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The role of banks in financial restructuring in countries of the former Soviet Union
Journal
of Banking
and Finance
17 (1993)
1059-1072.
North-Holland
The role of banks in financial restructuring in countries of the former Soviet Union Henry N, Schiff~an* Fund, Washington, DC 20431, USA
l~tern~~~onai Monetary
The financial restructuring of enterprises is fundamental to the modernization of the economies of countries of the former Soviet union (FSU). If the models in the West presage the process that will be followed in FSU countries, and with the lack of alternative institutions for intermediation in channeling savings to corporate finance, banks will play a significant role in this process. Enterprise restructuring can proceed even before privatization as conditions evolve with some incentives of a private enterprise economy. As the role of banks changes from distribution of financing under a state plan to one of credit assessment, banks will have access to info~ation concerning enterprises’ financial conditions which will also enhance their ability to perform an investment banking function in restructu~ng. The most signi~cant factor which will enable banks to lead restructurings is their position as the main creditors of large state enterprises, which will enable banks to gain increased authority in determining whether enterprises will be tinancialiy reorganized or will be liquidated in whole or in part. This will also raise the issue of potential undue concentration of economic power. The paper describes a typical restructuring transaction in the West, to determine whether similar transactions could be undertaken by banks in FSU countries, and examines in some detail the elements needed to be successful. Banks in FSU countries, as in the West, can arrange tinancing from different sources to try to ensure that there is an appropriate capital structure that will meet the new projected cash flow of the enterprise. Banks’ activities in enterprise restructuring raise certain concerns for bank supervisors relating to conflicts of interest, asset quality, earnings, and liquidity. Since successful restructuring of enterprises is vital to the process of transition to a market economy, supervisors should ensure that the scarce budgetary resources available for this process are used in an optimal fashion.
Introductjon
The financial restructuring of enterprises is fundamenta1 to the modernization of the economies of countries of the former Soviet Union (herein referred to as ‘FSU countries’). ’ If the models in the West presage the process that will be followed in FSU countries, banks will play a significant Correspondence to: Henry N. Schiffmann, Consultant, Banking Supervision and Regulation Division, Monetary and Exchange Affairs Department, International Monetary Fund, Washington. DC 20431, USA. *The views expressed are those of the author and do not necessarily represent those of the International Monetary Fund. ‘The discussion in this paper is also applicable to other former centrally planned economies in an early stage of financial sector reform. 03?8~266~93/$06.~
0
1993-Elsevier
Science Publishers
B.V. All rights reserved
1040
HA.
Sc~i~~~~,
The role
sf hanks i~~nanc~al restructuring
role in this process. The magnitude of the need for financial resources for companies that are owned by the state means that the government in its capacity of owner of enterprises will play a dominant role in the initial stage of this process. It is unlikely that private sector or foreign finance can meet the immediate needs. Indeed, since macroeconomic stability depends in important part on enterprise restructuring, the government is obliged to address this task as a major priority. Continued losses of large state enterprises compromises a government’s ability to reduce budget deficits and the effect on banks also impairs government’s ability to conduct appropriate monetary policy. With the emphasis in FSU countries on private sector initiative and reduction of the role of the state in the economy, and given the need for intermediation in channeling savings to corporate finance, banks’ activities in this area will be needed.2 In considering restructuring of enterprises, a distinction is sometimes made between financial restructuring and industrial restructuring. Financial restructuring refers essentially to improving the balance sheet of enterprises, usually by markedly changing the ratio between the amount of debt to net worth. In the case of enterprises in FSU countries, significant reduction in trade receivables from other enterprises is also required because of the substantial growth of arrears in inter-enterprise payments. When fnancial restructuring involves investments in debt or equity of an enterprise, the providers of such financing usually will require that there are strong prospects for the debt to be paid when due or that the enterprise will be profitable so that dividends and capital gains will be realized on the enterprise’s stock. For most large state enterprises in FSU countries, significant industrial restructuring is required to give assurances that enterprises will be profitable with their new financial structure, Industrial restructuring involves rationalization of the enterprise so that it will be profitable, and includes such factors as product research, selection and design, production methodology, and marketing. The discussion of bank restructuring of enterprises in this paper encompasses both financial and industrial restructuring of an enterprise, since banks’ commitment of resources to an enterprise will usually require rehabilitation of the basic activities of the enterprise. In focusing on banks, however, the paper emphasizes what banks can do as financial institutions and not on industrial restructuring per se. Microeconomic
Enterprises
background and macroeconomic
in the FSU have a formidable
needs
task in adapting
to the new
‘It is expected that banks will increasingly become privatized, but even before majority ownership is transferred from the state, banks will be expected to act as if they were private enterprises. Indeed, for the new function of banks in credit analysis to be successful, banks will have to exercise objective judgement.
H.N. Scotsman,
The role
ofbanks ~~~nancial restruetur~ng
I061
conditions of a market economy. At present, state owned enterprises are generally characterized by limited response to market challenges, financial losses or minimal gains, excessive borrowing from banks, and accumulated arrears in payments to other enterprises. The tradition of central planning, hierarchical bureaucratic management structures, insulation from foreign competition, distorted relative prices, and limited or nonexistent financial markets are all factors which will have to be overcome in adapting to the new business environment.3 Besides balance at the microeconomic level, successful transition of FSU economies will require macroeconomic balance. Only with such balance can the interplay between demand and supply conditions in a sound structural and institutional setting of a market economy be expected to yield optimal results.4 The search for a viable policy path for the transformation to a market economy has also been considered a sequencing problem among five elements - pricing reform, privatization, de-monopolization of public enterprises, financial stabilization, and external liberalization.5 There is also a complex problem of sequencing of specific reforms in each of these elements. For example, successful financial stabilization and financial sector reform will require early action to restructure banks and their nonfinancial customers, thereby permitting specific reforms in the financial sector to be effective.6 One question is the extent to which enterprise restructuring is synonymous with privatization. The optimal performance of an enterprise can be expected when it is privatized, but much can be done even under state ownership as conditions of the market evolve. While the disciplines and incentives of central planning are being dismantled, they can be replaced with some incentives of the market with less than full privatization.’ Managers can be motivated with financial rewards similar to those in a market economy. In regard to determinants of incentives and efficiency, it has been suggested that competition and regulatory policies tend to have much stronger effects than privatization per se.8 There are many examples of industries with privately owned enterprises which exhibit substantial ineffrciencies caused by government policies such as state subsidies, protectionist trade policies, price controls, and barriers to entry, while state owned enterprises may be efficient if there is strong competition in the product market.
3See Galal (1989, p. 119). ‘See Guitian (1992, p. 13). 5See Oppenheimer (1992, p. %ee Balino and Sundararajan ‘Oppenheimer (1992, p. 48) organization of production is former COMECON countries *See Yarrow (1990, p. 4).
56). (1991, p. 13). indicates that the disappearance of motivational guidelines for the the universal factor which explains the large decline in output of as their systems changed.
