Chart Fun | Into Thin Air
Later —people would ask why, if the weather had begun to deteriorate, had climbers on the upper mountain not heeded the signs? Why did veteran Himalayan guides keep moving upward, ushering a gaggle of relatively inexperienced amateurs — each of whom had paid as much as $65,000 to be taken safely up Everest — into an apparent death trap?
— Into Thin Air, Jon Krakauer
A sharp eyed Bengali mathematician, Radhanath Sikdar, discovered what came to be known as Mount Everest in 1852. Humankind had to wait a century before Everest would be scaled for the first time in 1953. Within the next thirty years, the mountain was scaled more than a hundred times. Once an odyssey for elite mountaineers, relatively inexperienced climbers began expeditions to Everest from the mid-80s. In 1996, on the descent from the summit, a blizzard caused the deaths of eight people. It was the worst Everest disaster at the time.
Perfectly good weather had morphed into an unfriendly force within moments. And turned a normal situation into a tragedy.
The above excerpt from Jon Krakauer’s personal account of the disaster illustrates the psychological aspects of hindsight thinking. It also illustrates how rapidly altered conditions change incentive structures.
A leading publicly listed Indian financial is in the throes of a massive restructuring exercise at the moment.
Once a favorite perch for eager equity investors, this financial turned into a pariah overnight. Previously unseen operating forces sheared at the seams, causing base assumptions of a lucrative future to rapidly turn into questions on the Company’s very existence.
As things stand today, large numbers of bond and equity holders are facing up to the prospects of salvaging the situation. For many retail investors, mutual funds and banks, this restructuring would be a first-time experience with a publicly listed financial grappling with a near-death experience.
This post delves into various aspects of this near-death event-in-motion. More importantly, it will expound on the incentive structures that are likely to influence outcomes.
The Situation
The Company belatedly released results for year ended Mar’19. Excerpts of interest:
Balance Sheet; Excerpts of interest:
The Problem
The feedback loop of problems afflicting this Company:
- Too much debt.
- Too little equity.
- An asset-liability mismatch.
- Credit Rating downgrade.
- Lack of fresh credit lines from counter-party lenders. This exacerbates 3.
- Losses on existing loan book. This exacerbates 2.
- Sum total of the above effects, and an Unchanging 1 has turned a ‘normal’ situation into a going-concern threat.
The Fix
The fixing process essentially boils down to the following:
- Raise equity.
- Reduce debt. Drastically.
- Restart credit lines from counter-party lenders.
However, the recast process in this situation has been complicated by capital structure dynamics.
Incentive Structures: How could the restructuring look like?
The recast process could take one of various forms. Not all scenarios can be depicted here. For illustration of how incentives are likely to influence behavior, a few potential scenarios are laid out. This Johnny Nobody blogger is not privy to progress of actual discussions.
I. The Company has proposed the following Resolution Plan to the lenders.
The Company has offered the carrot of no principal haircuts. In exchange, the Company is pushing for a moratorium on debt repayments, and new funding from banks. An extension in debt maturities will usually be part of such packages. There is no mention of fresh equity financing in this Plan. Prima facie, the no principal haircut would likely be welcomed by all debt holders.
It will be interesting to see what the Company offers as compensatory interest. One would expect them to advance the lower-rates-and-longer-maturities argument, citing going-concern issues. The Company has a strong this-is-all-we-can-afford-or-else-we-all-perish negotiating line.
Debt and bond holders — majority of whom have invested in the debt at Par values — would face the prospect of:
- Not agreeing with the Plan, and risk losing their investment in full.
- Agreeing with the Plan, and hope to salvage whatever they can.
Fixing the repayment cycle is only one half of the solution, though. It does not fix the structural issue of kick-starting fresh revenue lines. The Plan, relies on an assumption of fresh funds from banks; the very folks that find themselves in a hole! It is stretch to expect them to accede to fresh financing in this situation.
Fresh equity financing is the need of the hour. The Company’s Plan makes no mention of this.
Time to consider other potential scenarios.
