Jun 26, 2022

Over the last two years, the corporate sector has faced unprecedented challenges as a result of the COVID-19 pandemic, which resulted in lost income, reduced profits, and a deterioration in the business environment. As such, it is important for business owners to understand the key options available to ensure that their companies stay afloat and grow in the long run. Companies facing significant financial challenges have several options to consider. These include bringing in new capital in the form of debt or equity, as well as going the extra mile and requesting time to restructure their businesses.

We have previously covered a topical on “Business Restructuring Options” in 2020 and concluded that business owners should fully understand the Insolvency Act as it helps in offering struggling businesses a second chance to reorganize themselves and come out stronger and viable businesses, as well as encouraging entrepreneurship by providing a path to redemption in the case of a viable venture that has run into turbulence and just needs room to restructure. In this week’s topical, we shall cover debt restructuring amid the tough economic environment. We shall do this by taking a look into the following;

1. Introduction,
2. The Process of Restructuring Debt,
3. Types of Debt Restructuring,
4. Examples of Debt Restructuring in Kenya,
5. Advantages and Disadvantages of Debt Restructuring, and,
6. Conclusion

Section 1: Introduction

All businesses, be it start-ups or established companies, require funding in order to meet their operating expenses, purchase inventory and acquire machinery among other expenses. To meet these expenses, businesses seek funds through a variety of channels, including i) borrowing from banks or retail and institutional investors, ii) equity - where investors provide funds for a company in exchange for a stake in the company, iii) venture capital, v) personal financing, vi) shareholder capital injection, and vii) reinvesting profits, among others. Debt and equity are the most common methods of raising funds for a business.

In this topical, we shall focus on Debt and Debt restructuring. Debt restructuring is the process by which a business or entity that is experiencing financial difficulties and liquidity distress, renegotiates with lenders and enters into an agreement with the lender with more favorable terms that will save the business from insolvency or severe cash flow issues. For instance, Company A owes Bank X an outstanding debt of Kshs 10.0 mn that is due on 31^st July 2022 but Company A is facing severe liquidity constraints. In this case, the Company may negotiate a one-year extension to July 2023, with installment payments in between.

Debt restructuring is also pursued by countries as well, not just companies. A recent example of this is the G20 Debt Service Suspension Initiative (DSSI) which ran from May 2020 to December 2021 with the G20 countries suspending debt repayments totaling USD 12.9 bn. According to the World Bank, Kenya joined the initiative in January 2021 and saved a total of USD 1.2 bn (Kshs 140.0 bn) in 2021 which significantly helped Kenya reduce its level of debt distress. Additionally, debt restructuring could take place between an individual and a lender as was seen in 2020 in Kenya, when banks restructured loans by extending maturities and interest repayment dates, and, accepting lower loan installment amounts.

Some of the common reasons that have led firms to pursue the debt restructuring process include:

1. Reduction in cash flows – A cash flow shortage happens when more money is flowing out of a business than is flowing into the business which means that, a business might not have enough money to cover its operating expenses. If the outflows are largely debt repayments, then business can consider the option of debt restructuring,
2. Failure or delay in payments by customers – when the rate at which money goes out is faster than the rate at which money comes in, the cash flows of a business especially one that does not have reserves is highly affected. This trickles down to a reduction in cash flows,
3. Management failures – Lack of proper debt servicing plans, poor risk governance and lack of financial planning could lead to excessive borrowing stemming from activities such as over-expansion of the business or high operating costs,
4. High competition – Despite the advantages competitive markets provide, risks abide for firms that are unable to keep up with trends in the market. A company might deteriorate in performance due to stiff competition from new entrants or current sector competitors, and,
5. Tough operating environment – unprecedented occurrences such as the COVID-19 pandemics, significant sectoral changes or huge change in consumer behaviors and patterns occasioned by key macro-economic factors, such as inflation may significantly affect a firm’s cash flows and disrupt its obligations.