Bank attributes for restructuring enterprises
As the owner of enterprises, the government has a major role in determining the future of large enterprises, but banks can be critical agents for change in determining which enterprises will survive and in what form and in improving enterprise performance. Banks can serve as catalysts for rearranging the way in which particular enterprises are managed, by identifying problems and recommending solutions. The government will have to u~t~rnatel~ decide on the di~~o~it~on of state assets, but the decisions in particular cases shoufd be ~n~~e~~~~ by proposals for restrnct~r~ng presented by banks. in three East European countries, Hungary, the former Czech and Sfovak Federal Republic (CSFR), and Poland, the government assigned special responsibilities to banks in the general programs to restructure enterprises in those countries. In I-fungary, the program for recapitalizing banks is linked to the restructuring of enterprises. The government provided guarantees for fifty percent of the nonperforming loans of the three large state owned banks which guarantees become applicable only in liquidation proceedings of enterprises. This requires banks to take a pro active stance to realize the guarantees. Furthermore, the enterprises must obtain approval of their ~~stru~tu~ng phms from the banks. Xn Pofand, the government is recapitalizing the nine banks that resuhed from the partition of the mo~~bank and the banks are then expected to participate in the re~t~~tu~~~ and privatization of enterprises by forgiving some loans and by exchanging Ioans for equity in enterprises. Again, enterprises must submit restructuring plans to banks to obtain this relief. In the former CSFR, the government made funds available for reducing the debt of enterprises whose viability was compromised by the high level of debt and assigned to banks the responsibility for identifying enterprises eligible for debt relief, There is an absence of developed capital markets in FSW countries from which significant sources of financing for restructured enterprises could be expected, as in the West. In the abserme of we~j-fun~t~o~~~~capital markets and a fuilg developed system of property rights and private ownership, asset hofders are assumed to hofd ~~q~jd assets, either domestic-currency denominated in savings accounts or cash, or foreign-currency d~norn~n~~ed.~ This liquidity could be channeled by banks, either for their account or as managed assets, to financing for enterprise restructuring and perhaps provide a more productive outlet for savings than holding of foreign exchange assets or bank deposits. The absence of significant capital markets also means the lack of established capital markets institutions such as investment banks, securities brokers, investment companies, and asset managers. These institutions will %ee Calve and Frenkel(193L
p. 3).
emerge in FSU countries, as they have in East and Central Em~pe.“~ However, because they will be new firms, they may lack credibility to perform new functions of restructuring and banks should have a competitive advantage for this business by virtue of the tradition of banks as financial institutions.” 1 As the role of banks changes from distribution of financing under a state plan to one of credit assessment, banks will have access to information concerning enterprises’ financial condition which will also enhance tkeir ability to perform an ~~v~~~rn~n~ banking function in restructuring. As indicated below, by virtue of having s~bs~an~a~ funds available for investment in restr~eiu~ng trausacti~ns, banks should receive the mandate from enterprises to assist in these activities over newiy established firms whose activities are mainly advisory. Perhaps the most significant factor which will enable banks to lead restructurings is their position as the main creditors of large state enterprises, With increased autonomy of banks in the credit allocation process and with the increasing adoption of bankruptcy laws, banks will gain increased authority in determining whether enterprises will be financially reorganized or will be liquidated in whole or in part. If banks play as significant role in enterprise restructuring as appears may be possible, it will raise the issue of potential undue conccntrat~ou of economic power, In some countries, incl~dj~~ Germany and Japan, banks exercise considerable inflnence over the manag~meni of enterprises, as discussed further below. To the extent that enterprises are greatly dependent upon bank financing, this is an expected result when banks seek to assert their position as creditor to protect that interest. Only in countries which have alternative sources of corporate finance like money and capital markets, or institutions like pension funds and insurance companies, or for companies that are not dependent on external finance because they generate sufficient funds from operations, can this concern be avoided. When there is significant competition among banks and when enterprises have alternative sources of funding, banks may not be as dominant as when there is little competition. However, given the magnitude of the financing required to restructure tke large state enterprises in FSU countries, there may be relatively few banks that are capable of undertaking the larger tra~sactions~ even allowing for syndication among other banks, because the lead bank often dictates the basic terms of the transaction Thus, public policy makers will have to bc mindful of this factor and consider policies to moderate banks’ influence if ‘“Appatently some 400 investment companies were formally registered in the former Czech and Slovak Federal Republic to participate in the voucher system of privatization of enterprises. Banks organized many of these funds and, thus, assumed the investment banking function of asset manager for investment companies. “In FSU countries, particular banks may have a very recent corporate existence, but banks as institutions in the form of the monobank and specialized hanks are recognized.
appropriate. In the United States, bank influence over enterprises has been a concern and banking organizations are therefore limited in the extent to which they can own shares with voting rights in nonfinancial enterprises.‘* A European Community directive also sets limits on aggregate equity investments by banks in enterprises.
Investment banking In the West, institutions known as merchant banks in the UK, investment banks in the US, and universal-type banks in continental Europe have been the leaders in financial restructurings of enterprises.i3 These are banks that are active in the money and capital markets through underwriting and distributing debt and equity securities, dealing in securities for their own account, and managing assets of third parties. Some of these institutions do restructurings largely as an advisory activity, by identifying and creating attractive investment opportunities and then arranging debt and equity financing from various sources - institutional investors like insurance companies and investment funds, commercial banks, and pooled funds of individual investors. The most successful firms in this field are those that can bring substantial financial resources of their own to a transaction. This provides credibility for an investment opportunity that is presented to other investors. Thus, while in FSU countries, nonbank advisory firms with skill in identifying investment opportunities probably will play some role in enterprise restructuring, banks should become the leaders in this area because of the substantial resources that they can invest in a transaction which enables them to speak more authoritatively.14 For example, in a securities offering to finance part of a recapitalization of an enterprise, a bank which underwrites an issue on a firm basis (i.e., it guarantees to the issuer that the securities will be sold and it will buy for its own account any portion of the issue that it is unable to sell to the public) will have a significant advantage over a financial services company that acts merely as a broker and cannot guarantee the full purchase of an issue. The next section briefly describes a typical restructuring transaction in the West, which relates to bank activities that will be required in restructuring of a large state enterprise, to determine whether similar transactions could be ‘ZSuch policy of limiting the significance of bank investment in enterprises is also to make banks impartial arbiters of credit so that banks do not unduly favor enterprises in which they have an equity investment and disfavor competitors of those enterprises. 131n continental Europe, such activity is usually conducted within a separate department or subsidiary company of the universal bank. The activities of these banks in this paper will be described generally as investment banking. 140f course banks will not be able to rest on their laurels and will have to show a track record to continue to be significant players in enterprise restructurings.
undertaken by banks in FSU countries, and following sections examine in more detail the elements needed to be successful in this field. Divestitures
Often in a large conglomerate corporation, which consists of several different types of businesses, the headquarters decides that the continuation of a line of business is no longer sullicientiy profitable to retain or no longer fits in with its new corporate strategy. It therefore is amenable to offers to purchase the unit, which has been a profitable venture. Offers are sometimes made by the managers of the unit, by an investment company. by an investment bank, or by another congiomerate. Prospective investors analyze whether the unit as an individual enterprise will be an attractive investment opportunity, taking into account in particular the expense of financing the purchase. Some of the financing of the purchase will be in the form of shareholder capital, some in the form of debt securities sold in public markets or privately placed with institutional investors, and some will be commercial bank financing. Often the bank financing will be for a shorter term than the debt securities. Thus, if the proposed transaction is sufliciently attractive to prospective investors, they will present an offer to purchase the unit for sale to the selling company. An investment bank wilf usuatiy invest for its own account in some portion of the equity securities and wifl commit to the transaction funds of investors that it manages. As compensation for its services, the investment bank receives a fee from the investors whose funds it manages and expects to receive signilicant income in dividends and capital gains from the equity securities that it purchases. Often at the inception of a transaction, if an investment bank is engaged by the selling company to find a buyer, it receives substantial fees for its analytical and marketing work. fnvestment banking vs. venture capital
In the transaction described, a significant aspect is that the unit fur sale was a viabte enterprise in a relatively stable business environment= In FSW countries, many of the large state enterprises that are to be restructured are unprofitable in commercial terms and face considerabie uncertainty in the new dynamic business climate. Thus, in general, the risk of investing in a restructured enterprise in a FSU country is substantial. In addition to a determination that the cost of financing the purchase of an enterprise is manageable, an evaluation of the commercial feasibility of the enterprise has to be made. This includes an assessment as to whether the products of the enterprise have markets in light of changes, inter alia, in relative prices, loss of assured markets, and foreign competition. In the West, investments in
1066
H.N.