II. Non-convertible debt holders and bank debt holders agree to an [X]% haircut. Fresh equity infusion of INR [X] Crore. Increase in Coupon Rates, after a moratorium period.
One may propose a debt to equity swap. However, this conversion of debt to equity will have to be augmented by a fresh round of equity infusion. The debt to equity conversion is a change in nomenclature of capital that’s already been consumed by the business. To kick-start fresh lending, an additional equity buffer would need to be infused into the Company.
If the bank debt and non-convertible debt holders agree to a [X=20%] haircut on the face value of their holdings, and assuming an INR [4,000] Crore fresh equity infusion around prevailing market prices, the Company’s leverage would fall from 12x currently to under 4x. The fresh equity raise assumption is around half of accumulated net worth, and nearly 3x the Company’s market cap! The equity shares outstanding would expand 14x. One may also propose a Step-up Coupon Rate program, after a moratorium, to compensate debt holders for their troubles and induce their participation.
The fresh equity buffer would provide the Company some breathing space, giving comfort to lenders to advance fresh financing.
Here’s where things get interesting…and complicated.
- More than 75% of the value of the debentures outstanding under each Series would need to agree to the Terms.
- Why would an incoming fresh equity investor wade into this situation?
Bond holder incentives
(1) poses a problem as the debentures are held widely across multiple Series by the public. Most are unlikely to keep track of this event, or wouldn’t know how to act in such situations. If they do not vote, a key condition precedent would not be satisfied; scuttling the Plan.
Bondholders Hope/Reality Matrix:
Due to optics, small holders may be lucky enough to receive full payments. But it is a Big If. The other components of the Plan need to be in motion for this premise to be satisfied.
New Equity investor incentives
An incoming equity investor would be wading into a severely distressed situation. Compensation, and adequate protection requests may be reasonably expected from the equity investor. The investor would likely insist on (1) as a key condition precedent before agreeing to the equity infusion. The Haircut Plan would need to be in place for the equity infusion to have its desired effect.
Existing Equity shareholders incentives
(2) would also put the ball in the court of the Company’s equity shareholders. The new infusion would require a Special Resolution.
Existing equity shareholders have already seen a substantial erosion in the value of their investments. Their incentives would favor any Plan that potentially saves the Company, and helps revival. They would need fresh infusion of equity.
This could come via:
- Rights Issue, where shareholders participate at a lower price than market.
- New equity investor.
Rights Issue, at a discount to the already depressed market price, may not be acceptable to either the Company, or the shareholders. Attention would therefore shift to the new equity investor.
For this, a Special Resolution would need approval by at least 75% of shareholders. Institutions own a little over 15% of the Company. Non-institutions own just under 46%. Small equity holders hold 28% of the Company. They may play a not-insignificant role in proceedings.
III. Sustainable/Unsustainable Debt, with/without equity infusion.
With this, stakeholders would be venturing further into thin air.
A Good Bank/Bad Bank structure; by segregating existing debt into sustainable and unsustainable components, may be proposed.
This structure would be contingent on the quantum of fresh equity raised.
Prospects Matrix for this scenario:
The Blue represents the best prospect for all stakeholders. Red represents the worst prospect.
The Company, and stakeholders are grappling with thin air here.
This event-in-motion is an interesting illustrator on many fronts. The most prominent takeaway is the speed with which the wheels can come off of financials. What looks like a perfectly healthy state of affairs can rapidly devolve into a going-concern threat. All it takes is a collective loss of confidence.
When providers of financing take a funding vacation, the oxygen supply to a financial can deplete rapidly.
Often ending in death, or painful near-death experiences. Most times, the system doesn’t seem to emerge wiser.
The other aspect is the role of incentives in determining outcomes in tough situations. The near-death episode in this instance is a first-time experience for most stakeholders. Most are not equipped to parse the situation in its entirety. They do not have historical crutches to summon to support themselves.
Individually rational behavior in such instances can rapidly lead to a collectively irrational outcome.
The near-death episode will likely prove this right.
For stakeholders.
