Perspective
Fadi Majdalani
Marc-Albert Hamalian
Ronald Maalouf
Georges Al Feghali
How to Restructure
Kuwait’s Investment
Companies
Why Facing Financial
Reality Is Critical
Contact Information
Beirut
Fadi Majdalani
Partner
+961-1-985-655
[email protected]
Marc-Albert Hamalian
Principal
+961-1-985-655
[email protected]
Marielle Sarkis, Sabine El Najjar, Nay Abiramia, and Saleh AlSaleh also contributed to this Perspective.
Booz & Company
EXECUTIVE
SUMMARY
After the financial crisis began in 2008, many of Kuwait’s
investment companies and their creditors were in considerable distress. The investment companies’ business model
relied on short-term debt to fund illiquid assets. Once banks
cut off this funding this business model was no longer viable.
Instead of directly confronting these asset–liability mismatches
and unprofitable business models, the investment companies
resisted accepting their losses. The banks, with their own
capital issues, agreed to “extend and pretend” agreements
in which credit lines remained open and losses were not recognized. These agreements staved off bankruptcy for many
zombie companies, but they also hoarded and depleted capital
that could have been invested more productively elsewhere.
The result has been a drag on economic growth.
Many of these debt agreements are
expiring, which provides banks,
regulators, and shareholders with
an opportunity and an obligation to
structure improved debt work-outs. A
new approach is needed to distinguish
between investment companies with
viable long-term businesses and those
that are nonviable. For those with
viable businesses, new restructuring plans must allow them to settle
Booz & Company
debt obligations and reduce leverage.
Nonviable investment companies
should leave the market expeditiously through asset liquidations.
Stakeholders need to confront the
depth of the problems in the investment companies. By doing so they
will free up capital and thereby allow
Kuwait to put the financial crisis
behind it and the financial sector to
play its proper role in the economy.
1
KEY HIGHLIGHTS
• Many of Kuwait’s investment
companies have suffered
enormous losses since the
financial crisis but thanks to extend
and pretend loan agreements with
creditors they continue to exist as
zombie companies—investment
vehicles that tie up or destroy
capital (estimated at around
US$40 billion) that could be
productively deployed elsewhere.
• A legal and regulatory
environment that favors debtors
has helped to keep these zombies
going. Laws recently enacted
to strengthen the financial
sector have actually made debt
restructuring more difficult.
• As loan agreements between
investment companies and
creditors expire, stakeholders
need to resolve the investment
company debt dilemma by
separating viable from nonviable
businesses, restructuring debt
sustainably, and facilitating
managed liquidations and
market exits.
2
EXTEND AND
PRETEND
The financial crisis hit Kuwait’s
investment companies particularly
hard. Their business model depended
on using cheap, short-term debt to
finance operations, the purchase of
illiquid assets and dividend payments
to shareholders. When the global
financial crisis broke in 2008, and the
worldwide recession worsened, the
banks cut off any new short-term, lowcost funding. This squeezed, or froze,
all operations that were expecting,
and that required, continuous funding.
Many investment companies invested
in such assets as non-listed equity and
direct ownership in real estate, which
are tricky to unload at short notice. As
the value of these difficult-to-monetize
assets started to drop, Kuwait’s investment companies struggled to meet
their debt obligations.
The banks were also in a tight
spot. They faced investment companies that could rely on a Kuwaiti
legal system that favors debtors,
which meant investment companies
could refuse to accept the severity of the problem. Unsurprisingly,
the investment companies pushed
to reschedule their debts without
acknowledging or writing down
their losses. At the same time, the
banks were coping with their own
diminished capital positions, making
them similarly reluctant to book
losses. Consequently, many of the
debt work-outs agreed at that time
were extend and pretend arrangements that papered over the problem
without addressing the investment
companies’ insolvency and weak
business model.
