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Restructuring in the Middle East           Date: 2009-09-01

Article prepared by Pauline Renaud containing summary of an interview with Ziad El-Khoury, and published in the Financier Worldwide September 2009 Issue.

 

The ability of banks to lend continues to be affected by the financial crisis, and the Middle East is no exception to that trend. Indeed, many businesses are struggling to meet repayments, and are running the risk of defaulting on their loan obligations. Others are worse off still, teetering on the brink of bankruptcy.

Consequently, restructuring has become a priority for many Middle Eastern companies, although the process is more complicated than in other jurisdictions. Firstly, restructuring is a relatively new phenomenon to the region, and secondly, the presence of Islamic financing instruments means that restructurings tend to play out a little differently. As such, companies and creditors will need to be particularly vigilant when conducting restructuring efforts in the region.

 

Restructuring activity on the rise


Until a few months ago, restructurings in the Middle East were more or less a rarity. This was due to a number of factors, including the region’s tendency to avoid public failure of businesses, the mistaken belief that the Middle East would not be impacted by the financial crisis, and the fact that insolvency laws have failed to keep pace with the economic development, notes Simon Schmidt, a partner at Patton Boggs LLP.

“But out of necessity, activity has picked up over the last few months, as government-related entities, off which much economic activity feeds, have begun to publicly consolidate subsidiaries and group companies. No major corporate failure has yet been publicised, although the Saad Group/Al Ghosaibi issues may result in being resolved more publicly than is customary. The general rule is that creative and piece-meal ways are being sought to keep businesses alive since the regulatory frameworks are either insufficient or untested,” he observes.


Of course, certain sectors are seeing more activity than others. “Obviously, real estate and financial services have been hit particularly hard regionally,” asserts Oliver Holder, managing director at Deloitte Corporate Finance Limited. “A marked difference is that, up to now, international banks rather than local banks have tended to initiate restructuring processes. But the difference is likely to become less pronounced as we go through the next 24 months,” he adds. The global turmoil has also reanimated the longstanding debate as to how family-owned businesses ought to be restructured. Indeed, given the large number of such companies, this form of restructuring may mark a new trend in the coming few years, and is likely to contribute to an uptick in the number of restructurings. M&A-led restructurings are also on the rise. “Significant consolidation activity is starting to occur in the struggling banking and real estate related sectors,” notes Andrew Lewis, a partner at Norton Rose LLP. “However, consolidations are challenging, often requiring substantial injections of new capital to create a viable merged entity, and are progressing slowly. The long-awaited merger, featuring former leading Dubai mortgage lenders Tamweel and Amlak, is a good example,” he says. The two companies have been in merger talks since November, but the collapse of the credit markets scuppered their business models, and the process has been on ice ever since. A banking licence is yet to be granted by the government, and the companies themselves are still not lending.


Indeed, consolidations and restructurings generally come complete with an abundance of challenges that both borrowers and creditors have to face. One of them is to be able to obtain reliable information regarding the extent of the financial difficulties. With a high level of cross-ownership in the region, it can prove difficult to rapidly identify and address the different issues. Also, creditors’ rights and options in the region are often more limited than in other countries, while borrowers are struggling under heavy debt, thereby making the restructuring process longer and more complex, delaying a potential recovery. “As a result of the slowing global economy, an increasing number of borrowers are failing to meet their loan obligations,” says Ziad G. El-Khoury, of counsel at Squire, Sanders & Dempsey LLP. “Bankers lending to such troubled borrowers are often faced with a dilemma: enforcing liquidation – which can provide certainty of a short-term return but can also involve a significant loss of principal – or giving the borrower more time, which adds yet more uncertainty to a risky recovery process. In tough liquidity conditions, such as today's global credit crunch, credit professionals are required to quickly identify what is causing borrowers problems, and provide the most appropriate and cost effective financing solution,” he advises, adding that those solutions can be specific to the sector concerned, therefore requiring specialist knowledge. Some experts predict that, going forward, banks will likely adopt more formalised credit-scoring processes and will have a stronger focus on ongoing monitoring creditworthiness. Borrowers will therefore be required to provide more regular information about their financial situation to lenders.


Fluctuating asset values is another main issue. “If lenders believe the market is going down, they will demand more collateral and lend less against existing collateral. This should create opportunities for asset managers, as most banks do not wish to manage large portfolios of real estate and other assets,” explains Mr Schmidt. “Large majority government-owned but public listed developers, whose market capitalisation is based to a large extent on land values, have been unwilling to write down the value of these assets. Public scepticism about valuations has led to volatility in share prices, which has fed into the rest of the stock markets, largely sentiment-driven.” Such volatile markets are considered to be a disincentive to long-term investments, particularly in the infrastructure sector. Overall, several sectors, including retail, financial services, tourism, and real estate, have been particularly affected by the crisis. “The issue with real estate is that, as a bank, when you look at possible balance sheet exposures, you need to consider whether there is real estate exposure further down the chain – that is, to really understand where funds have been deployed by borrowers,” says Mr Holder. “In many cases, the road ultimately leads to real estate investment. Going forward, banks will be likely to adopt more formalised pre-lending decision making processes and have a stronger focus on the ongoing monitoring of credit risk.”


