A Salvage Fund for Companies in Distress

The advent of this fund opens the door to limitless opportunities for companies who find themselves in distress.

At Last - a Salvage Fund for Companies in Distress

Source: Andrew Leontsinis, partner in Bell, Dewar and Hall

(Published in the May 2006 edition of Credit Guarantee’s Credit Notes)

Over recent years many academics and practitioners have spoken of the need for a change away from the liquidation culture prevailing in South Africa to one of business recovery. The benefits of recovery over liquidation to all interested parties – the creditors, stakeholders, employees and the distressed company itself –are self-evident. Creditors in particular have come to realize that hey will frequently benefit more from having a distressed company back in the marketplace than from it being in liquidation. 

The current sate of South African legislation has been blamed for the difficulty which a distressed company experiences in persuading creditors to exercise patience whilst it formulates a rescue plan for consideration by creditors.

The advent of this fund opens the door to limitless opportunities for companies who find themselves in distress.

The lack of protection which the South African Companies Act and Insolvency Act afford distressed companies is an almost insurmountable hurdle which these companies must face when finding themselves in a position where they are unable to satisfy the claims of creditors as they fall due. This lack of protection undoubtedly prevents companies which could otherwise successfully trade out of their difficulties, from being able to persuade creditors to allow them the time to do so. Creditors are free to, and secured creditors in particular tend to, adopt the liquidation route rather than the recovery route.

The view that current legislation is the cause of the belief that the only outcome for a distressed company is liquidation, fails to the account of the difficulty experienced by recovery practitioners in achieving the one fundamental requirement for any successful recovery: The ability to secure sufficient funds to enable the business to continue trading.

The first thing a recovery practitioner does in determining whether there is a business that can be saved is to assess the cash position of the distressed company. Depending upon how bad the situation is, it can be a major effort to secure sufficient funds for some form of the business to carry on trading.

The obvious sources are creditors and debtors, the asset lenders, the bank and the shareholders. These sources, more particularly traditional lenders, are most often very reluctant to introduce any further form of funding. Moreover, as every business recovery practitioner has experience, the difficulty in securing funding often proves to be the demise of any prospects of recovery.

If the required funding cannot be secured then the further steps in business recovery, namely to realize improvements to the business over a period of time, usually involving changes in management and a radical re-organization of the way the company works, cannot be implemented.

The advent of South Africa’s first distressed strategy, fund, which made its debut in January this year, is therefore a welcome event. The SA Distressed Salvage Fund LLP (the Fund), a South African hedge fund, is a collaborative effort between experienced credit experts and hedge fund professionals. Working in conjunction with EDGE Capital, one of South Africa’s largest hedge fund managers, the company Distressed Debt Management (Pty) Ltd is the appointed investment adviser to the Fund. The Fund provides a flexible source of funding for distresses companies and, as such, may well provide an alternative to liquidation.

Hedge funds are private pools of investor capital. Similar to private equity funds, they are lightly regulated partnerships. US-based Magnum Funds estimate the global hedge fund industry to be in the region of $1,5 trillion and growing at about 20% per year with approximately 8 350 active hedge funds.

Contrary to widely held perceptions, hedge funds are not the high-risk financial gunslingers of the George Soros variety. Their primary objective is simply consistency of returns and preservation of investor capital. Research has established that hedge funds have in recent decades produced higher returns and lower overall risk than traditional investment funds such as shares and bonds.

The South African hedge fund industry has expanded rapidly in recent years. Some estimates put the industry at around R12 billion and growing. Yet, almost all of the roughly 100 domestic hedge funds invest exclusively in the equity and bond markets. The result of this concentration has been a growing demand from investors for new hedge fund strategies such as those investing in distressed debt.

If the international trend is any indication, the South African market for distressed investing has much potential. Greenwich Associates recently reported that hedge funds accounted for 82% of trade volume in US distressed debt and nearly 30% of volume in US sub-investment grade bonds and credit derivatives.

If it can be emulate the success of the well-known international distressed hedge funds such as the $8 billion Cerebrus Fund and Asian Debt Management’s $2 billion Galleus Fund, the SA Distressed Salvage Fund LLP will find its niche in the South African credit market. As for the Fund’s prospects, because it will be extremely focused, the Fund’s returns could be very good. However, the risk could be extremely high as well.

From a business recovery point of view the Fund offers many opportunities to distressed company experts. The Fund considers the purchase of equity, debt and trade or other financial claims of companies in or about to enter or exit insolvency or financial distress.

This will allow it to make use of prevailing company and insolvency legislation, more particularly in the field of schemes of arrangement and offers of compromise in terms of the provisions of Section 311 of the Companies Act. It will also allow it to make funds available to those parties interested in proposing such offers to creditors of distressed companies.

As far as longer-term turnaround and recovery strategies are concerned, this will lead the Fund to become involved in private equity strategies.

For distressed companies to successfully recover their business, it is critical that turnaround specialists are engaged before the company finds itself on the brink of liquidation. Distressed Debt Management (Pty) Ltd, the investment manager of the Fund, offers these skills. It is responsible for identifying distressed companies in which the Fund many invest and for implementing the Fund’s three principal strategies:

 

·        Turnarounds and corporate re-organizations;

·        Offers of compromise and schemes of arrangements between a distressed company and its creditors and/or members; and

·        Secured debt salvage.

Traditional funding for distressed businesses remains a perennial problem. With the advent of this distressed fund, with the Fund seeking a return on its investment usually by way of equity, it opens the door to limitless opportunities for companies who find themselves in distress. The Fund promotes itself as:

“South Africa’s first distressed strategy hedge fund in the event-driven class. It conducts short-term salvage operations of the debt of financially distressed companies, engages creditors in schemes of arrangements in terms of Section 311 of the Companies Act (1973) as well as investing in longer-term turnaround and recovery situations. The Fund has no exposure to the traditional financial markets and does not employ leverage. Valuation, administration and custody of the assets of the Fund are conducted independently by specialized service providers. Investments are made for both the short and long term and can be active or passive as to participation by the Fund in distressed matters”.

If the SA Distressed Salvage Fund LLP is able to achieve what the Cerebrus fund and the Galleus fund have achieved, then it will provide unique opportunities for turnaround of distressed companies in South Africa and promote the business recovery culture so sorely needed in the South African market.