Section 2: The Process of Restructuring Debt

The debt restructuring process involves heavy negotiations from both the borrower and the lenders, and as such it is important that both parties are satisfied with the outcome. To achieve this, many firms that pursue debt restructuring call on independent financial analysts and legal experts to guide the process. Debt restructuring can either be done through;

1. Voluntary negotiations between the parties – Refers to when the borrower and lender enter into negotiations without seeking court processes that may affect the borrower’s status as an ongoing concern, and,
2. Restructuring of the Business through a court process - As highlighted in our Business Restructuring Options topical, Kenyan laws provide alternatives on how a technically insolvent business can be assisted to get back to its feet and be able to service its creditors’ obligations and protect the interests of the other stakeholders. The available options include: (i) Administration, (ii) Company Voluntary arrangements, and, (iii) Liquidation. The process of administration is headed by an Administrator, a certified Insolvency Practitioner, who may be appointed by an administration order of the court, unsecured creditors, or a company or its directors. An administrator of a company is required to perform the administrator’s functions in the interests of the company’s creditors as a whole. The Administrator endeavors to achieve a better outcome for the company’s creditors than liquidation would offer – a process that often involves restructuring the debt obligations of the firm.

It is important to understand the main considerations before pursuing a debt restructuring proposal. Some of the considerations include:

1. Type of Debt – Funds may be raised by businesses either from financial institutions such as banks, or from individual and institutional investors through products such as commercial papers and corporate bonds,
2. Terms of Debt – The terms of debt are critical in any restructuring process as they will be the main components that will be affected when the restructuring process commences. These terms include the type of interest payable –whether fixed or floating, the interest rate, the repayment structure including frequency of installments and the tenor of the debt,
3. Affected Personnel – Some debt restructuring processes are coupled with organizational restructuring with the aim of reducing operational costs, including staff costs. In such instances, it is important to outline all affected processes and personnel beforehand and ensure all parties are sufficiently engaged during the restructuring process,
4. Restructuring costs – The restructuring process involves hiring the services of financial and legal experts which means additional expenses incurred by the borrower. Other costs include; severance packages, acquisition of new production materials, legal costs incurred when selling assets and payments due to regulatory bodies if the restructuring process requires regulatory approvals, and,
5. Source of new financing – In order to save a firm from insolvency and increase its debt repaying capabilities, additional capital is often required. This calls for fundraising activities from the borrower engaging prospective business partners.

Below we highlight the key steps in a typical corporate Debt Restructuring Process:

Steps	Action	More Details
Step I	Identify the sources of the liquidity challenges	The borrower is involved in identifying the key factors affecting the firm’s liquidity be it liquidity pulls or drags in liquidity.
Step II	Draft proposed solutions on how to resolve liquidity challenges clearly outlining what is required from the lenders and how both parties will be affected	It is important to prepare a detailed proposal that clearly states what type of restructuring is required, includes proper due diligence, and what specific actions are required from the lender. Secondly, the path to sufficient liquidity and money has to be clearly thought and detailed with case scenarios. Lastly, it is advisable to seek the services of an external independent Analyst, Firm or Insolvency practitioner, to aid in preparing the proposal. External experts often bring on board their experience and different views as well as solutions to the existing problem. This process may require signing of a Non-Disclosure Agreement (NDA) due to the sensitive nature of the information that will be discussed.
Step III	Open negotiations with the lender(s)	It is important to note that this step may take a long time before the lenders accept the restructuring proposal and there is no guarantee of success. Additionally, the lender may offer alternative options that may work better than the borrower’s restructuring proposal.
Step IV	Acceptance of Restructuring Terms	Here, the legal representatives from the borrower and lender sides capture the agreed new terms.
Step V	Engage all other parties to be affected by the Restructuring	In some cases, debt restructuring requires organizational and employee restructuring as well and it is important that all affected parties are fully informed and made aware of the Necessity, Details and Processes that will take place during the restructuring period.
Step VI	Implementation of the Restructuring Plan	The implementation requires the borrower doing their utmost to ensure that the path to money and reliable cash flows is attained in an efficient manner. This step may involve; a)      Fundraising activities, b)     Regulatory approvals, and, c)      Organizational restructuring.

