distressed investing in australia from turnaround

8/8/2019 Distressed Investing in Australia From Turnaround

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A guide or buyers and sellers

Distressed Investing in Australia


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About Blake DawsonOur focus is getting to the heart of your legal needs and delivering you commercially astute and practical

solutions. We have a proud history, long standing client relationships, a passion for challenging conventionsand thrive on cutting edge work.

We provide legal services to Australias leading companies and institutions as well as global corporations and

government. We are privileged to work with many of the organisations that are shaping tomorrows industries.

Blake Dawson delivers more than just the law. We value our relationships with our clients and look forward

to working with you.

Our Distressed Investing Practice

Our Distressed Investing practice has an established track record of assisting clients to successfully executethe restructuring, sale or purchase of distressed assets, companies and non-performing loan portfolios.

Our expertise spans all sectors including real estate, energy and resources, manufacturing and financialservices and we cover all geographic areas. We bring together a multi-disciplinary team of leading advisers

from our banking, restructuring and insolvency, corporate, property and tax teams to best structure yourdistressed deals. For further information, please visit our website at www.blakedawson.com

About PricewaterhouseCoopersPricewaterhouseCoopers provides industry-focused Assurance, Tax & Legal and Advisory services

for public and private clients in four areas:

corporate accountability

risk management

structuring and mergers and acquisitions

performance and process improvement

We use our network, experience, industry knowledge and business understanding to build trust

and create value for our clients.

Distressed Debt Group

Over the past decade, PricewaterhouseCoopers Distressed Debt Group has managed more than150 sell-side and buy-side engagements in over 25 countries. Overall the group has acted for more

than 30 international clients, 60 local buyers and various government agencies.

With dedicated staff located in Australia as well as Asia, Europe and Latin America we bring together

global experience with local capability, no matter where the deal is, to ensure a smooth and seamlessexperience. We are also uniquely positioned through our extensive relationships with the pool of global

investors, to ensure any deal is marketed to the widest possible audience of buyers.

The Distressed Debt group is an integral part of PricewaterhouseCoopers Corporate Advisory

and Restructuring practice which has a local presence in over 60 countries in the world.

2009. Blake Dawson and PricewaterhouseCoopers. All rights reserved.

This work is copyright. Reproduction of any part is welcome with prior permission from Blake Dawson and

PricewaterhouseCoopers. Requests and enquiries may be emailed to [email protected] [email protected].

Australian laws and regulations are constantly changing. This publication is intended only to provide a summary ofthe subject matter covered. It does not purport to be comprehensive or to render legal advice. No reader should act

on the basis of any matter contained in this publication without first obtaining specific professional advice. We invite

you to contact us for any further information or assistance.

PricewaterhouseCoopers refers to PricewaterhouseCoopers, a Partnership formed in Australia or, as the context

requires, the PricewaterhouseCoopers global network or other member firms of the network, each of which is aseparate and independent legal entity.


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Foreword Blake Dawson 2

Foreword PricewaterhouseCoopers 3

Overview Distressed investing in Australia 4

1. The who, the how and the why of buying distressed debt/assets 12

Who buys and sells distressed assets, and why? How big is the global market? What is Australias

place in this market, and what do potential investors think of Australia? What is the secondary debtmarket, and how does it operate in Australia and offshore?

2. Portfolio debt sales the key considerations in value 18

What determines the value of a portfolio of an individual credit or a portfolio of distressed debt?What are the key steps in the administration of distressed assets? How do debtholders recover

assets in Australia?

3. Using secured debt to control outcomes and obtain ownership of the assets 28

What are the legal boundaries within which distressed asset investors must move? What are the

rights and responsibilities of secured debtholders? How can debtholders best protect the valueof their assets?

4. Recapitalising distressed listed/unlisted companies 32

How can distressed asset investors recapitalise their assets? What are the differences betweenlisted and unlisted firms? How does the administration regime in Australia provide for companies

to be reorganised?

5. Why should an Australian bank sell debt? 36

If Australian banks have felt no need to sell distressed assets until now, why should they consider

it? Reasons include an increased number of buyers of distressed assets, the increasing drainon management time and focus on workout, the constraints on capital created by Basel II,and liquidity constraints brought on by the global financial crisis.

6. How does a non-performing loan portfolio sale work? 40

What are the steps in selling a non-performing loan, or a portfolio of loans? How are they pricedand how do sellers achieve the best price. What are the mechanics of servicing the portfolio

during and after the sale process? How can sellers best protect their interests?

7. Structuring options for sellers of debt/assets 46

How should banks and other sellers of debt structure their transactions? Options include outright

sale, a joint venture arrangement, or securitisation.

8. Tax implications of selling and buying debt 50

Tax issues are complex both for the buy side and sell side. What features of the Australian tax systemare relevant for distressed asset investment? What tax issues should sellers and buyers take into

account at the planning stage?

Appendix A Economic outlook 62

Appendix B Summary of Australian Big 4 Banks Basel II disclosures 64

Useful websites 66

Contributing authors 68

Contact information Back cover

able o contents


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Foreword Blake Dawson

The emergence and continued growth of a secondary market in Australia for

distressed debts and assets is a sign of the increasing depth and sophistication

of Australias financial markets.

Such a market is beneficial to the Australian economy for at least two key reasons.

Firstly, it adds much needed liquidity into the system, permitting parties with existing

positions to trade out those positions. Secondly, it creates a floor for distressed assets,

meaning that any business that is capable of being restructured is restructured.

Ultimately, by providing opportunities for new investors, the chances of preserving

stakeholder value and continuity of employment in Australian businesses are maximised.

For lenders and investors with existing positions, there is the option of selling

down their positions into the market. For potential investors with a knowledge

of distressed investing techniques, there is the opportunity to invest.

Australia is an attractive place to invest. The rule of law prevails and the legislative and

judicial processes are justifiably held in high regard. A number of the historical legal

impediments to secondary market trading have now been removed and the Australian

market is becoming more comfortable with the distressed investing techniques that arecommon features of other markets; these include loan to own strategies; pre-pack

formal appointments; and convertible note investing. By utilising these techniques,

an investor can look to minimise the risks associated with investing in distressed

companies or their assets.

Of course there still remain issues that lenders and investors must confront. The

Sons of Gwalia decision, for example, has not done much for Australias reputation

in other financial markets where shareholders are expressly excluded from competing

with creditors upon insolvency. These issues aside however, distressed debt and

asset trading is a market not to be ignored. In a time of uncertainty, it presents

significant opportunity for those who have the appetite.

As market leaders in restructuring and distressed investing, we are committed

to shaping this emerging market. For this reason we have partnered with

PricewaterhouseCoopers to produce this guide. Covering the key legal and

accounting issues, we hope this guide will arm you with the requisite knowledge

and understanding to participate in and take advantage of this exciting market.

James Marshall

Partner, Blake Dawson


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Foreword PricewaterhouseCoopers

When one door closes another door opens; but we so often look so long and so

regretfully upon the closed door, that we do not see the ones which open for us

When Alexander Graham Bell wrote this world famous quote it is doubtful that he

had in mind the financial crisis of 2008/09.

The Australian market is today facing a period of uncertainty like it has not facedsince the early 90s. Like then, globally banks today are facing a rapid build up

in non-performing loans and companies are facing unprecedented pressure on

their top and bottom lines. However the market is also a very different one today

to those uncertain days. In todays market there are so many more options open

to both distressed companies as well as lenders.

There exists a very real opportunity for banks to unlock the hidden value tied up in

non-performing loans. From freeing up management time to focus on newer more

pressing problems to releasing capital that needs to be set aside against all NPLs,

debt sales have a very real place in todays market as has been highlighted by the

American, European and Asian markets experience.

This is why, together with Blake Dawson, we have invested in this publication to further

develop the Australian market and to highlight some of the issues around the buying

and selling of distressed debt and assets and thereby encouraging the evolution

of this fledgling market in Australia.