Sc~~~~an,
The de
of banks in ~nancia~
restrueturin~
companies with this degree of risk is known as venture capital. Venture capital investors seek high returns for their investments, on the order of 30% to 40% per annum on their invested capital. Venture capital investors are usually not passive investors. They frequently have a representative on the board of directors of companies in which they invest and maintain close communications with the company.15 They consult with management concerning enterprises’ research and market development activities and financial management, and often provide advice based on their experiences with other companies. ’ 6
Potential for FSU banks to undertake restructurings To assess the technical and commercial feasibility of restructured enterprises in diverse fields requires skills of analysis which most banks in FSU countries probably do not have at the present time. Few investment banks in the West have such skills among their staff either. Investment banks engage consultants for advice on the technical and commercial needs of enterprises in diverse fields and such advice should be available to banks in FSU countries, either within their own countries, as engineering and management consulting firms develop, or from abroad. Thus, from among their existing customers or otherwise, banks should be able to identify enterprises which could be attractive investment opportunities if restructured both technically and financially and propose to the government a project which appears viable. With time, banks in FSU countries should develop expertise in managing equity investments like venture capitalists or banks of certain countries in the West, like in Germany and in Japan, where there has been a tradition of banks’ exerting direct control on enterprises. However, it is suggested that banks in FSU countries can take the lead in enterprise restructurings not because of their tradition of involvement with enterprises, but because they are the best qualified institutions to perform this needed role and are in a position to determine the fate of significant enterprises by virtue of their position as major creditor of enterprises.
Identifying
immediate
Banks can consider
restructuring opportuniti~ beginning
restructuring
of some enterprises
quickly.
By
‘*One rule of thumb of some venture capitalists is to invest only in companies that can be visited within three hours’ travel time. 16At the height of venture capital activities in the mid-1980s, venture capitalists usually invested in companies at an early stage of their development with the objective of selling their investments within live years, as the market price of shares that they held in successful companies would realize its largest probable gains. In the late 1980s and early in this decade, venture capitalists’ investments have included to a large extent investments in leveraged buy-outs involving financial restructuring of relatively mature companies.
getting started with an initial round of financial restructuring, the process of stabilization and structural reform could be smoother and more efftcient than otherwise. Revenues to the government from privatization could also be larger because of the improved liability structure of firms to be privatized. For the medium-term, it will be necessary to initiate complete diagnostic studies of some enterprises, following the completion of major relative price adjustments and key accounting reforms. Such studies may lead to more refined institutional arrangements to deal with industrial restructuring and asset liquidation, often in coordination with arrangements for privatization. Only a slow process of rejections and tough bargaining over an enterprise recovery plan, according to some, will instill the right discipline.” To begin the expedited process, banks can use some basic guidelines to determine which firms should initially be selected for consideration for restructuring. First, enterprises could be classified into those in poor financial condition but which are potentially sound, and those of doubtful viability. In the absence of reliable financial information on enterprises, it is difficult to rely on objective financial indicators alone for such classification. Such indicators, supported by other information on enterprise performance and prospects, would provide some basic guidance for subsequent decisions on tinanciaf restructuring. The basic indicators that can be used are of solvency and prolitabiiity, the latter based on projections, which are more meaningful for the restructuring analysis than past perfo~ance.‘~ Second, for potentially sound enterprises whose creditworthiness is mainly impaired by a weak capital structure - with major consequences both in terms of solvency and profitability - a part of the banks’ claims on such enterprises should be transformed into equity owned by the state, the public at large in a privatization program, or new equity investors, including banks.19 Third, enterprises whose financial condition is basically impaired by other structural weaknesses beyond an inadequate financial structure could be dealt with as part of a medium term industrial restructuring program. Claims of banks could be moved to the state and replaced by government securities carrying market related rates. For banks, this would be equivalent to writing off the loans and partial re~pitalization with government securities.20 “See Bruno (1992, p. 24). ‘%olvency and profitability are interrelated. The influence of profitability on solvency is quite obvious -- losses impair solvency, while profits can contribute to its improvement. Less obvious, the influence of solvency on profitability is also important. A shift within total liabilities towards debt versus equity, or vice versa, will influence profitability since debt involves interest expense while equity does not. “Capital structure can be defined in terms of the ratio of debt to own funds (debt ratio, for short). “Insofar as classification of firms into the unviable category, or subsequent write-off of their loans proves diflicult to accomplish quickly, then a partial debt-to-equity conversion could still be done, pending a full resolution of the problem enterprises.
1068
Mechanisms
H.N. Scbi~man, The role C$banks in ~nancial
restructuring
of control over enterprises
Banks should insist on having board representation in enterprises in which it has its largest investments, This is a means of maintaining close communications with enterprises’ management to keep abreast of developments in the enterprises’ business. The advice of the bank representative may be helpful to the company, for example, in advising of methods for new financing or of optimum ways of receiving payments from customers to maximize cash flow. In the financing agreements that are part of financial restructuring, banks can insist on covenants in loan contracts or in bond indentures that will discipline the financial management of enterprises to help insure that the credit extended will be repaid and that, in general, the enterprise’s sound financial management will lead to profitable performance which will enhance dividend payments and the market price of its equity securities. Such covenants would include, for example, agreements on financial statement ratios: current assets will exceed current liabilities by a certain margin; total borrowing will not exceed a multiple of net worth; current income will exceed debt service expense by a certain margin. Covenants can also include restrictions on sales of assets and on significant expenditures. If these covenants are violated, the bank or bondholders would have the option of declaring the loan or bond in default and it would become immediately due and payable. ” This exerts considerable in~uence on enterprise management to comply with covenants in financing agreements. If enterprises are in default and cannot pay the loan or bond principal that is due, they can be placed in bankruptcy proceedings and possibly liquidated. Thus, financing agreements can create strong incentives for sound enterprise tinancia1 management, independently of privatization. The enterprise managers who face the prospect of loss of their positions if financial covenants are not met should be as sufficiently motivated as those in private companies who are influenced by the prospect of gains on the exercise of stock options. Structure of transactions
The work of a bank in leading a restructuring will be multifaceted. First, it will have to identify a prospective transaction, in many cases from among enterprises for which it provides banking services. Then it will have to study the plan of restructuring, including the industrial restructuring. It will analyze the financial feasibility of the proposed capital structure including the reasonableness of the projections of cash flow regarding items such as sales volume and prices, and expenses for labor, materials, and equipment. It will negotiate with creditors of the enterprise regarding a reduction or “In the West, bondholders are usually bond indentures, which is usually a bank.
