The company's foreign financial creditors will normally agree with this request to standstill, either informally or in writing. Why? Because they will know instinctively that if it has come to this - an All Banks meeting - then the company's situation is serious, and rather than taking any rash actions which could force their fellow creditors to follow suit, it probably makes more sense for them to first obtain a better understanding of the company's present circumstances and any suggested solutions, and then decide what to do. The company's domestic financial creditors will also normally standstill, usually at the behest of local government officials.
In addition to getting some much needed breathing space from its creditors, the first company's All Banks meeting is very important for another reason. It will be at this meeting that many of the company's lenders will form a view on management. Management may not see many familiar faces at this meeting, as many of the company's lenders will have re-assigned their account to a debt recovery specialist within their bank or institution. These hard-nosed bankers may be unfamiliar with management and the company, and will be watching very carefully to assess management's ability to be truthful about the extent of the company's problems, and their stated level of co-operation.
This can be a tough meeting, and management and government representatives will be expected to provide thoughtful and candid answers to the difficult questions that lenders will ask:
- Why is the company in this position?
- Where has all the money gone?
- Is the government going to put in any new money? If not, why not?
These and other questions must be answered carefully, for no matter what the business review report ultimately says, if the company's lenders do not have faith and trust in management and the government that supports them, they are not likely to support the company s restructuring efforts.
The business review report: the good, the bad and the ugly
The business review report is all important as it sets the stage for the rest of the restructuring. It is the aim of the business review report to provide answers to the following types of questions that the company's lenders will want answered:
- Is the company solvent?
- What are its assets? How much are they worth? To what extent are they pledged?
- What is the extent of the company's debt?
- Are the company's operations viable? If not, what is the best means to extract value from the company's underlying assets?
- What resources does the company have to repay existing indebtedness?
- Are these resources sufficient to repay all existing indebtedness? If not, are they sufficient to service interest?
- What are the company's short/long term cash flow forecasts? Are they based on reasonable assumptions?
- What is the company's current cash position? Are there sufficient funds on hand to keep the company' s operations afloat? To pay interest? If not, how much money does it require in the short/long term?
The answers to these questions are important as they help indicate the overall financial health of the company and its ability to repay indebtedness from existing resources. If the report indicates significant financial problems but a viable underlying business or businesses able to generate cash flows to service debt, there will normally be a basis for a restructuring. However, if the underlying businesses are not deemed to be viable, as is often the case with PRC companies, then government involvement becomes all the more important to ensure that a restructuring is possible.
What is contained in a business review report?
The following information is normally produced in a business review report which, depending on the size and complexity of the company, can take anywhere from several weeks to between two and three months to complete. The following is completed for each material operating company within the group as well as a consolidated version at the group level:
- Due diligence style financial review of up-to-date balance sheet and profit and loss accounts (under international accounting standards as opposed to PRC accounting standards) to comprise the following:
- Narrative description and commentary of all main balance sheet items as of the most recent date as possible and an assessment of estimated realizable values for assets
- Details of all financial creditors such as terms and security
- Details on the group shareholding structure and any intra-group balances
- Details of all contingent liabilities (including bank guarantees)
- Overview of recent profit and loss accounts
- Monthly cash flow forecasts for the next 12 months (and potentially up to the next three to five years) including commentary on the underlying assumptions and sensitivity analyses
- Commentary on:
- The nature and viability of business operations
- Key markets served
- Competitive position within these key markets
- Current status of suppliers and customers
- Group-wide liquidation analysis broadly indicating what unsecured creditors would likely receive if the group were liquidated as opposed to restructured
- Recommendations on a way forward
Note: Audits are not normally conducted at the early stages of a restructuring as audited accounts do not necessarily provide the narrative descriptions of the businesses and balance sheet items that the company's financial creditors require to make informed decisions. Audited accounts may be completed in due course to verify management accounts.
Before the business review report is issued to the company's lenders, it is first presented to company management in draft form for their review, comments and confirmation that the numbers and other information are correct to the best of their knowledge. Once management signs-off on the report, the company's financial advisor will present the report to the company's lenders at a second All Banks meeting.
The second All Banks meeting can be a trying time for management and government representatives, as no matter what portrait of their company is painted, their bankers will often be unhappy. Why? Because the report will undoubtedly reveal problems that the company's bankers were not previously aware of, and no matter what the problems are--poor projected cash flows, long term assets financed by short term debt or poor investment using borrowed funds - the problems may very well be worse than what the bankers were expecting.
So the bad news is out. The company has done what its bankers have requested, and through the business review report, has revealed all about the company's finances and operations. Management has been transparent but what will the company's bankers do now? Normally, they won t do anything as rash as seeking to liquidate the company. Instead, they will take out their frustration on their predicament by asking management the following types of questions:
- Why didn't you tell us earlier that you had these problems?
- How could you let this happen?
- What are you going to do about it?
Hearing the company's bankers complain like this will certainly be a low point in the restructuring process for management. They will feel angry because they have done what was asked of them and now their bankers are not being particularly helpful. But management needs their bankers' help and co-operation, and by far the best way to get through this time is for management to just accept the criticisms and then convince the lenders to go along with the plans to reinvigorate the company.
But what if those plans require additional funds? What if the company has run completely out of cash to the point that management can't run the business and pay employees? What if management needs just a few million dollars to see the company through the next few months? Getting new money out of the company's bankers at this critical time is not easy.
The decision will be dependent on many factors including their assessment of the viability of the underlying businesses of the company, likely to be based on the business review report and on their faith in senior management. But the company's management be forewarned: its bankers will rarely consider any new funding requests, even if it means the company may go out of business, if the majority shareholder (usually the government) is not willing to contribute the vast majority of the new funds itself. If the company's bankers are looking favourably towards lending new money, management should expect those loans to be fully secured by tangible property.