Please read this with the open mind that Alexander Graham Bell advocates and

help us to help you realise this opportunity and in the end maximise recovery

during these uncertain times.

Michael McCreadie

Partner, PricewaterhouseCoopers

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Overview Distressedinvesting in Australia

Australia is really attractive to us...

...says the manager of a billion dollar global fund dedicatedto investing in distressed assets, who was interviewed forthe purposes of this publication.

Worldwide, distressed investment is a

US$50 US$100 billion industry. As theconsequences of the global financial crisis work

their way through the global economy, it is oneof the few areas that is set to grow significantly

in the years to come, as increasing numbers ofcompanies find themselves in difficult financial

circumstances and are unable to meet theirdebt commitments. Distressed M&A in the

US alone is set to grow by 93% this year.

Australia will follow. The boom years have

been good to the lucky country, but the

global downturn has significant implicationsfor Australian companies. Export markets

are stressed and the domestic economicsituation has darkened. Companies are laying

off large numbers of workers, are restructuringto avoid insolvency, and in some cases

are falling into administration.

For distressed asset specialists, Australia is

an extremely attractive market. Heres why:

Opportunities will proliferate as the economic

situation unfolds. The countrys banks are

managing a larger number of underperformingloans than they have seen in 15 years.

Their workout teams are overwhelmed. In alllikelihood, the supply of non-performing loans

from Australian banks will multiply as banksstruggle with the new business conditions

and become increasingly comfortable withthe idea of bundling and selling poorly

performing assets to third parties

The legal and accounting frameworks are

clear and comprehensible, unlike a number

of markets in the Asian region

The business operating environment is well

regulated and stable, with good infrastructureand well developed services

There is a large base of sophisticatedinvestors looking for alternative investment

opportunities in this new and exciting market.

The distressed investing market in Australia

has historically been very quiet. But this is

likely to change, and change rapidly.

Between December 2008 and January 2009,PricewaterhouseCoopers and Blake Dawson

interviewed a number of high profile marketparticipants, including representatives from

Australias major banks, foreign banks active

in the market, fund managers with experiencein distressed asset investing offshore,

and domestic private equity managersconsidering distressed deals.

This overview outlines our conclusions fromthose interviews together with research into

the opportunity for the creation of a secondary

or distressed investing market in Australia.This publication outlines the mechanics ofsuch a market, from the basics of distressed

asset transfer to the structure of such deals,

its legal framework and tax implications.

Understanding how to participate in distressed

investing will be vital in the coming monthsand years for those organisations that wish

to flourish through the downturn.


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Now, we are on the verge of a new market.

A market created by the rapid change ineconomic circumstances, by investment

capital looking for opportunities in anextremely difficult environment, and by

the need for Australian banks and otherfinancial institutions to find solutions

to new problems.

Through a period of 15 years of

uninterrupted growth, Australian lendershave experienced only modest levels of

financial distress amongst their customers.

Financiers in other parts of the world havedeveloped efficient markets for transferring

distressed assets off their balance sheetsto specialist investment funds and other

investors dedicated to the sector. But

their Australian counterparts have beenunder no pressure to do so.

With the global financial crisis rolling

through the Australian economy, financialinstitutions are likely to see a sharp

increase in non-performing loans and

other distressed assets. At the same time,banks revenues are reducing because of

lower demand for credit, and there will begreater pressure from both shareholders

and regulators to hold increased amountsof capital against impaired assets.

Meanwhile, distressed asset funds

operating across international marketsare eyeing Australia carefully. The countrys

well structured financial markets, rigorous

legal frameworks and clear regulatoryenvironment give it a competitive

advantage over its regional neighbours,and a clearly imminent increase in

financial distress is attracting attentionfrom those who seek to extract value

from financially troubled companies.

Global funds with experience in distressed

markets are cashed up and poised onthe sidelines. Over the next few years,

Australia may well see the birth of a

vibrant market for these assets, but itwill take a change in approach on behalf

of the major financial institutions, and afew breakthrough deals to kick start it.

Bad news risingAt the tail end of a 15-year boom, theAustralian economy is facing numerous

challenges. Seemingly overnight, thecredit crunch and the global financial

crisis have brought the countrys longest

unbroken period of growth to a halt.

The years of relatively easy credit that

fuelled the countrys optimism and itsinvestment in the future have ended.

In 2006, companies were offeredunprecedented amounts of leverage

to finance their futures and maintainsmooth cash flows. Much of that

Australian banks have neverreally thought about debt sales.

Tey have never really had to.

Senior manager, major Australian bank

Background

Australia has had little need for a distressed asset marketuntil today. A strong economy for well over a decadehas meant there have been relatively few bankruptcies,non-performing loans on banks books have been wellwithin manageable limits, and investors have had a wealthof positive, growth oriented opportunities to focus on.


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activity came to a stop in the middle

of 2007 as banks faced serious liquiditychallenges in the flow on from the sub-

prime crisis in the US. The early stagesof the credit crunch saw the collapse

of many Australian companies whoserise had been emblematic of the boom:

Allco Finance Group, ABC Learning,

Centro and Babcock & Brown beingthe highest profile casualties to date.

The spread of bad news through thefinancial markets has infected broader

sentiment throughout the economy.Companies, for many years unable

to recruit enough good people fastenough, have been laying workers

off in their thousands. Consumers,a mainstay of Australian prosperity for

over a decade, have stopped shopping.

Despite fast and deep cuts in officialinterest rates by the Reserve Bank of

Australia, industry has stopped investingand the housing market has stalled.

China, whose economic health has beencrucial for Australia, has also faltered in

recent months, its export-led GDP growthstumbling from over 10% over the last

decade to less than 7% at the end of

2008. Chinas unprecedented demandfor commodities placed a floor under

prices for much of Australias inventoryof natural resources, and underwrote

soaring share prices for the countrysblue chip mining companies and a flurry

of investment in small and mediumsized commodity enterprises.

China also directly invested tens ofbillions of dollars in Australian resource

enterprises. Much of this investment is

under pressure to continue to perform.The collapse in Chinas export markets

is rapidly flowing through to the Australian

mining community, and that sector, just

12 months ago the source of a greatdeal of economic strength, is undergoing

swift and unpleasant adjustment.

In short, the credit crisis is having a

significant impact on Australias industriesand enterprises. Many companies with

previously sound business models

have met with unexpected difficultywhen attempting to roll over their short-

term loans, causing sudden and severecash flow issues. Many have had to

quickly and radically adapt their businessoperations. Others have simply failed.

According to the Australian Securitiesand Investments Commission, the number

of companies entering administration inAustralia jumped 10.3% between 2007

and 2008 to 8,300, and the number

of insolvency appointments jumped byover 6% to 12,770.

Bad loans in the systemWith the economy in freefall, banks andother financial institutions are bracing

themselves for a major increase indistressed assets as companies and

consumers find themselves unable to

service the loans taken on in the goodtimes. By the end of the last fiscal year,

the major banks had already seen a risein bad debt charges, up some 174% over

the year to end June 2008. The first half ofcalendar 2008 was 54% higher than the

second half of 2007. By some measuresthe increase in bad debt charges in fiscal

2008 was up 183%, representing 0.41%of total loans. The Australian banking

industry hasnt seen this level of bad

debt charges since 1994, the tail endof the last downturn.


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Our conversations with the major banksindicate that many workout desks arealready eeling the pressure.