The debt restructuring process’ chances of success are high with sufficient commitment and follow-through from the borrower on repayments and an optimal business operating environment.

Section 3: Types of Debt Restructuring  

There are several ways in which a company can restructure its debt. It is important to note that not all companies that use debt restructuring strategies are seriously indebted, the strategies can also be used to gain a competitive advantage and generate more revenue. Debt restructuring can also be used to ensure the presence of a timely and transparent mechanism to assist companies in financial distress as well as reduce the losses incurred by lenders and shareholders as a result of the procedure. While some methods change very little about a company, others may completely transform it, and the best method depends on the company in question and the circumstances in which it finds itself. Some of the ways that a company can restructure its debt include;

1. Debt-to-Equity Swap - A debt to equity swap is a type of financial restructuring in which a debt is exchanged for a predetermined amount of equity in a company. A debt-to-equity swap is frequently used when a company is in financial difficulty and cannot repay its creditors without going bankrupt. The number of shares of stock awarded is determined by the outstanding debt and the value of the stock. A debt to equity swap, allows a company to deal with creditors proactively before creditors take steps to recover debts and, in the case of secured creditors, enforce its security or appoint an external administrator. On the other hand, a debt for equity swap may be a way for a creditor to avoid the costs of initiating debt recovery processes which may not be fully recoverable in most instances and may provide a way to participate in the company's future growth.

In a debt to equity swap, creditors recover their funds through dividends payable by the company to shareholders as well as share price appreciation which is crystallized when the creditors choose to sell their shares,

2. Debt to Assets – This refers to a debt restructuring in which the debtor transfers receivables from third parties, real estate, or other assets to the creditor to fully or partially satisfy a debt. The transfer may result from foreclosure or repossession. The fair value of assets transferred to the creditor in full satisfaction of the debt must at least equal the creditor's recorded investment in receivables or the carrying amount of the debtor's payables.

In a debt to asset conversion process, the creditors recover their funds through sale of the property or asset into which the debt has been restructured into,

3. Recapitalization - This refers to a company altering the proportions of its debt and equity or the composition of its share capital structure in order to reduce its outstanding debt burden, raise new equity, or reflect the risk levels associated with various types of equity. In this type, creditors are required to provide additional funding to the firm in order to support its growth prospects and provide much needed financial respite. This may be an appealing solution where it is believed that the business is fundamentally viable but is temporarily hampered by poor trading conditions and constrained cash flow. Existing equity holders who do not participate in the new round risk end up having their stake diluted,
4. Informal Debt Repayment Agreements - In the process of reducing debt payments or lengthening the debt schedule, a company may be able to have its interest rates reduced so that it can afford to pay its loan instalments, or it may agree to reduce the principal amount so that the debtor can afford its payments. Furthermore, a company may agree to have the debt repaid over a longer period of time, making it easier for the debtor to meet its payment obligations on time. Similarly, if a company cannot afford to repay its loan in full, a lender may allow it to pay in instalments, effectively lengthening the debt schedule, and,
5. Transfer to a New Company – Alternatively, all debt and equity stakeholders can agree on a plan to transfer the borrower's good or performing assets or business to a newly formed company. Financial creditors may accept debt in the new company, equity in the new company or both in exchange for reducing or cancelling their debt claims against the borrower. In the long run, it allows creditors to share in the profits generated by the new company after a restructuring as equity holders are entitled to dividends once there are sufficient distributable reserves or on any subsequent sale.

As companies look at the options of restructuring, it is important that the various stakeholders approach it from a Win-Win mind-set and be open to getting help as they redesign their businesses.