Besides those difficulties, some specific challenges with regards to Islamic finance may also arise. Defaults on Islamic bonds (sukuk) are only a recent phenomenon, and the integrity of default provisions and creditor protections in those instruments has just started being tested. But some experts believe that Islamic structures, backed by real assets and cash flows, should mean that collateral and security for those debt instruments will be easier to recover than conventional debt instruments. As a result, it is said that Islamic finance, as an industry, may become increasingly common in the years to come, given its low-risk reputation for both borrowers and creditors. Other analysts believe however that the current crisis has started exposing weaknesses in Islamic finance, including the limited number of refinancing modes.


Mr El-Khoury explains that the culture of debt restructuring in Islamic finance is poor and no adequate legal environment has been created to remedy this situation.

“Further, challenges to the restructuring efforts arise from the very core structure of an Islamic finance transaction,” he says. “The value of the instrument is hard to price because one needs to look into the underlying assets to be able to have an accurate estimate. Such pricing issues, added to the diversified nature of the assets backing financial instruments, make a consolidation effort hard to conceive. In addition, there is a maturity mismatch between the liabilities arising out of such instrument, which are short-term investments, and the underlying assets, which are long-term investments.” Investors and borrowers also have to bear in mind that restructuring efforts may be slow compared to conventional restructuring moves, as any change in the structure of the deal has to be examined and approved by a Shariah scholar before getting the go-ahead.


Besides the various potential obstacles when restructuring, companies are also likely to face disputes and litigation. They include claims against directors, trading claims, and labour disputes, among others. But some Middle Eastern countries lack clear and appropriate laws for regulating corporate disputes, and recourse to civil courts remains rare. As a result, disputes involving prominent groups are usually resolved through consensus and extra-judicial agreement. Other businesses are advised to keep legal action at a minimum, given the uncertainty of the outcome and the length of litigation. “The uncertainty that timely and reliable court remedies will be available, creates a converse concern to litigation risk for the parties who are more reliant on representations, warranties and covenants from the other parties in a restructuring – creditors more than borrowers in a debt restructuring, purchasers more than vendors where asset transfers are involved, and so on – to the extent that the covenants and warranties may be largely toothless,” says Mr Lewis. Some experts believe that this situation will likely result in more alternatives for dispute resolution being developed. Others predict that governments and regulators will enact new practices and rules, and create specialised courts to fill this regulatory gap.


Effecting a successful restructuring


Given the challenges restructuring companies are likely to meet along the way, different steps should be taken in order to limit risks. One of them is to be able to recognise, as early as possible, warning signs, in order to put in place an effective restructuring strategy. “The management should develop an ideal restructuring blueprint that assesses the company’s debt capacity under worst-case operating conditions, and establishes new, sustainable credit parameters that ensure future operating viability,” advises Mr El-Khoury. “The management may also want to identify and focus on core competencies and operations of the company, while developing a plan to dispose of non-core or unprofitable business units. We believe this will result in some M&A activity in the near future, but mainly on the level of small and medium businesses.” Appointing advisers during that process may be useful in order to implement effective and long-term changes.  Most experts, such as Mr Schmidt, also agree that maintaining communication and transparency about the situation of the company is vital for a successful restructuring. This can help avoid unexpected action from creditors, shareholders and investors, while persuading them of the viability of the restructuring plan. “Be sure to keep all stakeholders and participants in the process as informed as possible. Build trust through transparency and try to understand the situation by looking at it from the other side’s perspective,” says Mr Schmidt. “In most cases, it is in everyone’s interest to work to create a new economically viable structure, so that the debtor stays in business and continues to use the assets to generate cash flow to repay loans. Just keeping assets insured and maintained is a huge expense that can be avoided if the debtor stays in possession.” This dialogue between the different parties involved is expected to increase, going forward, given its impact on business restructuring. However, some professionals advise companies to start by having a clear understanding of their current situation before entering talks with banks, in order to best position themselves for a potential recovery.


Overall, more restructuring activity is expected in the months and years to come, as companies encounter more liquidity issues, says Mr Lewis. “There are numerous companies that lack the financial resources to go on and numerous stalled projects which are going nowhere. This paralysis needs to be broken with entities either being restructured or liquidated, so relevant assets can be transferred to a new owner at the price which makes the business or project viable again.” This increased restructuring activity will likely include more consolidations in order to create large, viable entities that would likely be more resilient to the downturn. This may notably be the case in the financial and real estate sectors, which remain very fragmented. Management teams will also need to implement changes in order to successfully restructure.

 

“The best teams will be the innovative ones, who are exploiting cost-saving opportunities and other operational improvements, while at the same time strengthening balance sheets and conserving cash,” believes Mr Holder. “At the same time, other stakeholders in the business will demand improvements in financial reporting and governance standards.” More regulatory reforms are also expected to take place, providing borrowers and lenders with more localised solutions during their restructuring processes. Those different developments will likely contribute to making restructuring processes quicker and less complex, which is key for companies trying to navigate the downturn.

 

http://www.financierworldwide.com/article.php?id=4733&page=1

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