Culture shift puts companies in ICU

EDCON adds its name to the list of major companies that banks have had to rescue over the past year. First it was Lonmin, whose crushing debt forced the company to almost entirely recapitalise. Then it was PPC. And now Edcon. The retailer’s lenders have been forced to convert R20bn of their debt into equity to allow the company to get back on its feet.

What is remarkable about these rescues is that they happened at all. Not too long ago, I suspect they would have all ended up in the hands of liquidators, where the companies would have been dismembered, assets flogged and staff put out of work while creditors were paid a fraction of the money they were owed. Instead, banks have taken a proactive approach, rolled up their sleeves and hammered out solutions that allow companies to continue operating. Of course, such an approach can provide them with the best shot at recovering their exposures.

But there is also something more going on: new thinking in financial circles over just how a company facing mortal peril should be dealt with. One can trace the evolution of this approach through the two major phases of corporate distress we’ve seen in the past 20 years: the dotcom collapse and the financial crisis.

The first was dealt with the old-school way: companies that failed were simply shut down and the assets realised whatever way possible. While serious fraud played a large part in the story, it was easy to put the likes of Enron and Worldcom into the hands of liquidators.

But the second forced a dramatic shift in thinking. The financial crisis started on the wrong foot with the bankruptcy of Lehman Brothers, a classic application of the old school, making for the largest bankruptcy in US history. Many thought the disciplining effect of shutting a company down, on everyone connected with it, was what was needed to keep creditors on their toes. The consequence was a system-wide meltdown as faith in the financial system collapsed. To the credit of US authorities, that near-death experience drove a Damascene conversion and marked a rapid shift in outlook. Companies were not condemned but rather every effort was made to rescue them. That contained the financial crisis and prevented it from becoming a far greater economic catastrophe.

In part, the trend towards rescues rather than bankruptcy has been encoded in law. Here, the new Companies Act provides for business rescue procedures rather than liquidation, following the example of the US’s chapter 11 of its bankruptcy code. But such law is helpful only to a point — remember that chapter 11 was used for Lehman. What has made the difference is a less tangible cultural shift, a willingness among lenders to work together to rescue companies rather than try to be the first out the door, combined with shareholders who give up rather than fight to the death. These factors go hand in hand with a willingness in boardrooms to recognise their own failures.

It is difficult to pin such cultural change on any particular causes. The extremely difficult economic conditions since the financial crisis have made it more important than ever to maintain confidence and provide stability. And the examples of successful turnarounds provide evidence that there is a better way than liquidation.

The fate of Edcon was written in 2007 when the initial deal was done to delist the company and put it in the hands of private equity, principally Bain Capital. The deal was done with unprecedented levels of debt at the peak of the pre-crisis boom, when consumers were spending and debt was cheap. But the cost of servicing that debt has been an unbearable burden for the company, forcing it to cut back and leaving the market to competitors to aggressively move into.

With Edcon’s debt due to mature in 2018 and 2019, it is already clear it will be impossible to settle. It has already rescheduled or exchanged various other obligations that became due in 2016 and 2015. It spent R4.3bn on interest on its R26bn of debt in the past year, making an operating profit of just R2.6bn in the same year. It could not function with that level of liability.

Bain Capital has completely thrown in the towel, with the business to be transferred to a new holding company structure, which will be controlled by the current creditors. The biggest will be Franklin Templeton Investments, the US fund manager that finds itself in an unusual position for a mutual fund operator. SA’s banks and several other investment houses are also exposed.

The ambition will be to improve Edcon’s operating performance and get it back onto the JSE to facilitate an exit.