Thanks to these arrangements, many
investment companies now continue
as zombies—investment vehicles that
are dead in all but name and that
tie up or destroy capital that could
be productively used elsewhere. For
example, some companies extended
their credit lines to fund their operating expenses rather than to create
value and develop a viable restructuring plan. However, many of the original extend and pretend agreements
are starting to expire, presenting the
banks and regulators with the chance
to fulfill their obligations and push
for a resolution of the investment
company debt problem. They can
force Kuwait’s investment companies
to accept meaningful agreements that
restructure debt sustainably for viable
companies and isolate nonviable
investment companies to facilitate
their managed liquidation and market
exit. Addressing this problem will
not cause too much pain to the banks
because it is of manageable scale.
Most investment companies in need
of debt work-outs are small. At least
individually, they are not a threat to
the banks. Only two investment companies have a debt balance of more
than KWD 500 million ($1.77 billion), a level that would significantly
affect numerous banks.
Booz & Company
BLEAK FINANCE
The ineffectiveness of the current
agreements and the impact of the
pro-debtor environment are clear five
years after the onset of the financial
crisis. The debt obligations among
Kuwait’s 55 publicly listed investment
companies have not been appreciably
reduced. At the end of the third quarter of 2012, investment companies’
total liabilities were equivalent to 63
percent of total assets, compared with
65 percent in 2008 (although in absolute terms total liabilities decreased),
according to consolidated financial
data from the Central Bank of Kuwait
(CBK). Furthermore, only about 55
percent of total debt has been worked
out—and even that figure flatters the
investment companies as most workouts involved postponing the debt
problem and not settling it definitively.
(That 55 percent of total debt is held
by nine companies, five of which are
still listed.) At best, a second round of
work-outs is required.
This means that 45 percent of investment companies’ debt still needs a
first-time work-out. Most investment
companies owing this debt remain
overleveraged, albeit at a misleadingly lower level than companies that
Booz & Company
have already had a first round of debt
work-out. The five listed companies
with ongoing work-out arrangements
have an 80 percent ratio of debt to
assets, compared with 70 percent for
the listed companies without workout arrangements. (One reason the
ratio is lower for those without ongoing work-out arrangements is that
not all listed investment companies
require a work-out.) In either case,
the level of debt is unsustainable.
It poses a problem for the banks,
the most important institutional
creditors, and for the investment
companies’ shareholders, whose accumulated returns on initial equity are
close to just 1 percent.
Another aspect of the worrisome
financial picture is that only 29 of
the 55 listed investment companies in
Kuwait had published half-year financials by November 2012. Of those, 21
reported losses, mainly because they
did not generate enough income to
cover operating expenses and financing costs. In addition, 10 investment
companies offer limited visibility
for investors and creditors into their
financial situation as they have either
not reported financials in one year or
3
HOW EXTEND AND PRETEND WORK-OUTS FAIL
To better understand why the earliest extend and pretend agreements failed,
consider a fictional but typical investment company. This typical Kuwaiti
investment company relied on short-term debt to finance the acquisition
of real estate and minority equity stakes in companies. After 2008, its
bank creditors restricted the typical investment company’s access to new
financing. Given the typical investment company’s limited operating cash
flow, the company soon defaulted on its debt payments. The value of the
typical investment company’s assets continued to decline and its liabilities
soon exceeded the realizable value of those assets. The typical investment
company’s problems derived from more than just weak liquidity; its business
model was fundamentally flawed (see Exhibit 1).
they have been delisted from the stock
exchange. These investment companies are almost certainly in significant
financial distress, although the lack
of transparency makes it difficult to
evaluate with precision.
Further evidence of the depth of the
investment companies’ problems is
revealed by their noncompliance with
CBK regulations announced in 2010.
These regulations came into force in
2012 and cover leverage, liquidity,
and foreign exposure ratios. As of
November 2012, seven companies out
of the 29 listed investment firms that
published half-year financials reported
leverage ratios that were noncompliant with the CBK’s regulations.
4
Debt work-out negotiations between the typical investment company and its
creditors lasted for more than a year, during which time the financial situation
continued to deteriorate. After each round of failed negotiations the typical
investment company’s board replaced the firm’s decision makers to try
and resolve the issue. The final work-out included haircuts (a reduction in
the market value of assets to provide collateral), loan-to-asset and loan-toequity swaps, and rescheduling remaining debt. Unfortunately, the work-out
agreement was not grounded in financial reality. Assets were swapped at
inflated book value, and creditors obtained overvalued equity shares in the
typical investment company. This led to a lower recovery ratio than claimed.