What happens next?
No matter what the business review report reveals about the company's troubles - mild, significant or severe - its bankers should eventually calm down and accept reality. They will understand that if there is a basis for a restructuring, it makes sense for them to at least listen to the company's restructuring proposals.
Management is now at the beginning of the end of the restructuring process. The current and prospective financial condition of the company is known. They have secured short term financing requirements (usually from the government). Now, in order to ensure the company's survival, they will have to propose a restructuring plan that will satisfy the company's lenders. The search for a solution is on.
It is at this time that management, in conjunction with the company's financial advisor and the government shareholder, should re-assess corporate strategy in light of the expected future performance of its existing businesses and assets. Among other things, this corporate strategy must address the company's need to restructure the organization, turning one that is under-performing into one that is:
a) Commercially viable
- Financially independent
Once this strategy is confirmed, a new corporate structure and business mix must be developed to address the new corporate strategy. This new structure should consider, among other things, whether:
- Operations should be streamlined
- New assets/equity/shareholders are required to support the strategy
- Non-core businesses and assets should be disposed of
- Under-performing businesses should be rehabilitated or closed
Once a new corporate structure has been devised based on the new or modified company strategy, cash flow projections should be prepared to demonstrate the consolidated company's ability to generate cash in the future.
The company's projected cash flows from its new, restructured entities will form the basis for any restructuring proposals regarding its existing debts. If the projected cash flows appear to be sufficient to repay all outstanding indebtedness over time - from operating sources or from asset sales - then the company's existing debts will most likely be re-scheduled accordingly. This is called a Self Rescue, the company has traded or managed itself out of its difficulties. Its lenders will normally be happy to accept such a scenario, as it sees loans being repaid in full, albeit over a longer period than originally anticipated.
If the company's projected cash flows are insufficient to repay all existing indebtedness in full, then management will have little choice but to consider presenting restructuring proposals that the company's lenders may not like: proposals calling for them to accept something less than full repayment; that is, asking them to accept a haircut.
While the company's bankers may not like such proposals at first, they will eventually recognize that such proposals are inevitable, as the underlying company or group of companies simply do not have the ability to repay their indebtedness in full from existing assets, and the alternatives available to them as lenders - such as liquidation - will produce an even lower return.
Role of the financial advisor
The role of the financial advisor during this difficult period is to help management find a way out of their problems and deal with the company's lenders. Typical financial advisory services in relation to the restructuring of a PRC company include:
- Leading the restructuring process on behalf of management and the government and coordinating the work of all other professionals involved
- Advising on the appropriate form and structure of the company's restructuring plan with the aim of negotiating continued support and agreement from lenders
- Acting as the interface between the company and the lenders
- Finding, and negotiating on the company's behalf with, potential new investors and potential buyers of group assets or businesses
- Assisting in raising new capital
- Advising the board, along with the company's legal advisors, on any regulatory requirements
- Advising on any announcements to be made in relation to the company's current and future financial position
What will become quite evident from the business review report and subsequent strategic review will be the extent to which the company has the ability to repay its indebtedness from its existing resources. If the company's ability is simply not there, then a Self-Rescue is out of the question. Instead, the company's financial advisor will work with management to develop debt restructuring proposals far removed from traditional western style debt restructuring plans featuring, for example, White Knights, debt-for-equity swaps, and zero coupon notes.
Why are PRC restructuring proposals so different from those developed in the rest of the world? Because most PRC entities undergoing a restructuring process are State-owned, with few assets that are capable of generating significant cash flows. Therefore, in order to restructure and repay some or all of its creditors, a PRC company requires government financial support.
PRC Debt Restructuring plans
PRC debt restructuring plans are usually comprised of (i) government injections of assets into the company, (ii) asset sales, and/or (iii) one-off cash payments (with funding from the government).
A common component of PRC debt restructuring plans is a government injection of assets into the troubled company. Asset injections take many forms, ranging from cash flow generating businesses such as the Guangdong Provincial Government's injection of the company that supplies Hong Kong with the majority of its water in the GDE restructuring, to developed and undeveloped property, to cash. Asset injections are used primarily when the company's underlying businesses are low cash flow producers and do not produce sufficient cash to repay creditors.
The extent to which asset injections coupled with the company's existing assets are capable of producing the necessary cash flows to repay all of a company's indebtedness varies from company to company, and lenders should not always expect that they will be sufficient to enable them to receive full repayment over time.
Virtually all PRC enterprises undergoing a restructuring process have surplus assets that are not fundamental to the operations of the business. One of the most common reasons why they are having to restructure is because they borrowed short-term funds to purchase such assets. These surplus assets usually include interests in:
- Property (such as hotels and office buildings)
- Property development projects
- Start-up businesses
- Other businesses unrelated to the company's core operations
While many of these assets will be minority shareholdings, many will be fully owned, and if not property related, they will usually be unencumbered. Many PRC restructuring plans will see at least one component being the sale of such surplus assets.
Many lenders to PRC entities do not prefer restructuring plans calling for payments over time. They do not like the uncertainty involved and instead prefer to have a quick exit via a one-time discounted payment in full and final satisfaction of their claim. Such a payment will normally require government funding. Some PRC restructuring plans will offer lenders the choice of either a long-term plan or a one-off plan. The key to lenders' decisions as to which plan to accept depends on many factors including provisioning policies and the amount of discount offered or required.
Restructurings in the PRC can be time consuming and complex. From their beginnings over two years ago to today, much has been learned and much continues to be learned about the unique requirements of a successful restructuring.
Note: This article was first published in a book called "Structuring for Success"
¬ PriceWaterhouseCoopers 2001