DOMESIC CREDI GROWH(ANNUAL % GROWH)

IMPAIRED ASSES AND BAD DEB EXPENSE

Michael McCreadie, PricewaterhouseCoopers

Impaired assets / gross loans & acceptances (left axis)

Bad debt charge / gross loans & acceptances (right axis)

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

Notes: 2006 onwards based on AIFRS

0%

5%

10%

15%

20%

25%

30%

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Total Housing Personal Business

Source: PricewaterhouseCoopers Perspectives: Major Banks Analysis, October 2008

Source: PricewaterhouseCoopers Perspectives: Major Banks Analysis, October 2008


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At the same time, the banks have

witnessed a marked increase inimpaired assets, up by 137% in fiscal

2008, or 0.43% total loans. While thisis still significantly below levels experienced

during the 1990s, the banks are alsoseeing significant increases in past-due

loans. During fiscal 2008, loans that were

past due 90 days or more with adequatesecurity increased 29% in aggregate.

Our discussions with a number ofworkout professionals in the major

banks indicate that many are facingunprecedented workloads. In many banks,

workout desks are perhaps the onlygrowing part of operations, with many

experiencing such growth in demandthey fear being overwhelmed.

While impaired assets and debt charges

are likely to increase significantly, bankmargins will be under pressure from

slowing credit growth on both theconsumer and business lending sides.

Total credit growth slowed in 2008 to10.5% from 16% in 2007, with growth

in business lending slowing to 13.7%in the year to September 2008 from

over 22% the previous year.

This points to a challenging environment

for the major banks, to say the least.

Things are likely to be worse for otherplayers in the financial services arena.

The foreign banks, second tier financialinstitutions, such as smaller banks, credit

unions and building societies, as wellas other non-bank financial institutions

are each facing their own issuesand financial strains.

A fear exists that foreign banks, underpressure to withdraw capital to support

their home markets, will pull out of the

Australian market, transferring theirAustralian loan portfolios, in aggregate

totalling some A$50 billion to A$80 billion,to other counterparties or reducing

funding lines. At the time of publication,

reports were emerging of the first ofsuch activity, with a major foreign bank

offering a portfolio of leveraged loansof up to A$100 million.

In response to the feared pullout of foreignbanks, in January 2009 the Australian

government launched a A$4 billion fund to

support commercial property developmentprojects that lose their international

financial backing due to the financialcrisis. Domestic banks will provide half

the funds capital.

Many second tier banks and other

smaller financial organisations areseeking consolidation or other forms

of partnership with larger institutions.Non-bank financial institutions have been

significantly weakened by the increase in

the cost of funding, as well as the collapsein demand for housing finance with the

fall in house prices.

Each of these issues creates new

pressures on Australias financial systemwhose most marked characteristic over

the past decade has been swift growthand fast innovation.

Distressed assetsA significant volume of distressed debt

is an unfamiliar problem for Australianlenders. Australian financial institutions

have generally adopted a much simplerbusiness model than their counterparts

offshore. While banks and other financiersin the US, Europe and Asia have actively

managed their balance sheets by sellingindividual loans or portfolios of non-

performing loans (NPLs) and otherdistressed assets to realise value and

transfer them off their books, Australian

banks have not done so, resolutelykeeping bad loans on their own books and

focusing on working them out themselves.


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Australian bankers, when interviewed about the lack of a local

market for distressed assets cite several reasons, the mostpersistent of which is that there has been no real need for one.

Australian banks have never really thought about debt sales,said one senior manager at a major Australian bank. There may

be a number of reasons for this. It may be that the structure ofAustralian loans the documentation has precluded trading

them. Secondly, banks may have had the view that they would

be foregoing too much profit were they to transfer their assets.And thirdly, because of their position in the community, banks

would be reluctant to hand their customers over to a distressedasset firm that may not have the same relationship imperative.

Other reasons given include a cultural reluctance to admitmistakes, as well as a focus on workouts as a core banking

competence that precludes the sale of NPLs.

None of these reasons would seem strong enough to dissuade

banks from entering into an active distressed debt market if thevolume of NPLs reached critical mass. As workout desks become

increasingly overwhelmed, as investors begin to offer prices thatreflect the fair value of the loans, banks will be forced to consider

the alternative to keeping all NPLs on their balance sheets.

Capital questionsOver and above the pressure banks are likely to feel fromincreasing volumes of distressed assets, regulators will have a

keen eye on banks management of capital. The introduction ofthe Basel II regulations this year will increase scrutiny of banks

NPL portfolios. There is growing concern among the bankingcommunity that both the banks and the regulators do not

yet appreciate the full impact of the new regulations as levels

of NPLs increase significantly.

Basel II requires banks to set aside up to 25% of the gross

loan value of NPLs as Tier 1 Capital, capital that could be freedup to generate income for the bank in other ways if the NPLs

were sold to another party.

According to one senior banker: If the full impact of Basel II

is applied, there is no way banks can afford to carry NPLs ontheir balance sheets during the tough times. He points out

that the Basel II regulations, if fully imposed, are extremelypro-cyclical, discouraging banks from lending during

downturns, and freeing up capital during boom times.

Te ull impact o Basel II is really unknownas yet as we have not lived through a cyclewith it. I the ull impact is applied, then there

is no way banks can aford to carry NPLs onthe balance sheets during the tough times.

We see a market waitingto come to lie.

Michael Sloan, Blake Dawson

Senior manager, major Australian bank


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Distressed corporatesThe distressed market is not just

confined to the impaired loans ofAustralian banks. Many listed and private

Australian companies and trusts areexperiencing severe liquidity problems

associated with looming refinancing datesand a lack of replacement debt capital.

To date, some larger listed corporates

have managed to reduce gearing and raiseliquidity through cut price raisings on the

equity market which, whilst dilutive, is abetter option than the other alternatives.

However, for private companies and listedcompanies with weak share prices, this

option is generally not available. A numberof off-shore and domestic funds and

lenders are now targeting distressedcorporates and offering them relatively

highly priced debt (usually with a right to

convert to equity upon agreed terms) tofund liquidity gaps. Such funds will also

consider investing equity but will seekassurances around the balance sheet

and matters such as class action risk.

Demand or distressBanks are indeed likely to consider selling

their distressed assets in the near future.At the same time, there is significant

demand for them from both global players

based in Asia and local private equityplayers looking to deploy their funds in

the distressed asset arena. The market inAsia has been active since the late 1990s,

when the number of distressed companiesshot up in the Asian financial crisis. Across

the globe, there are hundreds of entitiesthat invest in distressed assets, from

the major international players out of the

US, such as Cerberus and Lonestar, to

smaller specialist funds, many of whichhave pan-Asian funds that would consider

Australia and New Zealand part oftheir investment universe.

A survey of 100 hedge funds across Asiaby Debtwire in October 2008 found that,

after China and Indonesia, Australia is

the market where most distressed debtopportunities are expected to arise over the

coming year. At the same time, Australiasstrong legal framework and regulatory

environment give potential distressed assetinvestors security in their property rights,

an advantage over the less predictableChinese and Indonesian markets.

There are a number of things we likeabout Australia, says one manager at

an international alternative investment

fund. Firstly as a global fund we likethe language, the law and the corporate

governance framework. At the sametime, because we deal with distressed

assets we can see there are some realproblems brewing in the underlying

economy so we are likely to seesome opportunities arise there.

The country also has a greater levelof sophistication in terms of asset

management networks. We are a capital

provider, and cant service individual loansfrom a pool of them. Rather, we need to

tap into an existing infrastructure to helpus manage our assets, and that exists in

Australia, whereas it doesnt in some ofthe less developed markets in Asia.

A point made by many asset managerswas that, because many funds operate

on a global basis, any investments inAustralia would have to offer risk-adjusted

rates that were competitive with those


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attained in other parts of the world. At themoment, there is an impression that there

is something of a large spread betweenwhat sellers of distressed debt might

offer, and what buyers might pay.

My feeling, says another distressed

asset specialist operating across Asia,

is that the market in Australia is still inprice discovery mode. There is a fairly

large bid-ask differential.