The stated recovery rate of the principal debt was 95 percent, but the actual
ratio was 83 percent (see Exhibit 2).
Instead of resolving the typical investment company’s problems, the workout prolonged its zombie status. The typical investment company does not
have a sustainable equity cushion (the leverage ratio remains at 90 percent),
nor a strong source of cash inflow, and no financial maneuverability to restart
the business. As a result, the typical investment company’s creditors remain
vulnerable to further losses on assets, equity ownership, and rescheduled
debt obligations.
Booz & Company
Exhibit 1
The Financial Distress of a Typical Investment Company
REALIZABLE ASSET VALUE AND LIABILITIES
(IN KWD MILLIONS)
90
5
40
100
Cash
Minority Equity Investments
Real Estate
45
Liabilities
Future Value of Equity
-10
Realizable Asset Value 1
Liabilities and Future
Value of Equity
Realizable asset value = value after applying minority/illiquidity discounts.
Source: Booz & Company
1
Exhibit 2
Proposed Restructuring, and Realizable Asset Values, after Restructuring
TYPICAL INVESTMENT COMPANY DEBT WORK-OUT
Stated Value
(KWD millions)
Haircut
Actual Value
(KWD millions)
5.0
Description
Banks aimed to reduce haircut to avoid adverse market signals and accounting provisions
Loan-to-Asset Swap
15.0
11.0
Assets were mostly swapped at close to book value as the typical investment company was
unable to absorb further losses due to low capitalization
Loan-to-Equity Swap
10.0
1.4
Regulations in Kuwait stipulate that shares can be issued only at par (i.e., 100 Fils or 0.1
KWD). As such, the typical investment company’s debtors obtained 100,000,000 shares;
value of each share is around 14 Fils.
Rescheduling
70.0
70.0
Five years, including two years’ grace period and a reduced finance costs rate. The amount
of rescheduled typical investment company debt had a security ratio of 100%; however, the
typical investment company, lenders, and restructuring advisors were implicitly aware that a
default remained imminent.
Source: Booz & Company
Booz & Company
5
A DEBTORFRIENDLY
ENVIRONMENT
Despite weak fundamentals and poor
performance, investment companies
have successfully resisted change in
part because Kuwait’s legal environment favors debtors over creditors.
Bankruptcy proceedings are often
protracted because the courts are
unwilling to grant bankruptcy orders
without giving debtors an extended
period of time to remedy their
financial problems. This leeway gives
debtors the opportunity to conduct
discretionary bilateral negotiations
and extract more concessions from
their creditors. Moreover, limited
transparency in the market means
that debtors can mislead creditors about the value of assets when
exchanging them. This “information
asymmetry” between debtors and
6
creditors is a serious barrier to longterm debt work-outs.
The Financial Stability Law (FSL)
gives companies even more protections from creditors and less incentive to agree to work-outs, even
though it was introduced in 2009
after the financial crisis began. The
FSL is also vague on key issues,
such as the cram-down mechanism.
This mechanism—which imposes
a restructuring agreement despite
the objection of some creditors—is
essential for a swift restructuring
process because it prevents a minority
of dissenting creditors from blocking
the refinancing. Thus far, the FSL has
been used in only a few restructuring
plans, such as the Investment Dar
and A’ayan Leasing and Investment
Company cases. Even for these the
outcome has yet to be seen.
The creation of the Capital Markets
Authority (CMA) in 2010 has also
failed to accelerate the debt restructuring process. The CMA needed to
ramp up its regulatory capabilities
quickly in the face of complex finan-
cial market transactions. Instead,
the CMA created new uncertainties
affecting debt restructuring, such as
requiring a buyer of more than 30
percent of a listed company to make
a tender offer for the entire company—a rule that could discourage
potential buyers of distressed assets.
The CMA is also stricter on the legal
liabilities of board members, making
board members even more reluctant
to make tough decisions that could
prove wrong.