Section 4: Examples of Debt Restructurings in Kenya

As earlier mentioned, the two most common methods of financing a business are debt and equity. This is also reflected in majority of debt restructurings in Kenya – whereby the most prevalent type in the public domain is a debt to equity swap. The table below includes some of the debt restructurings known in Kenya:

No.	Institution / Fund (Borrower)	Lender	Year	Amount of Debt Restructured (Kshs)	Type of restructuring and more details
1	TPS Eastern Africa Plc (Serena Hotel)	Aga Khan Fund for Economic Development (AKFED)	2022	Kshs 1.7bn	Debt to Equity (100% conversion)   TPS Eastern Africa wants to convert Kshs 1.7 bn it owes Aga Khan Fund for Economic Development (AKFED) to a 19.4% stake. If approved, the Aga Khan Fund's ownership in TPS Eastern Africa will increase to 64.4% from 45.0%
2	National Bank of Kenya	KCB Bank	2021	3.5 bn	Debt to equity (100% conversion)   KCB Group acquired 100% stake in National Bank of Kenya in 2019
3	Two Rivers Lifestyle Centre (TRLC)	Undisclosed	2021	4.5 bn	Debt to equity (100% conversion)
4	Real People	Noteholders of a corporate bond issued by the firm	2021	1.3 bn	70% waived; Remaining 30% to be paid over 4 years
5	Amana Shilling Fund	Unit holders in the Fund	2020	0.3 bn	Debt to equity conversion (into 30% stake in Amana Capital)
6	Housing Finance (HF) Group	Crescent Finco LLP	2019	1.6 bn	Debt to assets (land and housing units) plus 12% return
7	TransCentury Limited	Kuramo Capital	2017	2.3 bn	Debt to equity (100% conversion into 25.0% stake in TransCentury Ltd)
8	Kenya Airways	The Government and several Banks	2017	59.0 bn	Debt to equity 100% of the debt was converted

Source: Annual Reports, Public Cautionary Statements, Company Press Releases, Online Research

We have included the highlights from the eight debt restructuring examples below:

1. TPS Eastern Africa Plc (Serena Hotel) - In June 2022, TPS Eastern Africa Plc (Serena Hotel) and Aga Khan Fund for Economic Development (AKFED) agreed to convert the Kshs 1.7 bn debt owed to the later into equity. The transaction, if approved by regulators, will increase AKFED’s direct shareholding in TPS Eastern Africa to 64.4% from the current 45.0%,
2. KCB Bank Debt to National Bank of Kenya (NBK) - National Bank converted the subordinated debt it owes KCB, of Kshs 3.5 bn, to equity in December 2021. This increased KCB’s equity in National Bank of Kenya to Kshs 8.5 bn in 2021 from Kshs 5.0 bn in 2019 when it completed it’s 100% acquisition of NBK,
3. Two Rivers Lifestyle Centre (TRLC) - The total debt amount was Kshs 10.9 bn out of which Kshs 4.5 bn was converted to zero-interest equity-linked instrument in December 2021. Key to note Two Rivers Lifestyle Centre is partially owned by Centum Investment Company which has an effective stake of 29.0% in Two Rivers. TRLC is owned by Two Rivers Development Limited (TRDL) and Old Mutual Properties, who both own 50%. Further, Two Rivers Development Limited ownership structure is as follows; i) Centum – 58.0%, ii) AVIC International – 39.0%, and, iii) Kenya Development Corporation (KDC) – 3.0%,
4. Real People - Total restructured debt was Kshs 1.3 bn unsecured notes out of the total Kshs 5.0 bn Medium Term Note. In December 2021, the Kshs 1.3 bn was restructured as follows: 70% of the principal amount was waived, while the remaining 30% was to be paid in three instalments February 2023, February 2024 and February 2025.
5. Amana Shilling Fund - Amana Capital through its regulated fund, Amana Shilling Fund (ASF) impaired Kshs 255.0 mn (about 59.0% of the total unit share value of Kshs 434.0 mn), following the collapse of the retail giant, Nakumatt after which the retailer defaulted on its Commercial Paper – eventually being into put under voluntary administration. The investors’ funds were converted into shares at the Amana Capital Ltd (ACL), with a cumulative stake of 30.0%. Each investor’s fund will be slashed by 59.0%.  The 30.0% equity shares were issued proportionally to individual holdings of funds lost in the Amana UTS Shilling Fund Class B. For a detailed analysis of the Amana Shilling Fund restructuring, please our Cytonn Monthly February 2020 and Cytonn Monthly August 2020,
6. Housing Finance (HF) Group – As per its 2019 annual report, HF Group owed Kshs 1.6 bn in Crescent Finco LLP which was transferred to a joint investment fund that primarily invests in property (Kshs 2.4 bn fund; with Kshs 1.8 bn in housing units, Kshs 0.6 bn in land and Kshs 0.06 bn in cash). The arrangement amounted to a debt to assets conversion of the Kshs 1.6 bn owed to Crescent Finco LLP. In the arrangement, the creditor, Crescent Finco, would be paid all its investments through cash conversion plus a 12.0% return over an undisclosed time period
7. TransCentury Limited - TransCentury entered into a convertible loan arrangement with Kuramo Capital, a private equity fund, wherein Kuramo Capital lent TransCentury USD 20.0 mn (Kshs 2.3 bn). In April 2017, the loan was converted to equity – Kuramo Capital gained 25.0% in TransCentury consisting of 93.8 mn shares worth USD 13.0 mn (Kshs 1.5 bn) and preference shares worth USD 7.0 mn (Kshs 0.8 bn). The preference shares are redeemable after 7 years at 4.9% coupon and 1.75x the par value, and,
8. Kenya Airways Plc - Kenya Airways restructured Kshs 59.0 bn debt owed to the Government and several banks. The debt was converted to equity – shares in the company and some key elements of the transaction include:
   1. Kshs 24.0 bn was owed to the government – after the debt-to-equity conversion, government’s shareholding in Kenya Airways increased to 48.9% from 29.8%;
   2. Kshs 35.0 bn owed to several banks – a consortium with the banks’ representatives was formed and jointly saw them receive a 35.7% stake in Kenya Airways in lieu of the debt.