At the same time, asset prices across

the globe have been falling steadily sincemid-2008, and many investors are sitting

on the sidelines waiting to see whena bottom might be found.

The picture is one of a market waiting tocome to life. On the supply side sit the

banks, with a growing pool of distressed

assets that will need to be managed forvalue, but constrained in their ability to

expand workout operations by supply ofexperience. They are also limited in their

capacity to hold NPLs by the need to setaside significant amounts of regulatory

capital against them. On the demand side,there are a large number of funds with

considerable amounts of capital available

ready and willing to invest in these assets.

With a change in approach from Australias

major banks, an adjustment in priceexpectations from both sellers and buyers,

and a detailed understanding of the legaland business issues discussed in the

rest of this publication, we anticipate thecreation and growth of a real market for

distressed investing in Australia over the

next few years. This growth will benefitbanks, investment funds, and, in the end,

companies experiencing financial distressto have an efficient market focused on the

ownership and management of their debt.

Tere are a number o things we like aboutAustralia. Firstly as a global und we like thelanguage, the law and the corporate governanceramework. At the same time, because we dealwith distressed assets we can see there aresome real problems brewing in the underlyingeconomy so we are likely to see someopportunities arise there.

Manager, international alternative investment und


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1. The who, the howand the why ofbuying distresseddebt/assets

The distressed debt market in Asia matured during the late1990s as numerous countries in the region went through aperiod of economic turmoil. The Asian financial crisis threwup many distressed opportunities offering alternativeinvestors above average returns. These opportunities,combined with a flattening of returns in the US/LatinAmerican distressed markets focused investorsattention on the Asian markets.

The initial influx of buyers came primarilyout of the US and included larger players/

funds such as Cerberus and Lonestar,

and finance houses such as GE. Targetacquisitions included large secured NPLportfolios, real estate and large corporate

debt. As the economic crisis worsenedmore opportunities arose across Asia and

especially in countries such as Taiwan,

Japan, Korea, Thailand, Philippines,India, China and Malaysia. With early

deals reportedly generating significantreturns, the market for distressed

debt quickly grew and the numberof players expanded exponentially.

While statistics vary, in todays marketthere is estimated to be hundreds

of investors involved in the distresseddebt market. The major distressed debt

investors have been around since the

early 1980s and have developed uniqueskills and expertise in valuing, buying and

managing distressed debt acquisitions.Initially the majority of distressed debt

investors originated in the US andEurope, but the growth of opportunities

in Asian markets in the last 10 yearshas seen the emergence of numerous

Asian-based buyers focusing solely

on Asian opportunities.

The current global economic turmoil hasseen a number of funds pull out of the

market and others take a very cautious

approach to investing. To quote a commonphrase, no one wants to catch a fallingknife. Our discussions with investors

have indicated that while this was thegeneral consensus in 2008, most expect

to revisit these views in 2009. Also it

would seem that established buyers arelooking to raise new funds and capitalise

on the movement of capital away fromtraditional areas to distressed investing.

The chart on page 36 indicates the extentof raisings by distressed funds over the

past couple of years.

A unique characteristic of the current

economic turmoil is the true global natureof the downturn. Previous downturns have

focused on particular regions and hence

distressed investors focused on particularmarkets. An issue for Asia Pacific sellers

is that due to the state of markets in theUS and Europe, the big global distressed

investors who work with a global pool ofcapital will focus their attention wherever

the best returns can be achieved.Currently this is in Europe and the US.

For the market in distressed debt to grow

in Australia, pricing and returns will haveto be comparable with global valuations.


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How are investors classied?

Distressed investors can generally be classifiedinto the following three categories:

1. Distressed debt unds(Hedge unds, private equity unds)

This category is made up of those buyers that have a

primary focus on distressed debt or assets. Many ofthe early players in the distressed market were funds

established by ex-investment bankers with wealthyclientele looking for above average returns. Historically

these funds have been subject to minimal regulatory

control and have therefore been able to preserve high

levels of confidentiality. In Asia at present there is alarge number of these types of funds ranging in sizefrom the small with more than US$50 million to invest

to the large with over US$1 billion available to invest.

In the current climate these funds are typically looking

for opportunities where they can bring to bear theirfinancial skills, such as restructuring a company to

maximise their returns. Typical investment size acrossAsia is US$10 to 25 million while some of the larger

funds will look at US$100 million plus opportunities.

Return requirements are generally in the 25% plusInternal Rate of Return (IRR) range. While usually

distressed funds prefer to invest on their own rather

than in a joint venture structure, in the current climatestructuring deals including joint ventures are becomingmore popular as a means to mitigate exposure and

enhance value to both the buyer and the seller.

New entrants into the market have been the

traditional Private Equity firms. As the number oftraditional private equity deals have slowed or the

risks and rewards have become relatively unattractive,

alternative forms of investment are being investigated.Traditionally private equity has purchased equity as

a means to assume control; however the distressedinvesting model of using the debt structure to secure

control with added security is becoming increasinglyattractive for those funds that still have cash.

The majority of these funds are offshore, but a numberof new funds are setting up in Australia.

2. Financial institutions(including investment banks,commercial banks and fnancial houses)

Many financial institutions have special situation

groups focusing on distressed debt investing.

Typically these operations form part of the bankand often focus both internally and externally.

For example, a special situations group can help theirparent institution with their own non-performing loans,

can help expand customer bases by purchasing non-performing loans from other financial institutions or

can invest their own funds.

Some of the more consistent investors here include

Morgan Stanley, JP Morgan, UBS, Goldman Sachs,Merrill Lynch, Standard Chartered, Standard Bank,

Deutsche Bank, HSBC, Citibank and GE.

These investors tend to have higher investment size

preferences in the range of US$15 to 20 million plus.

3. Local buyers

Both categories 1. and 2. are generally foreigninvestors, as typically their focus is cross border,

i.e. they will look to invest in multiple countries

within a region.

Given the growth in distressed debt opportunities

in Asia over the last 10 years, a number of localoperators have been established to focus on specific

country based opportunities. A good example ofthese are government supported entities established

to resolve local bank non-performing loan problemssuch as the Asset Management Companies (AMCs)

established in China, Thailand, India and Vietnam.

In Australia a number of local servicing companies

have also looked to purchase NPLs mainly focused

on the consumer credit card space and generallyon a forward flow basis.

Established buyers are looking toraise new unds and capitalise on

the movement o capital away romtraditional areas to distressed investing.


16/7214

Investors ocus on AustraliaThe attractiveness of the Australian market

to distressed investors is highlighted by thechart above 60% of the 100 investors

surveyed throughout Asia had significantor very high potential for distressed debt

opportunities in 2009. The same surveyfound China and Indonesia (the only two

countries rated more highly for distressed

opportunities than Australia) to be thecountries where it is most difficult for

creditors to exercise or enforce their rightsover security or to enforce their rights in

court. As a result, Australia is very much

on investors radars.The added attraction of the Australianmarket is the strength of the regulatory,

legal and governance environments.As one investor mentioned, when we

walk into an Australian court the chances

of us getting subjugated to a lower assetclass is pretty unlikely. In comparison to

other Asian markets, Australias stronglegal and regulatory framework provides

a relatively high level of comfort andsecurity for investors.

ypes o investments

Deal types

Most distressed debt investors

will look at a range of deal types

including the following:

NPL portfolios sold by banks (either

secured or unsecured, although securedportfolios tend to attract more interest)

High yield lending

Equity investments, often coupled

with high yield lending, particularlyin the real estate sector

Equity investments and/or highyield lending, in private companies

or State Owned Enterprises (SOEs)often combined with management

influence (e.g. seats on the board)

Distressed real estate or real estateseized by financial institutions and

subsequently offered for sale

Single credits of distressed debtors

Credit card portfolios or othertypes of receivable portfolios

(such as utility debts)

NPLs or NPL portfolios on

the secondary market.