represented
by a trustee,
for purposes
of administering
restructuring of the debt or the conversion of debt into equity. It will negotiate with management regarding changes in personnel and management practices and it will have to communicate with representatives of workers councils or labor unions regarding their possible participation in investment in the restructured enterprise and their expectations for wage contracts over the next few years. Finally, it will have to negotiate with the representative of the government responsible for the enterprise regarding the possible infusion of new funds to improve the financial position of the enterprise and important polices for the future of the enterprise from the viewpoint of new investors in several areas - privatization, payment of dividends, and industrial rationalization. Indeed, one of the most difficult matters to be resolved will be a reduction of the size of the enterprise in terms of employees, production facilities, and products. The social safety net policies of the government will be very important in this regard. The financing of projects that require substantial funds probably should not be undertaken by one bank. This is based upon general principles of diversification of assets as well as upon the fact that the needs for different types of financing for an enterprise may be incompatible with the asset and liabihty strategy of the bank. For example, a restructuring project may require a relatively large proportion of equity capital as opposed to bank financing or other debt because of the likelihood of a gestation period before the enterprise is projected to be able to generate income to originally pay significant interest. Banks generally need current income to defray current interest expense and such equity investment would be inconsistent with the need for current income. Other investors, however, like pension funds, may have less need for current income and could invest in the project consistent with their investment strategy. Thus, banks in FSU countries, as in the West, can arrange financing from different sources. They can syndicate loans among other banks for the bank financing component of a transaction, they can approach insurance companies and pension funds for investment in debt and equity securities, they can sell debt and equity securities to the public, they can pool relatively small investments of individual investors in investment companies or mutual funds, they can approach foreign enterprises in related fields and investment companies which wilf invest in FSU countries, and they can approach international financial institutions such as the European Bank for Reconstruction and Development and the International Finance Corporation, Negotiations with other prospective investors will be crucial to the success of a restructuring. The lead bank will try to ensure that there is an appropriate capital structure that will meet the new projected cash flow of the enterprise and to this end will try to arrange, as appropriate, iuvestments in the capital stock (perhaps including the conversion of existing debt), in short or medium term debt, and in long term debt. The contribution of equipment and
1070
H.N. Schi~~un,
The role of banks in ~~an~ial restructuring
proprietary technology from foreign enterprises may also constitute part of the investment package. For these efforts, the bank in its role of investment banker should be compensated with advisory fees and/or stock in the enterprise, in addition to prospective income from the debt and equity investments that it commits to the transaction. Such investment banking income could become an important source of revenue for some banks. Concerns for bank supervisors
Banks’ activities in enterprise restructuring raise certain concerns for bank supervisors. The restructuring of enterprises may determine to an important degree the condition of large banks that inherited a large volume of nonperforming loans of state owned enterprises. Since in assisting in the restructuring of specific enterprises, banks will be improving the quality of claims that they hold against certain enterprises, there is a potential for exploiting conflicts of interest which banks should carefully avoid so as not to impair the integrity of bank involvement in the enterprise restructuring process and the process itself. 22 When banks arrange financing from third parties to finance enterprises against which they hold claims, they should not improve their position at the expense of third partiesz3 Thus, in presenting investment opportunities in a particular enterprise to potential investors, full information concerning banks’ relationships in a transaction should be required to be clearly disclosed. 24 This will enable investors to consider whether the transaction is fair from their point of view or whether they should ask the bank to change the terms of the proposed transaction. Conflicts would arise, for example, when banks sell securities on behalf of an enterprise (or, in the capacity of investment adviser or asset manager, purchase such securities) which enables the enterprise to pay a liability to the bank. In some investment banks in the West, so-called ‘Chinese Walls’ are erected between different functions of the bank to avoid conflicts of interest. The persons who conduct securities trading are insulated from those who work on corporate finance and both are insulated from those who manage asset portfolios so that each separate unit will have no special inside information concerning securities of companies that one of the units is contemplating buying or selling. ‘*Of course some of the banks that inherited a large volume of nonperforming loans will themselves have to be restructured to be able to provide significant financing for enterprise restructuring. See, inter alia, Schiffman (1991) and Sheng (1993). ‘“This would include funds contributed by the government in bank recapitalization and enterprise restructuring schemes like in Hungary and in the former CSFR. Z41n the West, an opinion as to the fairness of the price of a securities issue is sometimes provided by banks for transactions managed by other banks and supervisors should consider the appropriateness of a requirement for a ‘fairness opinion’ by another financial institution or perhaps by an accounting firm regarding the role of a bank in a restructuring transaction.
Since enterprise restructuring will invo’ive participation by various investors, including workers in enterprises being privatized, the precise nature of the investment opportunity being offered should be presented to prospective investors. If there is not yet an applicable companies law or securities law in a particular country which would regulate securities issues under the aegis of a securities commission or other government body, the banking supervisor should ensure that in transactions in which banks play a leading role, prospective investors are presented with an ~~fo~at~on memorandum which contains the traditional informatio~~ for investor protection that is included in the West.25 Without an ~nfo~atiou memoranda, unsophisticated investors may not distinguish between securities of issuers, including investment companies, that are underwritten or distributed by a bank, and the deposit and ather liabilities of the bank, and if the securities diminish in value, it could have a detrimental effect on the liquidity of the bank. Independently of the investment banking activities of banks in enterprise restructuring, there are asset quality, earnings, and liquidity concerns of bank supervisors in relation to restructuring. Since part of the financial structure in a restructuring is equity securities of enterprises, there is a concern that equity securities held by a bank generate income and do not unduly impair liquidity. There should be strict limits on the holding of equity securities which do not pay d~v~dends~since banks need current income to pay interest on deposits rend other interest bearing li~b~ljt~es. Since some investments in restructured enterprises will be in the nature of venture capital7 there is also a concern with asset quality of such investments.‘” While banks may be an important source of equity investment in the new market economies, limits should be placed on the degree to which banks may invest in equity securities.27 Another concern is concentration of assets. Certainly equity investments in and loans to restructured enterprises should be aggregated for purposes of calculating limits on exposure to one enterprise. In addition, supervisors should consider subjecting guarantees extended in favor af enterprises to such limits. fn some FSU countries, there is a tradition of banks providing guarantees for loans by other banks and this may be required to induce banks to participate in syndicated loans to re~~~c~~r~ enterprises. 25Such~~~~~~~~~~~n would inch&e the ~rn~tit~~~ environment for the company, financial statements for at least three years, an analysis by management of recent tinanciai performance, a full description of the rights and relationships among different securities of the enterprise, a statement of whether there are any legal proceedings pending against the company which cauld have a material impact on its financial condition, and a statement of the enterprise’s auditing and dividend policies. 2”In the US, the experience of many venture capital firms has been that of ten investments, approximately two or three result in losses, five or six are mediocre, and one or two are very prolitable. “In ihe European Community, the Second Banking Directive stiputates a an aggregate limit on investments in equity securities of sirty percent of the net worth of a bank.
1072
H.N. Sch~~~~n, The role
ofbanks in~n~nc~ul r~str~eturing
In their assessment of the quality of banks’ management, supervisors should ascertain that banks that are becoming active in enterprise restructuring have staff with adequate skills for the investment banking activities involved. Supervisors should also ensure that in countries which adopt schemes like in East Europe, banks that have responsibility for distributing government funds for debt reduction or for approving restructuring schemes behave in a responsible manner, making decisions on the basis of objective criteria concerning the financial and commercial prospects of enterprises that are beneficiaries of financial assistance in restructuring operations. Successful restructuring of enterprises is vital to the process of transition to a market economy and supervisors should ensure that the scarce budgetary resources available for this process are used in an optimal fashion.
References Balino, T.J.T. and V. Sundararajan, 1991, Banking crises: Cases and issues (International Monetary Fund, Washington, DC). Bruno. M., 1992, Stabilization and reform in Eastern Europe: A preliminary evaluation, International Monetary Fund Working Paper 92/30 (unpublished). Calve. G.A. and J.A. Frenkel, 1991, From centrally-planned to market economies: The road from CPE to PCPE, International Monetary Fund-Working Paper 91/17 (unpublished). Galal, A., 1989, Institutional framework for efficient and sustainable restructuring of state-owned enterprises, Public Enterprise 9 (2). Guitian, M., 1992, The process of transition from central planning (International Monetary Fund, Washington, DC, unpublished). Oppenheimer, P.M., 1992, Economic reform in Russia, National Institute Economic Review, Aug. Schiffman, H.N., 1991, Resolving troubled thrift institutions and bad banks: Lessons for central in: The evolving role of central banks (International banks in developing countries, Monetary Fund, Washington, DC). Sheng, A., 1993, Bank restructuring (World Bank, Washington, DC, forthcoming). Yarrow, G., 1990, Privatization: Issues and problems, prepared for the World Bank Conference on Privatization and Ownership Changes in East and Central Europe, Washington, DC, June (unpublished).
of Banking
and Finance
17 (1993)
1059-1072.
