http://www.theaustralian.com.au/bus...f/news-story/bedb8371a52576243591fbe2d7d39506
If the nature of a business is such that it is likely to experience material value destruction as a result of being If the nature of a business is such that it is likely to experience material value destruction as a result of being wound up, then converting debt into equity to avoid the business becoming insolvent may result in the bank getting a better return on its debt, in the long run, than if it simply wound up the company.
MANY Australians would no doubt like to know how to get a bank to convert their borrowings into equity in their business.
If only it were that easy.
Banks are essentially rational and, while shares can offer superior returns, it is not the space banks traditionally choose to occupy. Banks like to lend money and earn interest, safe in the knowledge that if the business becomes insolvent, the bank's right to repayment will rank in front of shareholders -- and if the bank's loan is secured, in front of unsecured creditors. So, why would a bank choose to convert its loan into equity? At it simplest, if a bank thinks that converting its debt into equity will give it the best overall return, then logic suggests that it should do this.
The Pasminco debt-for-equity swap, ultimately structured as a refloat, is one of the most successful public examples of this. Pasminco went into administration in September 2001, largely due to a significant fall in global zinc prices. The banks determined that the best possible return on their debt would be achieved by refloating the core business. A new company, Zinifex, was created, into which the best Pasminco assets were transferred. Zinifex successfully floated in April 2004. Zinifex performed so well that it was effectively taken over by Oxiana in 2008, the merged businesses becoming OZ Minerals.
Pasminco was refloated after the company went into administration. The depth and sophistication of the players in the debt markets means that banks and other participants (including those with more flexible investment powers -- such as "hedge funds") are increasingly prepared to consider the merits of a debt-for-equity swap before a company goes into administration. In broad terms, as part of a "workout" analysis. But performing a debt-for-equity swap before a company goes into administration brings its own range of issues. So, why would a bank consider doing this?
Historically, banks would seek to wind up a non-performing business to recover amounts owed to them. This customarily involved the appointment of a liquidator (or a receiver, if the bank was secured), whose mandate was to sell the assets for the best possible price and apply the proceeds towards the payment of the business's debts.
Depending on the nature of the business, this can be a very certain and straightforward process. If the business is relatively simply structured and its main asset is, say, a commercial property with a readily ascertainable value, then the bank will have a good feel for its likely value in a winding up.
But it is not always that simple. Some large businesses are not primarily "bricks and mortar". Their assets are often intangible, made up of complex contractual arrangements that require specialist staff and expertise to implement and maintain. Most importantly from a bank's point of view, those contracts may permit the counterparties to them to bring them to an end on the winding up of the business. To use the "bricks and mortar" analogy again, it is a bit like having the building vaporise the moment the winding up starts. So, the very act of winding up a company can result in value destruction.
Restructuring a business before it is wound up brings other challenges, though, including tax consequences and regulatory capital impacts. And banks are invariably conscious of their reputations these days, so they will also be concerned about the possible reputational impact of being seen as an investor in, rather than a lender to, a company.
But in many respects the biggest challenge a bank will face to successfully implementing a debt-for-equity swap pre-winding up is time.
Under Australian law, a director can be personally liable for debts of a company incurred while it is insolvent. While this may well be appropriate in terms of protecting creditors, it can mean that even if a company's major creditors are supportive of the company trading out of its difficulties, the directors, faced with the prospect of personal (and possibly criminal) liability, may choose to effectively initiate the winding up process by appointing an administrator to the company.
In fact, time may well have been the culprit for Pasminco. Pasminco and its banks were attempting to put a standstill agreement in place (under which its banks would agree not to call for repayment of their loans for a period), but before it could be implemented, its directors formed the view that the company was no longer able to pay its debts as they fell due, and appointed administrators.
This brings us back to our initial point, namely, banks are essentially rational. If the nature of a business is such that it is likely to experience material value destruction as a result of being wound up, then converting debt into equity to avoid the business becoming insolvent may result in the bank getting a better return on its debt, in the long run, than if it simply wound up the company.
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