COUNRIES RAED ON HEIR DISRESSED DEB OPPORUNIIES IN 2009

Source Debtwire: Asia-Pacific Distressed Debt Outlook 2009, December 2008. Survey canvassed 100 hedge fundmanagers and proprietary trading bankers.

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

China

Indonesia

Australia

South Korea

India

Thailand

Vietnam

Philippines

Japan

Malaysia

Taiwan

Hong Kong

New Zealand

Singapore

Percentage of respondents

Significant Very High High Low None

65

49

38

36

25

16

21

17

12

14

9

12

3

8

17

23

22

16

25

27

18

24

21

17

21

20

14

13

8

15

22

31

29

36

41

37

43

43

47

32

54

36

4

11

16

13

17

16

15

17

19

19

18

34

26

28

4

2

2

4

4

5

5

5

5

7

5

2

3

15


17/7215

Assessment approaches

While each of the above investmenttypes will require a different assessment

approach, typically investors will consider

the following issues in relation to eachpotential transaction:

Determining an exit strategy depending on the nature of the

investment, exit strategies mayrange from regular debt repayments,

foreclosure actions, sale of assets orrealisation of equity holdings

Estimating future cashflow what arethe timings and total expected gross

cashflow amounts generated by the

proposed exit strategy, for examplethe timing and amount of forecast debt

repayments or the realisation of assets

Estimating costs to be incurred

in relation to the adopted exit strategysuch as outsourced collection costs or

the cost of establishing a local presence

Agreeing on the desired required return

factoring in the cost of debt/equity andestimated risk to the investment.

Key elements

While each investor has a specificinvestment decision matrix and

a preferred investment type, the

key elements that they all look forin any transaction include:

Reasonable transaction size relative tothe fund size, i.e. the effort to be put

into a deal needs to be justified througha meaningful investment amount.

Typically the average investor is lookingat deal sizes (across Asia) of between

US$10 to 25 million with larger investorslooking to allocate up US$100 million

on a deal by deal basis

Access to reliable and current data withwhich to make the investment decision

Certainty of a transaction taking place,especially in the case of a NPL sale

by a bank

A clear exit strategy including a relatively

predictable t imeframe. In this regardsome investors look for a relatively short

turn around such as less than 1 yearwhile others prefer longer timeframes.

It is not uncommon for distressed debtinvestments to have an average life

of 2 to 4 years

Above average return requirements while return requirements vary between

investors and for each investment type,all distressed investors are looking

for above average returns.


18/72

Traded distressed debt includes secured andunsecured bank debt, trade debts, liquidated

and unliquidated damages claims and otherchoses in action.

The transfer of economic risk associated with a debtmay be achieved either by transferring the debt itself

so that the purchaser of the debt enters into a directrelationship with the debtor or by sub-participation

of the debt in which case the purchaser assumes

the economic risk associated with the debt pursuantto a contractual relationship with the seller only.

Debt transfers are normally carried out by legal

novation or assignment and the mechanism for

transfer is likely to be set out in the relevant loandocumentation. Any such transfer must be carried

out in accordance with the terms of the loandocumentation which may include restrictions on

the minimum amount of debt that can be transferredor the nature of transferees. For instance, it is

common for loan agreements to include provisionsproviding that the debt may only be transferred

to another financial institution.

Sub-participation is more flexible because thedebtor is not party to the arrangement and

has no influence on the terms. For this reason,portfolio sales are likely to be carried out by

sub-participation. Sub-participations can be funded(the purchaser makes payment upfront) or unfunded

(the purchaser indemnifies the vendor in theevent of a payment default).

A funded sub-participant assumes a credit riskon the seller whereas in the case of an unfunded

sub-participation the seller assumes a credit risk

on the purchaser.

Sub-participants are also exposed to increased

cost risk and withholding tax risk as they do notreceive the benefit of the protections under the loan

agreement. Similarly a sub-participant will not be ableto access market disruption provisions.

Where only part of a particular debt is sub-participateda key issue will be how voting rights under the relevant

loan are executed. Generally, the lender of recordwill not be able to split its vote so voting rights will

generally go to the institution with the largest exposuresubject to consultation. However, in some instances

where the lender of record is keen to protect a clientrelationship it may be reluctant to cede voting control

even to a sub-participant of the majority of its debt.

Other important considerations in distressed debttrades are whether the sub-participant has the ability

to force a transfer of the debt to it and whether itreceives an interest in ancillary rights to the debt

(e.g. claims against advisors in respect of reportsprovided to the vendor).

In distressed debt trading a central issue of focus iswhether the purchaser is taking the risk only on the

level of return or on the risk of the validity of the claim.Often the vendor will retain the risk that the claim

is rejected by a liquidator.

The Asian secondary debt markets (including

Australia) have not yet developed their own

standard documentation or terms for distresseddebt trading, but the Asia Pacific Loan Markets

Association is seeking to progress standardiseddocumentation for Australia. For most trades within

these markets, parties typically adapt local par debttrading documents using distressed debt terms

from the US market (Loan Syndication and TradingAssociation (LSTA) terms) or the European market

(the Loan Marketing Association (LMA) distresseddebt trading terms). Standard documentation

available includes risk transfer documentation and

associated documents for carrying out a debttrade such as confidentiality arrangements.

Secondary debt trading terms

16


19/72

Perspective

17

The unique characteristic of the current economic turmoil is the global

nature of the downturn. Major global distressed investors will focus

their attention wherever the best returns can be achieved. Australias

advantage is the strength of our regulatory, legal and governance

environments, which offer security for investors.

Sellers of distressed debt need to know about likely buyers (who

generally fall into three main categories: foreign distressed debt

funds, foreign financial institutions and local buyers), their returnrequirements, their preferred investment types and approaches,

how they make their investment decisions and the key elements

of what they look for in a transaction.

Important considerations for both buyers and sellers are the

secondary debt trading terms and the transfer of economic

risk associated with a debt. Any transfer must be carried out

with the terms of the relevant loan documentation.

The Asia Pacific Loan Markets Association is seeking toprogress standardised documentation or terms for distressed

debt trading for Australia. Currently parties typically adapt local

debt trading documents from the US or the European standard

terms. Standard documentation available includes risk transfer

documentation and associated documents for carrying out a

debt trade such as confidentiality arrangements.

In comparison to other Asian markets,Australias strong legal and regulatoryramework provides a relatively high level

o comort and security or investors.


20/7218

2. Portfolio debt sales the key considerationsin value

The factors that will impact pricing include:

The credit approval process

The quality of the portfolio

The type of sale

The quality of information

The timing of the sale.

The risks posed by each of these factorscan be minimised by ensuring a robust

and transparent process.

The main variables that will be considered

by the buyers include the following:

How much of the individual debt

will be recovered?

How long will it take to collect?

How much will it cost to collect?

What is the risk associated with thedebt recovery process?

The key considerations are summarisedin the diagram below.

How much o the individualdebt will be recovered?The key determinant of value will be

the proportion of the outstanding debtthat can be realistically recovered

from the borrower.

Corporate loansFor corporate loans the first question

is whether or not the loan is secured,and if so, what is the realisable value

of the underlying security. The key issue

here is how current is the appraisal.

Once a floor has been set on the loan

value the next question to be addressedis whether the borrower is likely to seek

to restructure the loan. Issues that needto be taken in to account include:

Are there personal guarantees?

Are there director liability issues?

Who has provided the guarantees?

Is the company still trading?

A BUYER'S KEY CONSIDERAIONS

How much

will I collect

and from

what sources?

When will

I collect?

Servicing

and

Management

Costs

Discounted

for return

requirements

(incorporating

leverage)

Valuation

There are many interlocking factors that will determinethe value for the transfer of a loan portfolio.