North-Holland
The role of banks in financial restructuring in countries of the former Soviet Union Henry N, Schiff~an* Fund, Washington, DC 20431, USA
l~tern~~~onai Monetary
The financial restructuring of enterprises is fundamental to the modernization of the economies of countries of the former Soviet union (FSU). If the models in the West presage the process that will be followed in FSU countries, and with the lack of alternative institutions for intermediation in channeling savings to corporate finance, banks will play a significant role in this process. Enterprise restructuring can proceed even before privatization as conditions evolve with some incentives of a private enterprise economy. As the role of banks changes from distribution of financing under a state plan to one of credit assessment, banks will have access to info~ation concerning enterprises’ financial conditions which will also enhance their ability to perform an investment banking function in restructu~ng. The most signi~cant factor which will enable banks to lead restructurings is their position as the main creditors of large state enterprises, which will enable banks to gain increased authority in determining whether enterprises will be tinancialiy reorganized or will be liquidated in whole or in part. This will also raise the issue of potential undue concentration of economic power. The paper describes a typical restructuring transaction in the West, to determine whether similar transactions could be undertaken by banks in FSU countries, and examines in some detail the elements needed to be successful. Banks in FSU countries, as in the West, can arrange tinancing from different sources to try to ensure that there is an appropriate capital structure that will meet the new projected cash flow of the enterprise. Banks’ activities in enterprise restructuring raise certain concerns for bank supervisors relating to conflicts of interest, asset quality, earnings, and liquidity. Since successful restructuring of enterprises is vital to the process of transition to a market economy, supervisors should ensure that the scarce budgetary resources available for this process are used in an optimal fashion.
Introductjon
The financial restructuring of enterprises is fundamenta1 to the modernization of the economies of countries of the former Soviet Union (herein referred to as ‘FSU countries’). ’ If the models in the West presage the process that will be followed in FSU countries, banks will play a significant Correspondence to: Henry N. Schiffmann, Consultant, Banking Supervision and Regulation Division, Monetary and Exchange Affairs Department, International Monetary Fund, Washington. DC 20431, USA. *The views expressed are those of the author and do not necessarily represent those of the International Monetary Fund. ‘The discussion in this paper is also applicable to other former centrally planned economies in an early stage of financial sector reform. 03?8~266~93/$06.~
0
1993-Elsevier
Science Publishers
B.V. All rights reserved
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Sc~i~~~~,
The role
sf hanks i~~nanc~al restructuring
role in this process. The magnitude of the need for financial resources for companies that are owned by the state means that the government in its capacity of owner of enterprises will play a dominant role in the initial stage of this process. It is unlikely that private sector or foreign finance can meet the immediate needs. Indeed, since macroeconomic stability depends in important part on enterprise restructuring, the government is obliged to address this task as a major priority. Continued losses of large state enterprises compromises a government’s ability to reduce budget deficits and the effect on banks also impairs government’s ability to conduct appropriate monetary policy. With the emphasis in FSU countries on private sector initiative and reduction of the role of the state in the economy, and given the need for intermediation in channeling savings to corporate finance, banks’ activities in this area will be needed.2 In considering restructuring of enterprises, a distinction is sometimes made between financial restructuring and industrial restructuring. Financial restructuring refers essentially to improving the balance sheet of enterprises, usually by markedly changing the ratio between the amount of debt to net worth. In the case of enterprises in FSU countries, significant reduction in trade receivables from other enterprises is also required because of the substantial growth of arrears in inter-enterprise payments. When fnancial restructuring involves investments in debt or equity of an enterprise, the providers of such financing usually will require that there are strong prospects for the debt to be paid when due or that the enterprise will be profitable so that dividends and capital gains will be realized on the enterprise’s stock. For most large state enterprises in FSU countries, significant industrial restructuring is required to give assurances that enterprises will be profitable with their new financial structure, Industrial restructuring involves rationalization of the enterprise so that it will be profitable, and includes such factors as product research, selection and design, production methodology, and marketing. The discussion of bank restructuring of enterprises in this paper encompasses both financial and industrial restructuring of an enterprise, since banks’ commitment of resources to an enterprise will usually require rehabilitation of the basic activities of the enterprise. In focusing on banks, however, the paper emphasizes what banks can do as financial institutions and not on industrial restructuring per se. Microeconomic
Enterprises
background and macroeconomic
in the FSU have a formidable
needs
task in adapting
to the new
‘It is expected that banks will increasingly become privatized, but even before majority ownership is transferred from the state, banks will be expected to act as if they were private enterprises. Indeed, for the new function of banks in credit analysis to be successful, banks will have to exercise objective judgement.
H.N. Scotsman,
The role
ofbanks ~~~nancial restruetur~ng
I061
conditions of a market economy. At present, state owned enterprises are generally characterized by limited response to market challenges, financial losses or minimal gains, excessive borrowing from banks, and accumulated arrears in payments to other enterprises. The tradition of central planning, hierarchical bureaucratic management structures, insulation from foreign competition, distorted relative prices, and limited or nonexistent financial markets are all factors which will have to be overcome in adapting to the new business environment.3 Besides balance at the microeconomic level, successful transition of FSU economies will require macroeconomic balance. Only with such balance can the interplay between demand and supply conditions in a sound structural and institutional setting of a market economy be expected to yield optimal results.4 The search for a viable policy path for the transformation to a market economy has also been considered a sequencing problem among five elements - pricing reform, privatization, de-monopolization of public enterprises, financial stabilization, and external liberalization.5 There is also a complex problem of sequencing of specific reforms in each of these elements. For example, successful financial stabilization and financial sector reform will require early action to restructure banks and their nonfinancial customers, thereby permitting specific reforms in the financial sector to be effective.6 One question is the extent to which enterprise restructuring is synonymous with privatization. The optimal performance of an enterprise can be expected when it is privatized, but much can be done even under state ownership as conditions of the market evolve. While the disciplines and incentives of central planning are being dismantled, they can be replaced with some incentives of the market with less than full privatization.’ Managers can be motivated with financial rewards similar to those in a market economy. In regard to determinants of incentives and efficiency, it has been suggested that competition and regulatory policies tend to have much stronger effects than privatization per se.8 There are many examples of industries with privately owned enterprises which exhibit substantial ineffrciencies caused by government policies such as state subsidies, protectionist trade policies, price controls, and barriers to entry, while state owned enterprises may be efficient if there is strong competition in the product market.
3See Galal (1989, p. 119). ‘See Guitian (1992, p. 13). 5See Oppenheimer (1992, p. %ee Balino and Sundararajan ‘Oppenheimer (1992, p. 48) organization of production is former COMECON countries *See Yarrow (1990, p. 4).
56). (1991, p. 13). indicates that the disappearance of motivational guidelines for the the universal factor which explains the large decline in output of as their systems changed.