It is important to note that in the case of Real People, Noteholders who were the lenders to the firm, accepted to waive 70.0% of their debt highlighting that during the debt restructuring process, the lenders may in some instances take a haircut which is necessary in order to help the borrower repay fully the remaining debt. However, on the other hand, the majority of the debt to equity conversions have been fairly successful. Debt to equity swaps are often an equivalent of a long term investment wherein the creditors believe in the company’s recovery and future good financial performance.

Section 5: Advantages and Disadvantages of Debt Restructuring

In order to make an informed decision with regards to corporate debt restructuring, it is also important for firms to understand the advantages and disadvantages that come along with debt restructuring. Some of the advantages and disadvantages of debt restructuring include:

Advantages

1. Low Interest Rates – Existing loans may be at a higher interest rate and high interest rates are likely to put a strain on the repayment schedule of a debtor especially during times of economic distress. As such, one of the key consideration when restructuring debt is usually lower interest rates. In an informal debt repayment agreement, the creditor and debtor have the option of initially lowering interest rates until the debtor is back on their feet, after which they can use whatever interest rate they deem appropriate. The benefit of a lower interest rate is that it has a cascading effect in that you pay less than before, which means you have more money to run your business and make it grow and consequently pay out the existing debts,
2. Business Sustainability - The COVID-19 economic shocks have had a negative impact on business cash flows, with many businesses going into debt to stay afloat. If the current economic climate persists for an extended period of time, several businesses may fail due to a lack of funds to operate effectively and efficiently. As a result of the debt overhangs, firms have been forced to settle for more favourable terms in loan repayment plans, making room for finance planning to ensure that the businesses remain afloat,
3. Greater Satisfaction of the creditor as opposed to Bankruptcy – As opposed to bankruptcy, the creditor involved in debt restructuring are assured of getting their principal back or at least something equivalent to the debt. In most cases, creditors lower the interest  rates or prolong the repayment period but eventually get compensated,
4. Supervision by the administrator over the process of restructuring – The administrator ensures that the company meets its obligations and identifies effective recovery strategies. In the event that the company does not perform its obligations, the administrator has the right to declare the company’s bankruptcy, and,
5. Protection of Company Assets which would otherwise have been pursued by the creditors. With debt restructuring, such an eventuality is unlikely to happen. With minimum payments and lower interest rates, a business is in a better position to repay debts, thus protecting the business assets. If you take up debt restructuring fast enough, creditors are unable to proceed with the execution of the liability, as legal proceedings are suspended and then terminated.