21/7219

Addressing each of these questions will

assist in determining if a restructuringor renegotiation of the debt will be

possible. If a restructuring or discountedpay out is not possible then how

much of the loan over and above thesecurity is recoverable? Some of the

issues here include whether there are

guarantees in place, what assets arebehind the guarantors and where are

the guarantors located?

Consumer loansFor consumer loans the questions

are similar:

Are the loans secured, and if so,

what is the realisable value of theunderlying security?

What are the chances of renegotiating

the loans?

What are the chances of recovering

any of the shortfall after realisingthe security?

For unsecured loans what are thechances of recovering any amount

from the borrower?

What is the likely timing of any

liquidation dividend?

To determine the likelihood of recovery,

borrower characteristics such as age,sex, location and employment status

must be assessed. Other factorsinfluencing recoverability will be the

type of loan and what it was used for

and what sort of recovery process hasthe loan been through?

How long will it take to collect?

Any purchaser of debt will factor in thetime value of the investment, and discount

the future payment stream back to present

value. Assumptions regarding the timeit is likely to take to recover the debt will

have significant influence on the overallvaluation. There are a number of factors

that will be key, including:

What restructuring or discounted

payoff is to be put in place,and over what period?

How long will it take to forecloseon a property?

What are the potential impedimentsto enforcing security?

How long is the typical bankruptcy

process for corporates or individuals?

How long does it take to sell assets?

How far through the recovery processis the seller?

Australianinsolvency proceduresThe main steps in each of the majorformal recovery procedures in Australia

are outlined below.

Administration

Voluntary administration is the mostcommon formal corporate rescue process

used in Australia. It is most often initiated

by the directors of the company becausethe appointment of an administrator

will relieve the directors from any riskof personal liability for insolvent trading

in relation to debts incurred followingthe appointment of an administrator.

An administrator can be appointed bythe directors (by resolution), a liquidator

of the company, or the holder of a fully

secured charge over the company.

Te emergence and continued growth o asecondary market or distressed debts andassets is a sign o the increasing depth andsophistication o Australian nancial markets.

James Marshall, Blake Dawson


22/7220

The appointment of an administrator gives

an independent insolvency practitionerthe power to administer and conduct the

companys business. Administrators aregiven wide powers to control and manage

the company, and the directors are notpermitted to exercise any powers except

with the consent of the administrator.

The administration process underAustralian law is driven by the votes of

unsecured creditors at creditor meetings.Courts do not supervise the process

but can adjudicate on issues that ariseupon the application of interested parties,

including the administrators. Whilstin administration, statutory moratoria

prevent proceedings against the companybeing commenced, charges being

enforced against the company (subject

to a 13 day decision period for holdersof full security) or property being recovered

from the possession of the company,except in certain circumstances.

However, there is no moratorium

preventing contractors from terminatingtheir contracts on the basis of an

insolvency event c lause. In many casescontracts will contain default provisions

which allow for termination upon theappointment of an administrator.

The administrator must generally

report to the creditors, in writing,within 30 business days of appointment

specifying the options for the companysfuture. The options are either a deed

of company arrangement, liquidationor return of the company to the control

of the directors. The report will containthe administrators recommendation

as to which option is in thecreditors best interests.

Administrators are given wide powersto control and manage the company,

and the directors are not permittedto exercise any powers except withthe consent o the administrator.


23/7221

Action Timerame

Notice of appointment sent to creditors 5 business days from appointment

First meeting of creditors 8 business days from appointment (omit the first day)

Second meeting of creditors Up to 30 business days from appointment

Adjournment of second meeting of creditors Permitted for up to 45 business days with creditor approval;further extensions possible with court approval

HE KEY SEPS AND IMELINES FOR VOLUNARY ADMINISRAION

Given the extensions which may be made

to the timing of the second meeting ofcreditors, in complex administrations

it may take between 3 and 12 monthsbefore the companys fate is voted upon.

At the second meeting of creditors, thecreditors vote on whether the company

should enter into a deed of companyarrangement, be liquidated, or returned to

the control of the directors (a majority voteis counted in terms of numbers and value).

Significantly, no court approval is required.

If a deed of company arrangement

is entered into, the limited statutory

requirements allow tremendous flexibility.Deeds can be used to implement almost

whatever type of arrangement the situationrequires from a simple compromise of

debts to a complete corporate restructure,a capital raising or a continuation of the

business. Recent reforms have alsoenhanced this flexibility by facilitating

post-restructuring equity raisingand debt financing.

Where the creditors accept a proposal

that the company is to continue to trade,the execution of the deed of company

arrangement marks the end of theadministration. The terms of the deed

replace the statutory moratorium oncompany debts and the arrangement

binds all of the companys creditors,shareholders, directors, the company

and the deed administrator.

Administration andChapter 11 comparedOverseas investors are often interestedto compare Australias voluntary

administration regime with theUnited States Chapter 11 procedure.

The table on page 22 highlights the keysimilarities and differences between

Australias voluntary administration

and the United States Chapter 11regimes, based on the Australian

Governments, Corporations and MarketsAdvisory Committee, Discussion Paper,

Rehabilitating large and complexenterprises in financial difficulties,

September 2003.


24/72


25/7223

ReceivershipFinancers typically require a debtorcompany to provide security, usually a

mortgage debenture, containing a fixedand floating charge. The debenture usually

allows the financier to appoint a receiverto the debtor upon default under the

instrument. A receiver is appointed tothe company for the purposes of realising

company assets to discharge the debt

owing to the secured creditor. Receiversenjoy sweeping powers under both the

debenture and statute, including the powerto take possession of the companys

assets, realise those assets or carryon the business of the company.

The terms of the security govern theappointment. The secured creditor decides

the identity of the receiver and, in doingso, is under no obligation to consult with

the debtor company. Usually the receiver

is a professional insolvency pract itioner.

A receiver owes duties principally to the

secured creditor, not to the debtor or itsunsecured creditors. However, a receiver

is subject to statutory duties in exercisinghis or her powers, including a duty of care

in exercising a power of sale to achieve amarket price. The receiver is also subject

to the supervision of the court and thecorporate regulator, Australian Securities

and Investments Commission (ASIC).

The appointment of a receiver offers

considerable advantages in terms

of immediate control (particularly ofcommencement, which may take only

1 to 2 days), cost and flexibility. However,

it does not create a moratorium onthe initiation or commencement ofproceedings against the debtor.

In a very limited number of casesa court is given the statutory power

to appoint a receiver.

Usually a deed of indemnity is provided

by the secured creditor to the receiver.

The timeframe required for a receivershipto be completed depends on the

complexity of the receivership and thereceivers ability to recover the secured

creditors security. A company canconcurrently be under both administration

and receivership. Creditors with acharge over all or substantially all of

a companys assets can choose to

appoint a receiver over the top of anadministrator. The receiver can then deal

with the secured assets unfettered by theadministration. Accordingly a prospective

purchaser of assets would usually dealwith the receiver, and not the administrator.

Such concurrent appointments (especiallyto large companies) are common.

However, concurrent appointmentscan make balance sheet restructuring

very difficult, given that the focus of

secured creditors is usually the saleof secured assets.

Liquidation

Winding up may be initiated by courtorder (winding up in insolvency) usually

upon a creditors petition, or by thecreditors (creditors voluntary winding up).

A simple creditors voluntary winding uptakes between 6 to 8 weeks and entails

various notices and meetings. A complex

winding up, which may involve recoveryactions being pursued through the courts,

could take considerably longer.

The liquidator winds up the company

and applies the assets to satisfy theliabilities and distributes any surplus to the

shareholders. The directors powers ceaseupon the appointment of the liquidator.

There is a stay on proceedings againstthe company. Liquidators have extensive

forensic recovery powers, can recover

voidable transactions and bringclaims against directors.

Set out on page 24 is a table thatoutlines the liquidation priority regime

for secured creditors for both fixedand floating charge assets.