Bank attributes for restructuring enterprises
As the owner of enterprises, the government has a major role in determining the future of large enterprises, but banks can be critical agents for change in determining which enterprises will survive and in what form and in improving enterprise performance. Banks can serve as catalysts for rearranging the way in which particular enterprises are managed, by identifying problems and recommending solutions. The government will have to u~t~rnatel~ decide on the di~~o~it~on of state assets, but the decisions in particular cases shoufd be ~n~~e~~~~ by proposals for restrnct~r~ng presented by banks. in three East European countries, Hungary, the former Czech and Sfovak Federal Republic (CSFR), and Poland, the government assigned special responsibilities to banks in the general programs to restructure enterprises in those countries. In I-fungary, the program for recapitalizing banks is linked to the restructuring of enterprises. The government provided guarantees for fifty percent of the nonperforming loans of the three large state owned banks which guarantees become applicable only in liquidation proceedings of enterprises. This requires banks to take a pro active stance to realize the guarantees. Furthermore, the enterprises must obtain approval of their ~~stru~tu~ng phms from the banks. Xn Pofand, the government is recapitalizing the nine banks that resuhed from the partition of the mo~~bank and the banks are then expected to participate in the re~t~~tu~~~ and privatization of enterprises by forgiving some loans and by exchanging Ioans for equity in enterprises. Again, enterprises must submit restructuring plans to banks to obtain this relief. In the former CSFR, the government made funds available for reducing the debt of enterprises whose viability was compromised by the high level of debt and assigned to banks the responsibility for identifying enterprises eligible for debt relief, There is an absence of developed capital markets in FSW countries from which significant sources of financing for restructured enterprises could be expected, as in the West. In the abserme of we~j-fun~t~o~~~~capital markets and a fuilg developed system of property rights and private ownership, asset hofders are assumed to hofd ~~q~jd assets, either domestic-currency denominated in savings accounts or cash, or foreign-currency d~norn~n~~ed.~ This liquidity could be channeled by banks, either for their account or as managed assets, to financing for enterprise restructuring and perhaps provide a more productive outlet for savings than holding of foreign exchange assets or bank deposits. The absence of significant capital markets also means the lack of established capital markets institutions such as investment banks, securities brokers, investment companies, and asset managers. These institutions will %ee Calve and Frenkel(193L
p. 3).
emerge in FSU countries, as they have in East and Central Em~pe.“~ However, because they will be new firms, they may lack credibility to perform new functions of restructuring and banks should have a competitive advantage for this business by virtue of the tradition of banks as financial institutions.” 1 As the role of banks changes from distribution of financing under a state plan to one of credit assessment, banks will have access to information concerning enterprises’ financial condition which will also enhance tkeir ability to perform an ~~v~~~rn~n~ banking function in restructuring. As indicated below, by virtue of having s~bs~an~a~ funds available for investment in restr~eiu~ng trausacti~ns, banks should receive the mandate from enterprises to assist in these activities over newiy established firms whose activities are mainly advisory. Perhaps the most significant factor which will enable banks to lead restructurings is their position as the main creditors of large state enterprises, With increased autonomy of banks in the credit allocation process and with the increasing adoption of bankruptcy laws, banks will gain increased authority in determining whether enterprises will be financially reorganized or will be liquidated in whole or in part. If banks play as significant role in enterprise restructuring as appears may be possible, it will raise the issue of potential undue conccntrat~ou of economic power, In some countries, incl~dj~~ Germany and Japan, banks exercise considerable inflnence over the manag~meni of enterprises, as discussed further below. To the extent that enterprises are greatly dependent upon bank financing, this is an expected result when banks seek to assert their position as creditor to protect that interest. Only in countries which have alternative sources of corporate finance like money and capital markets, or institutions like pension funds and insurance companies, or for companies that are not dependent on external finance because they generate sufficient funds from operations, can this concern be avoided. When there is significant competition among banks and when enterprises have alternative sources of funding, banks may not be as dominant as when there is little competition. However, given the magnitude of the financing required to restructure tke large state enterprises in FSU countries, there may be relatively few banks that are capable of undertaking the larger tra~sactions~ even allowing for syndication among other banks, because the lead bank often dictates the basic terms of the transaction Thus, public policy makers will have to bc mindful of this factor and consider policies to moderate banks’ influence if ‘“Appatently some 400 investment companies were formally registered in the former Czech and Slovak Federal Republic to participate in the voucher system of privatization of enterprises. Banks organized many of these funds and, thus, assumed the investment banking function of asset manager for investment companies. “In FSU countries, particular banks may have a very recent corporate existence, but banks as institutions in the form of the monobank and specialized hanks are recognized.
appropriate. In the United States, bank influence over enterprises has been a concern and banking organizations are therefore limited in the extent to which they can own shares with voting rights in nonfinancial enterprises.‘* A European Community directive also sets limits on aggregate equity investments by banks in enterprises.
Investment banking In the West, institutions known as merchant banks in the UK, investment banks in the US, and universal-type banks in continental Europe have been the leaders in financial restructurings of enterprises.i3 These are banks that are active in the money and capital markets through underwriting and distributing debt and equity securities, dealing in securities for their own account, and managing assets of third parties. Some of these institutions do restructurings largely as an advisory activity, by identifying and creating attractive investment opportunities and then arranging debt and equity financing from various sources - institutional investors like insurance companies and investment funds, commercial banks, and pooled funds of individual investors. The most successful firms in this field are those that can bring substantial financial resources of their own to a transaction. This provides credibility for an investment opportunity that is presented to other investors. Thus, while in FSU countries, nonbank advisory firms with skill in identifying investment opportunities probably will play some role in enterprise restructuring, banks should become the leaders in this area because of the substantial resources that they can invest in a transaction which enables them to speak more authoritatively.14 For example, in a securities offering to finance part of a recapitalization of an enterprise, a bank which underwrites an issue on a firm basis (i.e., it guarantees to the issuer that the securities will be sold and it will buy for its own account any portion of the issue that it is unable to sell to the public) will have a significant advantage over a financial services company that acts merely as a broker and cannot guarantee the full purchase of an issue. The next section briefly describes a typical restructuring transaction in the West, which relates to bank activities that will be required in restructuring of a large state enterprise, to determine whether similar transactions could be ‘ZSuch policy of limiting the significance of bank investment in enterprises is also to make banks impartial arbiters of credit so that banks do not unduly favor enterprises in which they have an equity investment and disfavor competitors of those enterprises. 131n continental Europe, such activity is usually conducted within a separate department or subsidiary company of the universal bank. The activities of these banks in this paper will be described generally as investment banking. 140f course banks will not be able to rest on their laurels and will have to show a track record to continue to be significant players in enterprise restructurings.
undertaken by banks in FSU countries, and following sections examine in more detail the elements needed to be successful in this field. Divestitures
Often in a large conglomerate corporation, which consists of several different types of businesses, the headquarters decides that the continuation of a line of business is no longer sullicientiy profitable to retain or no longer fits in with its new corporate strategy. It therefore is amenable to offers to purchase the unit, which has been a profitable venture. Offers are sometimes made by the managers of the unit, by an investment company. by an investment bank, or by another congiomerate. Prospective investors analyze whether the unit as an individual enterprise will be an attractive investment opportunity, taking into account in particular the expense of financing the purchase. Some of the financing of the purchase will be in the form of shareholder capital, some in the form of debt securities sold in public markets or privately placed with institutional investors, and some will be commercial bank financing. Often the bank financing will be for a shorter term than the debt securities. Thus, if the proposed transaction is sufliciently attractive to prospective investors, they will present an offer to purchase the unit for sale to the selling company. An investment bank wilf usuatiy invest for its own account in some portion of the equity securities and wifl commit to the transaction funds of investors that it manages. As compensation for its services, the investment bank receives a fee from the investors whose funds it manages and expects to receive signilicant income in dividends and capital gains from the equity securities that it purchases. Often at the inception of a transaction, if an investment bank is engaged by the selling company to find a buyer, it receives substantial fees for its analytical and marketing work. fnvestment banking vs. venture capital
In the transaction described, a significant aspect is that the unit fur sale was a viabte enterprise in a relatively stable business environment= In FSW countries, many of the large state enterprises that are to be restructured are unprofitable in commercial terms and face considerabie uncertainty in the new dynamic business climate. Thus, in general, the risk of investing in a restructured enterprise in a FSU country is substantial. In addition to a determination that the cost of financing the purchase of an enterprise is manageable, an evaluation of the commercial feasibility of the enterprise has to be made. This includes an assessment as to whether the products of the enterprise have markets in light of changes, inter alia, in relative prices, loss of assured markets, and foreign competition. In the West, investments in
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The de
of banks in ~nancia~
restrueturin~
companies with this degree of risk is known as venture capital. Venture capital investors seek high returns for their investments, on the order of 30% to 40% per annum on their invested capital. Venture capital investors are usually not passive investors. They frequently have a representative on the board of directors of companies in which they invest and maintain close communications with the company.15 They consult with management concerning enterprises’ research and market development activities and financial management, and often provide advice based on their experiences with other companies. ’ 6
Potential for FSU banks to undertake restructurings To assess the technical and commercial feasibility of restructured enterprises in diverse fields requires skills of analysis which most banks in FSU countries probably do not have at the present time. Few investment banks in the West have such skills among their staff either. Investment banks engage consultants for advice on the technical and commercial needs of enterprises in diverse fields and such advice should be available to banks in FSU countries, either within their own countries, as engineering and management consulting firms develop, or from abroad. Thus, from among their existing customers or otherwise, banks should be able to identify enterprises which could be attractive investment opportunities if restructured both technically and financially and propose to the government a project which appears viable. With time, banks in FSU countries should develop expertise in managing equity investments like venture capitalists or banks of certain countries in the West, like in Germany and in Japan, where there has been a tradition of banks’ exerting direct control on enterprises. However, it is suggested that banks in FSU countries can take the lead in enterprise restructurings not because of their tradition of involvement with enterprises, but because they are the best qualified institutions to perform this needed role and are in a position to determine the fate of significant enterprises by virtue of their position as major creditor of enterprises.