Along with a legal and regulatory
framework that favors debtors,
the government created programs
designed to help investment companies to the detriment of creditors. For
instance, the government agreed to
settle in full investment companies’
debts to foreign banks. This was done
by shifting the debt to the local banking sector. The government deposited
funds in local banks as a guarantee
to allow them to initiate new loans to
the investment companies. The result
was that debt work-outs were postponed and local banks increased their
exposure to investment companies.
Booz & Company
A NEW CHANCE
TO RESTRUCTURE
Defaults are once again looming after
several years of avoiding the problem.
Banks, regulators, and shareholders
should use the expiry of the extend
and pretend agreements to seek a
comprehensive solution. The timing is
propitious as the banks are now better
capitalized than before, which means
they can absorb the inevitable losses.
Forcing the investment companies to
tackle asset–liability mismatches and
weak business models will push some
of these investment companies into liquidation. Unpleasant though this may
be, it will pave the way for healthier
investment companies to emerge with
sensibly restructured debt and firmly
grounded businesses.
Stakeholders will need to take action
on three fronts for these new agreements to succeed.
1. Separate Viable from Nonviable
Businesses
The CBK and the CMA should
mandate an independent task force to
conduct an honest inventory of assets,
Booz & Company
segregating troubled assets from viable
ones. This task force is necessary
because the first round of restructuring
demonstrated that executives in some
investment companies do not evaluate
their assets accurately. The valuation
and monetization potential of all assets
must then be assessed and compared
with the liabilities and debt maturities.
Following the review of assets, the
task force needs to answer three questions about each company’s finances
to determine its viability.
• Are solvency levels acceptable or
has equity been completely wiped
out?
• Is recurring income from monetization, dividends, or fees adequate to
sustain overhead and repay debt?
• Are funds available to continue operations and fund new
investments?
2. Restructure Debt Sustainably
Investment companies that pass the
viability test have two options for
debt restructuring: out-of-court or
through the mechanism of the FSL.
Out-of-court work-outs: As a first
step, the company should seek a
consensual agreement among all its
creditors. This will often require the
assistance of an independent mediator,
such as the official regulator. Therefore
the regulators, as a legitimate third
party, should actively participate in
out-of-court restructurings. The CBK
should act as a facilitator, driving
the process whenever needed. For
instance, the CBK might push a strong
lender to swap loan exposure into
illiquid but attractive assets (such as
land and dividend-yielding minority
equity ownerships), which allow for
monetization over a longer time frame.
FSL work-outs: If a restructuring
agreement is not reached within an
acceptable time frame of three to six
months, the investment company
should seek regulatory protection
in the form of an FSL work-out.
This will facilitate a court-approved
restructuring and protect the investment company from creditors that
might prefer to take the company
straight into bankruptcy. To encourage such applications, the FSL must
be improved. For example, the FSL
needs an effective cram-down mechanism. The FSL should outline creditors’ approval thresholds and more
clearly define solvency and eligibility
criteria. Additionally, the FSL process
should be shortened. Currently,
bureaucracy and uncertainty about
how to apply the law can delay the
7
CONCLUSION
initial analysis for a restructuring
proposal by up to eight months.
In the case of either an out-of-court
or an FSL work-out, restructuring
plans need sound information, creditors’ alignment, and innovative longterm solutions.
• Sound Information: Investment
companies must provide transparent and accurate information
about their assets to all stakeholders, including regulators. In addition, financial projections should
be realistic and reflect current
market conditions.
• Creditors’ Alignment: The plan
must establish credit committees
with clear rules and processes
(for example, decision-making
mechanisms and frequency of
meetings) so that creditors have a
forum in which to articulate and
resolve conflicts. Such committees
might, for instance, agree to
collateralize all assets at market
values to give all creditors as
much security as possible, thereby
reducing conflict between secured
and non-secured creditors.
8
• Innovative Long-Term Solutions:
Restructuring plans should balance the long-term survival of the
business with its creditors’ ongoing
protection. For example, management can legitimately acquire the
flexibility to meet debt obligations
through loan-to-equity swaps with
several recovery options, grace periods, and debt relief based on agreed
triggers. In addition, covenants can
ensure that creditors have sufficient
control over their claims.