26/7224

LIQUIDAION PRIORIY REGIME

Realisation o fxed charge assets(e.g. property, plant, equipmentand goodwill)

Realisation o oating charge assets(e.g. stock, work in progress and debtors)

Priority waterfall Priority waterfall

Costs of realising fixed charge assets Costs of realising floating charge assets

Secured creditor debts Employee entitlements

Employee entitlements Secured creditor debts

Unsecured creditors Unsecured creditors

Shareholders Shareholders

Recovering debts romindividuals: Bankruptcyand sale under amortgage/oreclosureAn issue that frequently arises for portfoliosales of non-performing loans concerns

the ability to enforce against individualsreal property. The relevant timeframes

and operation of personal foreclosureand bankruptcy laws can be relevant

to considerations.

A lenders power of sale is heavily

regulated. Generally, a lender can enforceits power of sale over mortgaged property

1 month after the borrowers default. The

timeframe and procedures are lengthy andcomplex and they vary from State to State.

If a lender fails to recover all of its fundsfrom the sale of property, the lender

has recourse to the borrower for the

outstanding amount. This is the mostimportant distinction between Australian

real property mortgages and those ofthe United States.

To realise this amount, the lender can usethe bankruptcy procedure. This can be

quick and effective if the borrower, anxiousto avoid bankruptcy, finds funds to pay

the outstanding amount within 21 days(see page 25). However, the process

can take months if the bankruptcy runs

its course, especially if the borrowercontests the bankruptcy notice.


27/7225

BANKRUPCY IMEFRAME

Action Timerame

Creditor issues bankruptcy notice,

demanding payment

First step

If person ignores notice a creditors

petition for bankruptcy can be made

At least 21 days after the bankruptcy

notice

In all cases there is an applicationto court for a creditors petition

for bankruptcy

Within 7-14 days of the expiry ofthe bankruptcy notice, but not more

than 6 months

Court determines application (ifsuccessful, court sequesters bankrupts

assets and appoints a Trustee)

Within 4 to 8 weeks of application

Trustee notifies creditors ofthe bankruptcy

After 42 days of Trustees appointment

Trustees report to creditors on likelihoodof receiving dividends

After 3 months of Trustees appointment

Trustee may pay dividends, interim

and final

Usually after 3 months

of Trustees appointment

How much will it cost to collect?

Bankruptcy

The costs of collecting the debts caninclude a wide range of costs which willneed to be factored in to any valuation

calculation. Investors will typically factorin any of the following costs:

The cost of servicing the portfolio.This will usually be provided by a third

party servicing company. There area number of such organisations in

Australia, primarily set up to service theconsumer debt market, however some

also have corporate capabilities

Administration costs of the purchaser

Tax costs which will typically need to

take into account corporate profitstax and withholding tax on repatriating

profits if the investor is offshore.Corporate profits tax is generally around

30%, whereas interest withholding tax

in Australia is generally around 10%

Other specific costs such as legal

costs, auction costs, commissioncosts and stamp duty costs.

Recapitalising a distressed companycan be achieved either inormally orthrough a ormal insolvency procedure.


28/7226

What is the risk associated with the purchase?

There are many factors that may be taken intoaccount when determining the discount rate to be

applied to the net present value of the future cashflow. One approach is to apply a formula and calculate

the weighted average cost of capital. This takes intoaccount such variables as the risk free rate, country

risk premium, debt to equity ratio, cost of debtand the effective tax rate.

Any calculation however will need to be comparedto the investors desired internal rate of return for

distressed investments, whether they be portfoliosor single credits. A common theme that many of

the larger investors have expressed is that they areworking in a global environment and they are therefore

competing against returns in deals in Europe andthe US. If they can get similar or better returns on

deals in other markets, then it is hard to get thesepast credit committees. As such most investors have

indicated they are working on internal rates of returns

in excess of 20 25%. For more information onusing secured convertible notes see page 34.

Sons o Gwalia risk shareholders as unsecured creditorsThe Australian High Court case of Sons of Gwalia v Margaretic(Sons of Gwaliadecision) confirmed

that shareholders in publicly listed companies may prove as unsecured creditors in the administrationor liquidation of the company in respect of a successfully established claim for misleading and

deceptive conduct or non-compliance with the continuous disclosure regime by the company

prior to its insolvency. Such claims are generally founded on a companys failure to discloseits true financial state to the market.

The circumstances in which a shareholder will be able to establish a claim are limited, both in relationto the factual and legal circumstances. For example, there will usually be practical difficulties in

establishing such claims, particularly in proving the elements of reliance on the alleged misleadingand deceptive conduct and causation (there is no fraud on the market in Australia).

While these shareholder claims may be difficult to establish, the existence of such potential claims mustbe considered in valuing distressed debt since such claims may dilute the value of the unsecured debt.

Following the Sons of Gwaliadecision the Australian Federal Government commissionedthe Corporations and Markets Advisory Committee (CAMAC) to examine whether the law

should be changed. CAMAC released its report on 29 January 2009.

While its members were not in complete agreement, CAMAC recommended that legislative reform

was not required to overturn the Sons of Gwaliadecision or to postpone, cap or prohibit aggrievedshareholder claims. CAMAC considered that any move to limit the rights of recourse of aggrievedshareholders where a company is financially distressed could be seen as undermining apparent

legislative aims to provide shareholders with direct rights of action in respect of corporate misconduct.

The Australian Federal Government is considering CAMACs recommendations. Legislative reform

would be required to reverse or limit the effect of the Sons of Gwaliadecision and it is unlikely that theAustralian Federal Government will make any decision on this issue for quite awhile. Until there is any

legislative reform, shareholders will be able to make claims against an insolvent company based on thefact that they were misled into buying shares in the company and will be treated as unsecured creditors

in respect of those claims.

If investors acquire secured debt or invest in distressed companies using secured convertible notes,

this risk can be avoided.


29/72

Perspective

27

Large oreign investors haveindicated they are workingon internal rates o returns

in excess o 20 25%.

The first step is assessing the value of the distressed debt.

Sellers of distressed debt need to be aware of the factors which determine

the value of the loan portfolio and the buyers key considerations. Pricing

depends on various factors including the credit approval process, the

quality of the portfolio, the type of sale, the timing of the sale, and the risks.

Buyers will consider the type of loans, whether they are corporate or

consumer, how much of the individual debt can be recovered, whetherthe debt is secured or unsecured, how long it will take to collect, how

much this will cost and the risks associated with the debt recovery process.

Buyers need to be aware of Australian corporate insolvency procedures,

the differences between voluntary administration, receivership and

liquidation, as well as bankruptcy procedures for individuals. The key

steps, timeframes, costs of each process, as well as the extent of power

to administer and conduct a companys business are crucial considerations.

Assessing the risks associated with the purchase is a major consideration.To determine the discount rate to be applied to the net present value of

future cash flow, one approach is to calculate the weighted average cost

of capital taking into account variables such as risk free rate, country risk

premium, debt to equity ratio, cost of debt and the effective tax rate.

In valuing distressed debt of a company, buyers also need to be aware of

the effect of the Australian High Court case of Sons of Gwalia v Margaretic,

discussed on page 26.


30/7228

3. Using secured debtto control outcomesand obtain ownershipof the assets

Thus, a secured creditor can opt out

of the voluntary administration process

and enforce its security. If the securedcreditor fails to take this step within the

13 days it will be unable to enforce itssecurity during the period of the voluntary

administration; however a practice hasdeveloped whereby administrators extend

this period in order to encourage securedcreditors to support their appointment.

In the case of a secured creditor whoseentitlement does not extend to the whole

or substantially the whole of the companysproperty, then that secured creditor will

be unable to appoint a receiver withoutthe administrators or the courts consent.