Identifying
immediate
Banks can consider
restructuring opportuniti~ beginning
restructuring
of some enterprises
quickly.
By
‘*One rule of thumb of some venture capitalists is to invest only in companies that can be visited within three hours’ travel time. 16At the height of venture capital activities in the mid-1980s, venture capitalists usually invested in companies at an early stage of their development with the objective of selling their investments within live years, as the market price of shares that they held in successful companies would realize its largest probable gains. In the late 1980s and early in this decade, venture capitalists’ investments have included to a large extent investments in leveraged buy-outs involving financial restructuring of relatively mature companies.
getting started with an initial round of financial restructuring, the process of stabilization and structural reform could be smoother and more efftcient than otherwise. Revenues to the government from privatization could also be larger because of the improved liability structure of firms to be privatized. For the medium-term, it will be necessary to initiate complete diagnostic studies of some enterprises, following the completion of major relative price adjustments and key accounting reforms. Such studies may lead to more refined institutional arrangements to deal with industrial restructuring and asset liquidation, often in coordination with arrangements for privatization. Only a slow process of rejections and tough bargaining over an enterprise recovery plan, according to some, will instill the right discipline.” To begin the expedited process, banks can use some basic guidelines to determine which firms should initially be selected for consideration for restructuring. First, enterprises could be classified into those in poor financial condition but which are potentially sound, and those of doubtful viability. In the absence of reliable financial information on enterprises, it is difficult to rely on objective financial indicators alone for such classification. Such indicators, supported by other information on enterprise performance and prospects, would provide some basic guidance for subsequent decisions on tinanciaf restructuring. The basic indicators that can be used are of solvency and prolitabiiity, the latter based on projections, which are more meaningful for the restructuring analysis than past perfo~ance.‘~ Second, for potentially sound enterprises whose creditworthiness is mainly impaired by a weak capital structure - with major consequences both in terms of solvency and profitability - a part of the banks’ claims on such enterprises should be transformed into equity owned by the state, the public at large in a privatization program, or new equity investors, including banks.19 Third, enterprises whose financial condition is basically impaired by other structural weaknesses beyond an inadequate financial structure could be dealt with as part of a medium term industrial restructuring program. Claims of banks could be moved to the state and replaced by government securities carrying market related rates. For banks, this would be equivalent to writing off the loans and partial re~pitalization with government securities.20 “See Bruno (1992, p. 24). ‘%olvency and profitability are interrelated. The influence of profitability on solvency is quite obvious -- losses impair solvency, while profits can contribute to its improvement. Less obvious, the influence of solvency on profitability is also important. A shift within total liabilities towards debt versus equity, or vice versa, will influence profitability since debt involves interest expense while equity does not. “Capital structure can be defined in terms of the ratio of debt to own funds (debt ratio, for short). “Insofar as classification of firms into the unviable category, or subsequent write-off of their loans proves diflicult to accomplish quickly, then a partial debt-to-equity conversion could still be done, pending a full resolution of the problem enterprises.
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H.N. Scbi~man, The role C$banks in ~nancial
restructuring
of control over enterprises
Banks should insist on having board representation in enterprises in which it has its largest investments, This is a means of maintaining close communications with enterprises’ management to keep abreast of developments in the enterprises’ business. The advice of the bank representative may be helpful to the company, for example, in advising of methods for new financing or of optimum ways of receiving payments from customers to maximize cash flow. In the financing agreements that are part of financial restructuring, banks can insist on covenants in loan contracts or in bond indentures that will discipline the financial management of enterprises to help insure that the credit extended will be repaid and that, in general, the enterprise’s sound financial management will lead to profitable performance which will enhance dividend payments and the market price of its equity securities. Such covenants would include, for example, agreements on financial statement ratios: current assets will exceed current liabilities by a certain margin; total borrowing will not exceed a multiple of net worth; current income will exceed debt service expense by a certain margin. Covenants can also include restrictions on sales of assets and on significant expenditures. If these covenants are violated, the bank or bondholders would have the option of declaring the loan or bond in default and it would become immediately due and payable. ” This exerts considerable in~uence on enterprise management to comply with covenants in financing agreements. If enterprises are in default and cannot pay the loan or bond principal that is due, they can be placed in bankruptcy proceedings and possibly liquidated. Thus, financing agreements can create strong incentives for sound enterprise tinancia1 management, independently of privatization. The enterprise managers who face the prospect of loss of their positions if financial covenants are not met should be as sufficiently motivated as those in private companies who are influenced by the prospect of gains on the exercise of stock options. Structure of transactions
The work of a bank in leading a restructuring will be multifaceted. First, it will have to identify a prospective transaction, in many cases from among enterprises for which it provides banking services. Then it will have to study the plan of restructuring, including the industrial restructuring. It will analyze the financial feasibility of the proposed capital structure including the reasonableness of the projections of cash flow regarding items such as sales volume and prices, and expenses for labor, materials, and equipment. It will negotiate with creditors of the enterprise regarding a reduction or “In the West, bondholders are usually bond indentures, which is usually a bank.