All investment companies’ stakeholders, whether creditors, shareholders,
regulators, or managers, must work
together to seize the opportunity for
realistic debt restructurings. Kuwait
will reap considerable economic
benefits when the almost $40 billion
in capital tied up in the investment
companies is liberated for productive
investment. The three-step restructuring process will identify those investment companies that are worth saving
and those that should be wound up.
Resolving the investment company
debt issue will dissipate the uncertainties about Kuwait’s financial sector as
a whole, demonstrate firmness by the
authorities, and allow for increased
investment in the broader economy.
3. Facilitate Managed Liquidations
and Market Exits
Nonviable investment companies
need to stop hemorrhaging financially.
Their shareholders must acknowledge
that their equity has been wiped out.
Their creditors must accept haircuts.
To assist with this process, regulators
should issue clear rules and guidelines
to force nonviable companies toward
market exits by allowing shareholders
to trigger voluntary liquidations and
regulators to trigger involuntary ones.
Also, regulators should have the power
to replace management with external
liquidators to manage the process of
closing the company and distributing
assets to stakeholders.
Booz & Company
About the Authors
Fadi Majdalani is a partner with
Booz & Company in Beirut and
leader of the firm’s Middle East
investment practice. He has
founded a private equity management company, and has
provided consulting services to
a number of investment companies and multibusiness holding
companies on topics ranging
from strategy, operations, and
organization and change.
Marc-Albert Hamalian is a
principal with Booz & Company
in Beirut, in the firm’s Middle
East investment practice. He
has experience in a broad
range of corporate finance
assignments. He specializes in
strategy-based transformational
change, debt restructuring, due
diligence, portfolio restructuring, and financial modeling.
Booz & Company
Ronald Maalouf is a
senior associate with
Booz & Company in Beirut in
the firm’s financial services
practice. He has experience
in strategy and turnaround
plans for banks, insurance
companies, and investment
companies.
Georges Al Feghali is an associate with Booz & Company
in Beirut, in the firm’s Middle
East investment practice. He
specializes in strategy-based
transformations and portfolio
restructuring for investment
companies, banks, and diversified conglomerates.
9
The most recent
list of our offices
and affiliates, with
addresses and
telephone numbers,
can be found on
our website,
booz.com.
Worldwide Offices
Asia
Beijing
Delhi
Hong Kong
Mumbai
Seoul
Shanghai
Taipei
Tokyo
Australia,
New Zealand &
Southeast Asia
Bangkok
Brisbane
Canberra
Jakarta
Kuala Lumpur
Melbourne
Sydney
Europe
Amsterdam
Berlin
Copenhagen
Düsseldorf
Frankfurt
Helsinki
Istanbul
Booz & Company is a leading global management
consulting firm focused on serving and shaping the senior
agenda of the world’s leading institutions. Our founder,
Edwin Booz, launched the profession when he established
the first management consulting firm in Chicago in 1914.
Today, we operate globally with more than 3,000 people in
58 offices around the world.
We believe passionately that essential advantage lies
within and that a few differentiating capabilities drive any
organization’s identity and success. We work with our
clients to discover and build those capabilities that give
them the right to win their chosen markets.
We are a firm of practical strategists known for our
functional expertise, industry foresight, and “sleeves
rolled up” approach to working with our clients. To
learn more about Booz & Company or to access its
thought leadership, visit booz.com. Our award-winning
management magazine, strategy+business, is available at
strategy-business.com.
©2013 Booz & Company Inc.
London
Madrid
Milan
Moscow
Munich
Paris
Rome
Stockholm
Stuttgart
Vienna
Warsaw
Zurich
Middle East
Abu Dhabi
Beirut
Cairo
Doha
Dubai
Riyadh
North America
Atlanta
Boston
Chicago
Cleveland
Dallas
DC
Detroit
Florham Park
Houston
Los Angeles
Mexico City
New York City
Parsippany
San Francisco
South America
Buenos Aires
Rio de Janeiro
Santiago
São Paulo