[Bowmans] Kenya: Restructuring distressed PE portfolio companies

By Joyce Mbui and Vruti Shah

As a result of COVID-19 and other market factors, private equity funds may well have investments in operating entities (portfolio companies) that may currently be experiencing declining revenues, liquidity constraints and potential challenges to servicing debt.

Where the business fundamentals of such distressed portfolio companies are sound, then there may be a number of restructuring options available to them. For restructuring action to succeed, it should be taken at the earlier stages of distress rather than at a point of no return.

There are three main stages a company goes through when it is in financial difficulty. The first is underperformance, where a cash generative business losses profitability. It is in this phase that the company has its best chances to effect a restructuring.

The next stage is distress, where the business of the company cannot fund any of its activities outside its immediate operations and it has difficulty meeting its commitments to its lenders or its trade creditors. Action taken in this period is useful though the options and the environment for a successful restructuring may be less than favourable.

The final stage is crisis, where the company faces a critical shortage of cash forcing it to use all of its cash generated by the business to meet debts as they fall due. By this time, it is either insolvent or about to become insolvent.

What next if a portfolio company is in distress?

If a private equity fund finds itself in a position where there are numerous signs that its portfolio company may be facing financial distress, then, as a first step, it should consider undertaking an independent business review (IBR) of the company.

The IBR would give an indication of the stability of the portfolio company and its financial viability in the short to medium term. It will also highlight any areas of concern that need to be addressed. If the results of the IBR reveal areas of concern, then the following considerations need to be taken into account.

Operational restructuring

Operational restructuring involves identifying the causes of operational underperformance and developing a strategy to achieve improvement. Operational restructuring focuses on the profitability of operations. It does not address the capital structure or financing structure of a company.

Balance sheet restructuring

A balance sheet restructuring involves restructuring the components of the business that form part of the reporting on the balance sheet. This is usually implemented by concessions made by debtholders and equity holders in an effort to make the balance sheet stronger. Stronger, in this context can mean a number of things but always involves the company having less leverage than it did before.

One element of a balance sheet restructuring could be the injection of additional cash. Cash (or liquidity) may be injected by equity or debt. Where a private equity fund is looking at debt financing as a way to raise capital or obtain funding, then there are several considerations that it needs to take into account, including:

– the portfolio company’s leverage ratios;

– contractual obligations and/or restrictions on incurring additional debt;

– whether any structure of debt financing may be treated as a voidable transaction under insolvency laws.

For equity financing, a review of the fund’s regulatory documents and shareholders’ agreement (SHA) (if any) as well as the company’s constitutional documents is needed to ascertain the:

– funding options and restrictions for the private equity fund at the fund level;

– funding provisions in the SHA; and

– consequences of dilution if the private equity fund has no more capital to inject into the company.

Another element of balance sheet restructuring is reducing leverage. This may be done by way of covenant waivers and resets, debt waivers or haircuts, extended maturity dates, or payment rescheduling combined with company-led contributions such as non–cash capital contributions or debt for equity swaps for shareholder loans.

Consensual restructuring versus statutory process

Any restructuring may be implemented consensually or by using a statutory process, depending on the situation. Where there are fewer key stakeholders and creditors, it is possible to effect a restructuring by using a consensual contractual route. This type of restructuring will require early, honest and open engagement with the company’s lenders and other key stakeholders. However, where there is a multitude of creditors, a formal restructuring process is more appropriate.

What are the available statutory processes?

The following statutory processes are available to implement a restructuring.

– Scheme of arrangement: an arrangement carried out between the company and a particular class of members or creditors. In order to be effective, the scheme of arrangement must be approved by the majority of the creditors or members (as applicable) representing 75% in value of those creditors or members. The scheme must be sanctioned by the court and a copy of the sanction order must be filed with the Registrar of Companies in Kenya. This is not an insolvency procedure and can be used by both solvent and insolvent companies.

– Pre-insolvency moratorium: this is a procedure that can be used by the directors of an eligible company to obtain temporary protection from creditors, while the company considers a business rescue plan. There is no eligibility threshold for a company to qualify for the moratorium, provided that the applying company is in financial distress. The moratorium will be for a period of 30 days, but the court has discretion to extend it for a further 30 days. This process must be supervised by a ‘monitor’ who must be a licensed insolvency practitioner.

– Administration: this allows for the reorganisation of an insolvent company or the realisation of its assets under the protection of an automatic 12-month statutory moratorium. It is conducted by an administrator who must be a licensed insolvency practitioner in Kenya.

– Company voluntary arrangements: this is a procedure proposed by the directors of a company which allows a company to satisfy debts owed by paying only a proportion of the amount owed or coming to another repayment arrangement. It is usually used to restructure unsecured creditors. It is supervised by a supervisor who must be a licensed insolvency practitioner in Kenya.

– Liquidation: This is usually the last resort where numerous efforts to rescue a company have failed. It spells the death of a company and is conducted by a liquidator who must be a licensed insolvency practitioner in Kenya.

Other considerations: Director’s duties

The private equity fund will have appointed directors to the board of the portfolio companies. These directors will have the same fiduciary duties as all the other directors of the company.

The Kenyan Companies Act has codified common law duties of directors and their conduct and includes possible liability if they fail. The duties owed by a director to a company are altered where that company is in or is facing the threat of insolvency. In those circumstances, directors have a duty to act in the interests of the company’s creditors as a whole (i.e. to preserve the value in the company in order to maximise the return to creditors).

This is important because the Kenyan Insolvency Act provides for two statutory offences of wrongful and fraudulent trading, which could result in the directors being personally liable if they are found culpable. Wrongful trading is usually a case of poor judgement or denial where the directors continue to trade when they know that there is no reasonable prospect of the company avoiding insolvency. Current and former directors can be found liable. Fraudulent trading occurs where the directors knowingly carry on trading with no intent to pay their debts.

Directors can mitigate the risk of liability by taking proactive measures, such as holding regular board meetings which are fully minuted, closely monitoring the company’s financial position, ensuring that directors who are nominees do not have conflicts of interest, and seeking legal and financial advice early.

Bowmans is a leading corporate law firm with a highly skilled team, track record and geographical footprint to provide both upstream and downstream services to the private equity sector in Africa. www.bowmanslaw.com/service/private-equity