represented
by a trustee,
for purposes
of administering
restructuring of the debt or the conversion of debt into equity. It will negotiate with management regarding changes in personnel and management practices and it will have to communicate with representatives of workers councils or labor unions regarding their possible participation in investment in the restructured enterprise and their expectations for wage contracts over the next few years. Finally, it will have to negotiate with the representative of the government responsible for the enterprise regarding the possible infusion of new funds to improve the financial position of the enterprise and important polices for the future of the enterprise from the viewpoint of new investors in several areas - privatization, payment of dividends, and industrial rationalization. Indeed, one of the most difficult matters to be resolved will be a reduction of the size of the enterprise in terms of employees, production facilities, and products. The social safety net policies of the government will be very important in this regard. The financing of projects that require substantial funds probably should not be undertaken by one bank. This is based upon general principles of diversification of assets as well as upon the fact that the needs for different types of financing for an enterprise may be incompatible with the asset and liabihty strategy of the bank. For example, a restructuring project may require a relatively large proportion of equity capital as opposed to bank financing or other debt because of the likelihood of a gestation period before the enterprise is projected to be able to generate income to originally pay significant interest. Banks generally need current income to defray current interest expense and such equity investment would be inconsistent with the need for current income. Other investors, however, like pension funds, may have less need for current income and could invest in the project consistent with their investment strategy. Thus, banks in FSU countries, as in the West, can arrange financing from different sources. They can syndicate loans among other banks for the bank financing component of a transaction, they can approach insurance companies and pension funds for investment in debt and equity securities, they can sell debt and equity securities to the public, they can pool relatively small investments of individual investors in investment companies or mutual funds, they can approach foreign enterprises in related fields and investment companies which wilf invest in FSU countries, and they can approach international financial institutions such as the European Bank for Reconstruction and Development and the International Finance Corporation, Negotiations with other prospective investors will be crucial to the success of a restructuring. The lead bank will try to ensure that there is an appropriate capital structure that will meet the new projected cash flow of the enterprise and to this end will try to arrange, as appropriate, iuvestments in the capital stock (perhaps including the conversion of existing debt), in short or medium term debt, and in long term debt. The contribution of equipment and
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The role of banks in ~~an~ial restructuring
proprietary technology from foreign enterprises may also constitute part of the investment package. For these efforts, the bank in its role of investment banker should be compensated with advisory fees and/or stock in the enterprise, in addition to prospective income from the debt and equity investments that it commits to the transaction. Such investment banking income could become an important source of revenue for some banks. Concerns for bank supervisors
Banks’ activities in enterprise restructuring raise certain concerns for bank supervisors. The restructuring of enterprises may determine to an important degree the condition of large banks that inherited a large volume of nonperforming loans of state owned enterprises. Since in assisting in the restructuring of specific enterprises, banks will be improving the quality of claims that they hold against certain enterprises, there is a potential for exploiting conflicts of interest which banks should carefully avoid so as not to impair the integrity of bank involvement in the enterprise restructuring process and the process itself. 22 When banks arrange financing from third parties to finance enterprises against which they hold claims, they should not improve their position at the expense of third partiesz3 Thus, in presenting investment opportunities in a particular enterprise to potential investors, full information concerning banks’ relationships in a transaction should be required to be clearly disclosed. 24 This will enable investors to consider whether the transaction is fair from their point of view or whether they should ask the bank to change the terms of the proposed transaction. Conflicts would arise, for example, when banks sell securities on behalf of an enterprise (or, in the capacity of investment adviser or asset manager, purchase such securities) which enables the enterprise to pay a liability to the bank. In some investment banks in the West, so-called ‘Chinese Walls’ are erected between different functions of the bank to avoid conflicts of interest. The persons who conduct securities trading are insulated from those who work on corporate finance and both are insulated from those who manage asset portfolios so that each separate unit will have no special inside information concerning securities of companies that one of the units is contemplating buying or selling. ‘*Of course some of the banks that inherited a large volume of nonperforming loans will themselves have to be restructured to be able to provide significant financing for enterprise restructuring. See, inter alia, Schiffman (1991) and Sheng (1993). ‘“This would include funds contributed by the government in bank recapitalization and enterprise restructuring schemes like in Hungary and in the former CSFR. Z41n the West, an opinion as to the fairness of the price of a securities issue is sometimes provided by banks for transactions managed by other banks and supervisors should consider the appropriateness of a requirement for a ‘fairness opinion’ by another financial institution or perhaps by an accounting firm regarding the role of a bank in a restructuring transaction.
Since enterprise restructuring will invo’ive participation by various investors, including workers in enterprises being privatized, the precise nature of the investment opportunity being offered should be presented to prospective investors. If there is not yet an applicable companies law or securities law in a particular country which would regulate securities issues under the aegis of a securities commission or other government body, the banking supervisor should ensure that in transactions in which banks play a leading role, prospective investors are presented with an ~~fo~at~on memorandum which contains the traditional informatio~~ for investor protection that is included in the West.25 Without an ~nfo~atiou memoranda, unsophisticated investors may not distinguish between securities of issuers, including investment companies, that are underwritten or distributed by a bank, and the deposit and ather liabilities of the bank, and if the securities diminish in value, it could have a detrimental effect on the liquidity of the bank. Independently of the investment banking activities of banks in enterprise restructuring, there are asset quality, earnings, and liquidity concerns of bank supervisors in relation to restructuring. Since part of the financial structure in a restructuring is equity securities of enterprises, there is a concern that equity securities held by a bank generate income and do not unduly impair liquidity. There should be strict limits on the holding of equity securities which do not pay d~v~dends~since banks need current income to pay interest on deposits rend other interest bearing li~b~ljt~es. Since some investments in restructured enterprises will be in the nature of venture capital7 there is also a concern with asset quality of such investments.‘” While banks may be an important source of equity investment in the new market economies, limits should be placed on the degree to which banks may invest in equity securities.27 Another concern is concentration of assets. Certainly equity investments in and loans to restructured enterprises should be aggregated for purposes of calculating limits on exposure to one enterprise. In addition, supervisors should consider subjecting guarantees extended in favor af enterprises to such limits. fn some FSU countries, there is a tradition of banks providing guarantees for loans by other banks and this may be required to induce banks to participate in syndicated loans to re~~~c~~r~ enterprises. 25Such~~~~~~~~~~~n would inch&e the ~rn~tit~~~ environment for the company, financial statements for at least three years, an analysis by management of recent tinanciai performance, a full description of the rights and relationships among different securities of the enterprise, a statement of whether there are any legal proceedings pending against the company which cauld have a material impact on its financial condition, and a statement of the enterprise’s auditing and dividend policies. 2”In the US, the experience of many venture capital firms has been that of ten investments, approximately two or three result in losses, five or six are mediocre, and one or two are very prolitable. “In ihe European Community, the Second Banking Directive stiputates a an aggregate limit on investments in equity securities of sirty percent of the net worth of a bank.
1072
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ofbanks in~n~nc~ul r~str~eturing
In their assessment of the quality of banks’ management, supervisors should ascertain that banks that are becoming active in enterprise restructuring have staff with adequate skills for the investment banking activities involved. Supervisors should also ensure that in countries which adopt schemes like in East Europe, banks that have responsibility for distributing government funds for debt reduction or for approving restructuring schemes behave in a responsible manner, making decisions on the basis of objective criteria concerning the financial and commercial prospects of enterprises that are beneficiaries of financial assistance in restructuring operations. Successful restructuring of enterprises is vital to the process of transition to a market economy and supervisors should ensure that the scarce budgetary resources available for this process are used in an optimal fashion.
References Balino, T.J.T. and V. Sundararajan, 1991, Banking crises: Cases and issues (International Monetary Fund, Washington, DC). Bruno. M., 1992, Stabilization and reform in Eastern Europe: A preliminary evaluation, International Monetary Fund Working Paper 92/30 (unpublished). Calve. G.A. and J.A. Frenkel, 1991, From centrally-planned to market economies: The road from CPE to PCPE, International Monetary Fund-Working Paper 91/17 (unpublished). Galal, A., 1989, Institutional framework for efficient and sustainable restructuring of state-owned enterprises, Public Enterprise 9 (2). Guitian, M., 1992, The process of transition from central planning (International Monetary Fund, Washington, DC, unpublished). Oppenheimer, P.M., 1992, Economic reform in Russia, National Institute Economic Review, Aug. Schiffman, H.N., 1991, Resolving troubled thrift institutions and bad banks: Lessons for central in: The evolving role of central banks (International banks in developing countries, Monetary Fund, Washington, DC). Sheng, A., 1993, Bank restructuring (World Bank, Washington, DC, forthcoming). Yarrow, G., 1990, Privatization: Issues and problems, prepared for the World Bank Conference on Privatization and Ownership Changes in East and Central Europe, Washington, DC, June (unpublished).