How businesses can overcome financial distress

Since the Covid-19 pandemic and the recent increase in inflation, many businesses are facing financial distress locally and internationally. Financial distress is defined as an event that occurs when a company generates positive cash flows in its day-to-day operations but it is insufficient to service the cash requirements of its funding structure. The high headline inflation rate in Rwanda (17.8% as of April 2023) has negatively impacted business revenue growth and profit margins creating cash flow burdens for businesses that were already highly leveraged. Despite the recovery of the Rwandan economy, businesses in some sectors continue to be in financial distress. A case in point would be the auction of the prime Kigali Business Center in August 2022. The banking industry remains stable and has been characterized by a low ratio of non-performing loans (NPLs) which stood at 3.1% as of December 2022. However, pockets of the economy have high non-performing loans, such as the agricultural and livestock sector at 26.5% in December 2022. For companies facing financial distress, the situation is complicated by the presence of few mechanisms available or exercised by businesses to rehabilitate their finances in Rwanda. During the Covid-19 crisis, the government intervened to support businesses in financial distress and reboot the economy with the Economic Recovery Fund, which was successful. But it was limited to debt. However, in many cases, a business facing financial distress must also make changes to the fund structure (mix of debt and equity). This article highlights a few structural solutions that various stakeholders could consider to support businesses in financial distress. Financial distress solutions should seek not to create a moral hazard by encouraging business financial mismanagement because of such safety nets. Equity cure/addition equity A particular solution to financial distress could be the equity cure process. Equity cure is defined as the process of curing debt-overburdened businesses through equity injection. Equity injection can be through various options, such as introducing a Rwanda-focused private equity fund (PE), or more SMEs could consider listing on the Rwanda Stock Exchange to manage their funding structure proactively through access to various types of investors. Another option might be the establishment of distressed funds by banks for the purpose of exchanging troubled debts with tradeable securities. The benefit of such distressed funds was seen in the aftermath of the 2008 global financial crisis in Portugal where the banking system was mainly affected by increasingly unsustainable levels of corporate and consumer loans. The established funds were mainly focused on real-estate portfolios, tourism-related businesses, and SMEs. The approach was for banks to be the main drivers of the restructuring efforts especially if they owned above 50% of the company’s debts; then they would be allowed to trigger ‘the Special Revitalization Procedure’, which is a fast track- procedure where senior creditors could impose their restructuring plan on management. In this instance, requesting management to sell some company’s shares to the fund. For companies to be purchased by these funds, they needed to show that they were operationally stable but highly leveraged. Scheme of arrangement Another solution could be introducing a debt restructuring mechanism known as a scheme of arrangement. A scheme of arrangement is a court-sanctioned procedure that allows a company to reconstruct its financial position through a compromise between shareholders and creditors (including bank debt) where debts are converted into equities and shares diluted. For a scheme of arrangement or any restructuring process to be possible, the company must have a positive business value but a negative equity value. Therefore, the arrangement allows the rehabilitation of the financial distress. For a scheme of arrangement to be successful in Rwanda, it will necessitate the introduction of a framework that allows banks (since most times they are the secured creditors) to recognize financial distress early and take prompt steps to resolve it. An example of such a framework is one introduced by India in 2015 known as the Strategic Debt Restructuring (SDR). The main element of SDR is that it empowers banks to take control of distressed companies using the debt-equity conversion and then selling it off to eligible buyers. The advantage of this framework is that the acquisition of shares by banks through SDR is exempted from regulatory ceilings. Within this framework, banks in India established stressed asset funds that trade the bank’s debts for equity in distressed companies. In conclusion, honing additional financial distress strategies that aim at rehabilitating financial distress using the options recommended above will allow the preservation of Rwandan companies for the benefit of their stakeholders (creditors, employees & shareholders) and the economy. Siongo Kisoso is the Managing Director of BK Capital and Marvella S Mutabazi is an Investment Services Analyst at BK Capital.

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How businesses can overcome financial distress