That Australia is in recession is no longer in dispute. How deep, how long, which sectors will be the hardest hit, which will lead the recovery and what that recovery will look like, are questions being asked by corporates, the financial sector, government and regulators alike.
Decoupling theories which postulated that Australia would be insulated from the GFC have been discredited. Australia faces the reality that it is merely one of a number of corks bobbing on the globalisation sea, albeit one of the lucky corks caught in the slow economic current, and one which is lagging by some six to 12 months the economic tides of the US and Europe.
Australia does have an important distinguishing factor from many of our northern hemisphere friends currently ravaged by the GFC - we have come from 17 years of strong economic growth, while most other countries have had at least one or two significant downturns in this period. While this can be regarded as a sign of the strength of the Australian economy, it does have a number of potentially adverse effects, specifically our capacity to respond to the deepening financial crisis.
Questions we should be asking in this regard include:
* Does Australia have the depth of highly skilled professionals necessary to deal efficiently with a systemic financial crisis? This is a query not infrequently raised by leading bankers.
* Do we have a regulatory system for insolvency which encourages and facilitates restructuring approaches?
* Do we have a culture of responding to financial distress in this country which provides efficient and effective ways of preserving value for distressed companies' stakeholders, including maximising the prospects of restructuring a business?
* Does the culture foster "positional"/ adversarial responses from the different stakeholders in corporate distress or does the culture promote a collaborative problem-solving approach to distress?
Some of these questions are best considered by comparing the responses and experiences of other jurisdictions. On the regulatory front, our insolvent trading laws push Australian directors, by the threat of personal liability, to put financially distressed companies into an insolvency process far too early.
This removes the option of a substantially less value-destructive "informal restructuring" which, in many cases, could have been pursued. Globally, this arcane situation is paralleled only by Germany, and even it has had the good sense to suspend these laws during this historic financial crisis.
We also have a situation where the value destruction of a formal insolvency process is exacerbated by the fact that there is no moratorium on the contractors to the company exercising contractual rights to terminate those contracts (so-called ipso facto clauses) upon the appointment of a voluntary administrator to the distressed company. In the US there is such a moratorium for companies in Chapter 11.
Without transgressing into the minefield of the Chapter 11 versus voluntary administration debate, there is no doubt that improvements could be made to our laws which would have a positive effect on responses to corporate distress - the two examples mentioned above are perhaps the most stark.
In terms of Australia's "culture" of responding to financial distress, it is interesting to reflect upon the experience of the UK over the last 10 to 12 years. In broad terms, it has seen a massive shift towards informal restructurings as the best means to deal with financial distress, and a corresponding move away from formal insolvency appointments.
As an illustration, 12 years ago the leading UK accountancy practices had the vast majority of their staff focused on work arising from formal insolvency appointments, and only a small minority involved in restructurings (to the extent that anyone at that time really understood what restructuring meant.) This changed a number of years ago, with the restructuring teams now far outnumbering the teams focusing on formal appointments.
Australia, I suspect, is embarking on a not too dissimilar transformation and much can be learnt from the UK experiences about how true restructuring is implemented.
A key element that drove the restructuring culture in the UK was the emergence of an active secondary debt market driven principally by US special situations or distressed investment funds. Initially there was great resistance to the emergence of these funds from the London market, including the traditional lenders.
However, today, these funds are recognised as an important part of an efficient market response to financial distress - and a useful and efficient market used by these same traditional lenders when they are seeking to exit a distressed situation.
Similarly, Australia now finds itself the focus of distressed debt funds or special situation funds from Asia and the US which are looking to access opportunities in this under-developed market. Domestic distressed funds are also setting up and our local superannuation funds are looking at such funds as investment opportunities to generate countercyclical returns.
These funds are not the corporate vultures of old, looking to profit from breaking up companies that might otherwise survive. Rather, these are funds that profit from the restructuring or turnaround of a business using their highly specialised skill set combined with significant capital resources. They are sophisticated funds with highly skilled managers who - quite distinct from primary lenders such as banks - look at a distressed situation as a value creation opportunity, rather than as an exercise in loss mitigation.
Ultimately, if the distressed company emerges as a viable enterprise, its once distressed debt will either fetch a considerably higher price on the market, or may be capable of being repaid in full by the company. Most commonly, distressed investors will recapitalise the balance sheet of a company by converting some of the acquired debt to equity - which more closely aligns the outcomes for the distressed investor with the success it achieves in restructuring the business.
The beauty of distressed debt investment, handled correctly, is that everyone benefits - the banks have a new, viable borrower; the management team works with a fresh and experienced partner; new capital is provided to expand the business; suppliers are assured of payment and ongoing business; and many employees will stay on and share in the growth of the company.
It does, however, involve the existing lender(s) selling debt at a discount that realistically reflects its value. It also often involves substantial equity dilution, but the reality of a distressed company is that shareholders would almost certainly be faced with a nil return if the company was allowed to continue down the "death spiral" to a formal insolvency process.
There are clearly questions about how this new type of capital is received by Australia's banks. There has, to date, been considerable reticence from the banks to engage with distressed investors actively to explore selling distressed or non-performing debts at realistic values (much as occurred in the UK over a decade ago). However, capital adequacy standards and provisioning requirements on deposit-taking institutions in relation to distressed or non-performing loans, combined with the resourcing difficulties in managing an unprecedented wave of corporate failure, may change that approach. The impending exodus of many foreign banks from Australian syndicates is also likely to create opportunities.
Australia can seize the chance to learn from the experience and innovations of overseas markets in how best to manage financial distress. It is an opportunity we should grab with both hands if we are to reduce the damage to Australian business resulting from the GFC. Clearly some businesses will not survive, but we must ensure that those that can and should survive are given every opportunity to do so.
- Henry Davis York partner Nick Dunstone
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