Disadvantages

1. Prolonged Repayment Period – Despite the flexibility that comes along with an extended repayment period, duration risks are bound to increase and consequently the chances of incurring higher costs. The longer the repayment period, the higher the interest paid. Additionally, it will take a company much longer to become debt free and also limit the choices of who the company can borrow from,
2. Cost of Restructuring - The greatest cost of corporate debt restructuring is the time, effort, and money spent negotiating the terms with all the required stakeholders including creditors and the authorities. The process can take several months and entail multiple meetings,
3. Partial Waiver of the debt – Depending on a company’s capability and financial prospects, occasionally creditors may be required to waive part of the debt amount in the process of restructuring. This may lead to loss of investment sums from the creditor sums of varying proportions,
4. Negative effects on the Company’s credit score – Debt restructuring being one of the best ways to help a business remain afloat, could have a negative effect on a company’s credit score driven by the modification of the original repayment agreement. However, the extent of the negativity will largely depend on several factors such as the size of the debt, the current conditions, reporting practices of the creditor as well as how much of the principal is already paid, and,
5. In case the restructuring plan is not approved, the company is declared bankrupt – Debt restructuring lacks guarantee and the company may continue to suffer financially even after restructuring. A court order could be used to replace a group's disapproval of the restructuring plan and declare the company bankrupt. Once this happens, the business’ assets will be sold off and the liquidation proceeds used to pay creditors

Key to note, during the restructuring process, a company operates in the same manner as before the restructuring. However, some actions require the approval of the restructuring administrator, who oversees the debtor's actions during the restructuring, and he/she is required to act with professional care so that the value of the debtor's assets does not fall and that the restructuring process is completed successfully. As a result, it is important that businesses understand the benefits of debt restructuring and leverage on the advantages, in the current economic environment.

Section 6: Conclusion

Credit risk has remained elevated in the present economic environment, and banks have kept access to credit tight even as firms need more financing, driving more businesses into financial difficulties. As such, we are of the view that business owners and companies should look for the ideal balance and trade-off depending on the specific circumstances of their business. Additionally, businesses need also be aware of all that debt restructuring entails, in order to select the best solutions in light of their objectives. For instance, entering into administration to halt or cancel a compulsory liquidation order should be data driven and done cautiously, as a company with little to no projected profitable future in its market sector may be better off liquidated and subsequently shut down instead. As businesses gradually recover, we expect the government to come up with ways of supporting enterprises as its role is to ensure that they provide the requisite operational environment for businesses and individuals to thrive. Some of our recommendations include:

1. Creating an enabling environment for restructuring - The legal and regulatory environment can both encourage and discourage restructuring. To encourage restructuring, special debt restructuring frameworks can include incentives for debtors and creditors. The government can ensure presence of a functional debt enforcement regime, which forces debtors to negotiate and come up with taxation rules that do not penalize debt restructurings and debt reductions for debtors and creditors. This will also reduce the costs associated with administration as companies would consider out of court settlements, and,
2. Support for SME restructuring - The government can also consider implementing support programs including legal, business, and financial advice in the development of restructuring plans for businesses, as well as financial support for the restructuring.

Disclaimer: The views expressed in this publication are those of the writers where particulars are not warranted. This publication, which is in compliance with Section 2 of the Capital Markets Authority Act Cap 485A, is meant for general information only and is not a warranty, representation, advice or solicitation of any nature. Readers are advised in all circumstances to seek the advice of a registered investment advisor.