Linda Tsarwe Business Correspondent
There has been an unusual interest in distressed companies by some local investors of late. Obviously the first question that comes to mind is what the rationale behind taking such a position is.
These companies are failing to make ends meet and it seems like a matter of time before many of them fold up. Nevertheless, a number of notable transactions have gone through the exchange and it is rumoured that the appetite for such companies remains high.
Given the liquidity challenges embattling the economy, is it of any value to allocate the little capital available to bleeding companies or it is more beneficial to channel the funds towards companies that have better prospects of recovery in the short term.
Investing in distressed companies or its debt is not uncommon overseas. In the United States of America (USA), certain hedge funds invest exclusively in distressed securities. Because of the state of their businesses, shareholders of the distressed company sell off the business at a relatively low value. Investors who buy into such businesses believe that they can turnaround the company and eventually sell it off at a higher value, hence reaping an attractive return. Likewise, because of the near bankrupt state of its issuer, bonds issued by these companies will mostly have been downgraded to junk and trades at low prices and high yields. Investors who buy distressed debt are also of the view that should the company turnaround, the ratings of the bond will improve and the prices will go up as the yield comes off.
However, there is a huge risk that the business might not turnaround and its value will tumble to as low as nothing. Because the downside risk is so high, the required return is as equally high to compensate for this potential loss.
Although this is a popular investment strategy in developed markets, it would be dangerous to assume that the same strategy can work in a country like Zimbabwe.
Firstly, the economic advancement of Zimbabwe and say, the USA, are worlds apart. While USA is the biggest economy in the world, Zimbabwe is way down the ranking order with an economy size that is about a third of what Apple alone makes in revenue per quarter! Implications of these disparities are significant. For example, while bailout for troubled banks are always an option in the USA, Zimbabwe is far from affording the same and in the event of trouble, banks have to hunt for an investor on their own or face a threat of closure.
Comparatively the big economies, though having gone through a phase of reduced growth, seem to be progressing forward while Zimbabwe is facing stunted growth. Indicators such as high debt to GDP ratio and high recurrent expenditure to total budget tell the story of how the country seems to be regressing. As a result key productive sectors have suffered and there has been a spillover effects to supportive sectors of these industries.
Companies such as Willdale are in their current state because of the low activity in construction industry compared to the peak periods in the nineties. Willdale, together with its competitors, is facing a contracted market since most construction projects underway are mainly residential, which are not big enough to support the industry. The situation was worsened by lack of capital at dollarisation, which remains the main impediment for most companies. To date, there has not been any tangible recovery, and shareholders have lost so much value. Regardless, there has been some significant interest in the company of late and turnover year to date amounts to over US$130,000 against about US$36,000 achieved same period in 2013. Art Corporation, another troubled institution, also ran a major deal recently on the exchange where close to US$700,000 in turnover exchanged hands. This translates to approximately 26 percent of its market capitalization. The general assumption is, like in the USA, a turnaround in the company could bring immense benefits to those that invested in the company during its distressed times, when the company was ‘undervalued’. Is that, however, possible given the economic environment? If the downfall of these companies was mainly due to the harsh economic environment, should one be investing in such a company when the economy itself has not changed for the better? Maybe the turnaround time earmarked is long term.
However, it seems that most of these companies do not have the luxury of time and if the macroeconomic environment remains harsh then drastic measures such as shutting down could be implemented.
Furthermore, most of these struggling companies have huge debt overhang, which eats into the little income they generate, through high finance charges. This implies that as long as the debt remains high, and coupled with a difficult economic environment, most of these companies will probably continue to make losses.
Shareholders will therefore lose value as capital becomes eroded. Taking over a company’s shareholding is just a first step, which simply changes the ownership structure of a company and does nothing much for the company operations. The onus will be up to the new shareholders to inject capital into the business which will be used to expunge debt and for working capital and capital expenditure needs. Unfortunately many of these investors are simply concluding their acquisition deals and start demanding returns forgetting that they invested in shells that require capital. A change in shareholders alone does not bring about the anticipated turnaround. In fact, shareholders might have to part with more funds before they can realise any value.
However, we cannot ignore that some of these struggling companies were rundown due to bad management. Even given the capital boost to kick-start production after dollarisation, and also having the advantage of a business model that works in this environment, some still failed to turn a corner and value has been immensely destroyed in the process.
In such a case, an investment into a distressed company might make sense if management is changed. Of course losses incurred over the years begs the need for capital injection into the business, but it is an investment channelled towards a highly possible recovery. Star Africa is one notable current recovery story.
Although there are still other major issues, such as huge debt, which are yet to be addressed, the strides made towards upgrading its sugar plant are a million steps in the right direction. There was also a shakeup in senior management in 2013 and valuable additions to their board. Clearly, the value of the new additions to the team are becoming visible. Although they are not out of the woods yet, they represent a typical case of a distressed company currently on the turnaround.
In a nutshell, the local market does not currently favour investment in distressed companies. Many companies are struggling due to an underperforming economy that is not conducive for business. Unfortunately, there has not been any improvement on the economic front, and it seems as if it is taking a further swing southwards. Lack of liquidity has worsened the crisis and most of these local investors taking an interest in distressed business probably do not have the financial muscle to fund the business over and above just acquiring its equity. Therefore, business performance can only get worse and most of these shareholders are bound to lose. For those that have pegged the turnaround for the long term, it might be unfortunate for them as they get a rude awakening that these companies cannot stretch that long either because of lack of capital or unfriendly economic environment or both.
However, for the few that have business models that work in this environment, but have company specific challenges, then a change of events into the positive is possible given those issues are addressed.
Generally, it is quite a risky and bold move for the investors who are putting their money on such companies, in a market where the solid giants such as Delta are having difficulty in recording growth. But again, fortune favours the brave and whether or not they have played their cards right is something which can only manifest in the future, and probably sooner than expected.
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