Investors Should Embrace Undervalued Opportunities in Reviving Insolvent Companies
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Investors Should Embrace Undervalued Opportunities in Reviving Insolvent Companies
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by Isaac Kwaku Fokuo Jr., Founder and Principal, Botho Emerging Markets Group, and Bathsheba Asati, Research Associate, Botho Emerging Markets Group
January 13, 2020
By refinancing or purchasing distressed firms, investors in Africa can unlock new opportunities in an underserved market for distressed assets and generate substantive ripple effects for local economies.
Insolvency confronts leading firms in emerging and developed markets alike. In the U.S., for example, an unprecedented number of over 400 firms with asset values upwards of $100 million filed for bankruptcy between 1999 and 2002 — and that was before the 2008 global financial crisis. Today, India’s Jet Airways, Kenya’s Nakumatt, and South Africa’s Eskom: household names from India down to South Africa are now among a growing number of emerging market companies that find themselves in financial turmoil. While distressed companies in countries like the United States can turn to capital markets and distressed debt funds for refinancing, their counterparts in emerging markets, particularly in Africa, often struggle for revival due to inadequate access to funding and immature local business support to guide restructuring efforts. By refinancing or purchasing distressed firms, investors in Africa can unlock new opportunities in an underserved market for distressed assets and generate substantive ripple effects for local economies.
Investing in insolvent firms in Africa can not only yield profits, but it can help stabilize local economies. Large-scale job loss and supply chain disruptions are just two phenomena that often accompany insolvencies, and the damage often has domino effects: studies show that 1 in every 6 insolvencies is the result of an associated company going into insolvency. These associated companies are typically suppliers and other major service providers. In emerging markets, the liquidation of a leading firm can often end up leaving lasting effects on the economy. In South Africa, for example, Eskom’s inability to meet the nation’s electricity demand due to mounting debt generated caused losses of about $140 million per day, to the economy. What is even more worrying is that, though there has been a wave of insolvency law reform across many markets such as Bahrain, Kenya, UAE, and Ghana, the investments in insolvent businesses have been slow to keep pace.
Distressed debt is an investment thesis more common in the West than in most emerging markets because of the cultural perceptions of failure and risk. In China, for example, business executives often view insolvency as a failure and a huge embarrassment, an attitude which adds to their reticence to bring in external advisors at times of trouble. In contrast, American executives simply view financial distress as part of the normal risk of entrepreneurial investment. American and other like-minded entrepreneurs may be more likely to seek professional support and explore business restructuring solutions much earlier in turbulent times, which significantly increases the possibility of reviving a financially distressed company.
Betting on investments in firms whose value has been underestimated as a result of insolvency has been a lucrative strategy for distressed asset investors in developed markets. African investors should follow suit and study the many cases - well-known companies from Apple to GM, and Delta that have recovered from the brink of insolvency and now operate competitively on the global stage. In 1997, for example, Microsoft invested $150 million in Apple, which, at the time, was in the midst of bankruptcy proceedings. Microsoft eventually sold its stake in Apple by 2003. Apple is now one of the world’s most valuable brands with a valuation of $206 billion.
One of the reasons behind the inactive market for distressed firms in emerging markets is that many investors and lenders have not fully understood how to optimize deals with distressed firms. How, then can one capitalize on this opportunity to generate enviable returns? There are many ways to benefit from investing in a distressed firm. For companies operating in the same sector, acquiring a financially distressed competitor is one way to increase market share, or, in some cases, mediate antitrust claims - as was the case with Microsoft. Alternatively, a firm can acquire the distressed company’s assets to support expansion plans at a significantly lower cost. Seasoned investors can also purchase these companies at a discount and deploy the requisite technical and financial needs to rebuild the company, selling it off later at a profit.
For lenders, offering debt financing to an insolvent company can offer a stronger bargaining position over other claims due to debtor-in-possession financing terms, which typically give higher priority to newer loans. In some instances, new lenders may be able to negotiate for faster repayment and even higher interest rates. Even more appealing is the fact that the distressed firm, after imposing a moratorium on existing debt at the point of declaring insolvency, cannot impose a further moratorium on debt accrued during restructuring. This means that the lender’s ability to enforce repayment cannot be limited by the borrower and the risk of repayment is, therefore, lower. In the US for example, debtor-in-possession financing, embedded in Chapter 11 - the Bankruptcy Code, has been very instrumental in incentivizing lenders to extend credit to financially distressed companies.
Investing or lending to an insolvent firm may initially seem like a very risky venture, but it can offer profitable opportunities. While investors in the Western world have witnessed this phenomenon first hand, in many emerging markets, this mindset shift must begin with a re-casting of the negative perceptions associated with insolvency. One of the savviest ways to approach and evaluate these opportunities would be through professional firms that can provide strategic advice on how to structure the investment, lower transaction costs, and protect asset value to fully optimize the opportunity. If Apple, Delta, and GM were able to successfully weather financial storms, with the right tools and investment, financial distress should be considered a setback rather than a death knell amongst businesses in emerging markets and should not be automatically viewed as a definitive sign that insolvent companies, all-too-often written off, have come to an end.