In these circumstances, the securedcreditor becomes subject to the actions

of the voluntary administrator during thecourse of the administration. An exception

to this rule arises if the secured creditor

takes steps to enforce its charge beforethe appointment of an administrator.

This enforcement power may, however,be restricted by the court on an

application by the administrator.

A secured creditor who is entitled to enforce a charge over thewhole, or substantially the whole of a companys property haswide powers of enforcement especially in relation to companiesthat may also be in administration. Such a secured creditorcan elect to appoint a receiver over the secured propertyeven during the first 13 days of an administration.


31/7229

Voting abilityIn a receivership, the receiver realises

assets for the benefit of the securedcreditor and there is no process for

unsecured creditors to vote. Thereforeunsecured creditors have limited formal

input into or influence over a receivership.

In a voluntary administration, the future

of the company is decided by a vote of

creditors. Resolutions are passed by amajority in number and value. If there

is a deadlock, the chairman of themeeting (the administrator) has a casting

vote. The casting vote may (but will

not always) be exercised in accordancewith the vote of the majority of the valueof the creditor pool. Thus, a party that

controls more than 50% of the liabilitiesof a company in administration, both

in value and number, may have control

of the outcome of voting and therebycontrol the companys destiny. Employees

typically form the majority of creditors innumber and thus are an influential voting

block. Secured creditors can vote in fullwithout valuing their security.

Duties afecting the powero sale section 420AA receiver exercising a financiers power

of sale over secured property must takereasonable care to sell the property at

no less than its market value, or if no

market value can be ascertained, at thebest price available in the circumstances.

This duty arises under section 420A ofthe Corporations Act 2001 (Cth). A similar

duty arises under common law.

These duties of care aim to ensure that

receivers do not sell assets at a discount

simply to recover secured debt quicklyand cheaply at the expense of both thesecured creditor and other creditors.

Generally, in order to fulfil these obligations

a receiver will pursue a structured andpublic sales process, including:

advertising the assets and requestingexpressions of interest

undertaking due diligence

organising tender bids

deciding on preferred bidder

selling to preferred bidder.

There is no equivalent to section 420Afor voluntary administrators, however,

the administrator has a duty to act inthe best interests of creditors and this

includes realising market value for assetssold. In certain circumstances it may be

necessary to sell a business very quickly

during an administration to preservegoodwill and avoid the termination of

contracts. While an administrator in sellingassets does not need formal creditors'

approval, usually creditors' views areconsidered before a sale is effected.

A receiver exercising a nanciers powero sale over secured property must take

reasonable care to sell the propertyat no less than its market value.


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Prepack appointmentsA pre-pack appointment occurs in

a receivership or an administration whenthe sale of an insolvent company, or its

assets, is negotiated by stakeholders(including creditors, shareholders, key

customers and key trade suppliers)and agreed before the formal

procedure is commenced.

The key advantage of a pre-pack is tomaximise the chances of a rescue for

the company while it remains a goingconcern without the loss of goodwill

usually associated with an unplanned

insolvency announcement. Pre-packsare commonly used on companies withcontract or service based businesses.

The process begins with negotiating thepre-pack arrangement. Once agreement

is reached, an administrator (or receiver)

is appointed, and the pre-ordained saleof the company or its assets is executed

expeditiously. Because the pre-packsale occurs without the business or

its assets being offered on the openmarket, the sale could be impugned as a

breach of the administrators or receivers

duty of care in selling the company orassets (discussed above). To avoid this,

administrators are required to showthat due enquiries were made regarding

the real value of the asset or businessduring the pre-pack process before the

administration, and that the sale continuesto be reasonable and in the best interests

of creditors after administration begins.

There have been few pre-pack

administrations and receiverships to datein Australia. This is due to the difficulties of

managing stakeholders and the concernsabout the duty of the administrator or

receiver in the sales processes. Althoughthis concern is legitimate, the pre-pack

sales exist to maximise the value of the

business and its assets and avoid theloss of goodwill often associated with

unplanned insolvencies.

Control strategiesA party looking to invest in a distressed

company or its assets will often seek toacquire secured debt in the company as

a first step to gain control and then drivethrough a sale or recapitalisation.


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Perspective

31

An important consideration for buyers when assessing a distressed asset is

to assess how much debt is secured because secured debt can be used to

control outcomes and obtain ownership of assets.

A secured creditor who is entitled to enforce a charge over the whole,

or substantially the whole, of a companys property has wide powers

of enforcement especially in relation to companies which may also be

in administration.

A control strategy for buyers is to acquire the secured debt and

drive through the sale or recapitalisation.

Buyers need to be aware of the duties placed on a receiver by the

Corporations Act 2001 and common law when exercising a financiers power

of sale over secured property to take reasonable care to sell the property

at no less than its market value, or the best price in the circumstances.

If a buyers strategy is to preserve value in a distressed company such as a

contract or service based business, one strategy is to enter into a pre-packarrangement, to maximise the value of the business and its assets and avoid

loss of goodwill, associated with unplanned insolvencies.

A party looking to invest in a distressedcompany or its assets will oen seek toacquire secured debt in the company asa rst step to gain control and then drive

through a sale or recapitalisation.


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4. Recapitalising distressedlisted/unlisted companies

These advantages include:

Tax advantages Asset sales can attract

significant stamp duty (although stampduties on business assets other than

land are progressively being phasedout in Australia)

Investors can retain companyspecific benefits such as the existing

infrastructure of a companys operations,including contracts and employees.

Recapitalising a distressed company can

be achieved either informally or through aformal insolvency procedure. A distressed,

though solvent, company and itslenders may decide that the company

can return to health despite its currentdifficulties with debt.

Privately-held companies can berecapitalised with relative ease. With

supportive lenders and shareholders,substantial new equity can be injected

quickly and with minimal publicity.

It may even be possible to recapitalise

a distressed company without thesupport of its existing shareholders.

Publicly listed companies face more

complex challenges, although it is equallypossible to recapitalise a distressed

listed company quickly.

The ASX Listing Rules generally limit theamount of equity that can be placed

to an investor without shareholderapproval to 15% in any 12-month period.

Australian takeover laws prevent aninvestor from subscribing more than

20% of voting shares in a companywithout shareholder approval. A significant

feature of shareholder approvals of this

nature is that an experts report as to theproposals fairness and reasonableness

is generally required, adding to thecost and complexity of the proposal.

Obtaining shareholder approval (andan experts report if one is required)

can result in considerable delay in thedistressed company getting access to new

funds, which it may not be able to afford.

However, there are various exceptionsto the shareholder approval requirement

that can be used to facilitate arecapitalisation quickly. In particular,

exceptions to both the 15% ListingRule limit and the 20% takeovers law

restriction are available for pro-rata rightsissues (including underwritten rights

issues) to shareholders. In addition,waivers from the general 15% rule can

be sought from ASX to facilitate rights

issues on an accelerated basis, whichcombine advantages to the company

of an accelerated institutional offer (quickaccess to funds) with the advantages

to retail shareholders of a rights issue(minimising dilution through participation

in the recapitalisation).

In some cases, recapitalising a distressed company canhave significant advantages over an asset sale.


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By way of example, suppose an investor

wishes to participate in a recapitalisationof a listed company in desperate need

of funds. The company could make aplacement to the investor of up to 15%

of the companys capital. The companycould then announce an accelerated

rights issue, underwritten by the investor.

Properly structured, the proposal wouldenable the company to access the funds

from the placement and the institutionalcomponent of the rights issue almost

immediately, and enable the investor toacquire a significant stake in the company

through the placement and by taking up

its entitlements and any shortfall under therights issue without the timing constraints,

cost and uncertainty associated withseeking shareholder approval for the

recapitalisation proposal.

In general, the techniques available to

listed companies are also available tomanaged investment schemes, such

as real estate investment trusts andinfrastructure vehicles, although additional

considerations arise due to their uniquestructure. In particular, amendments

to the entitys constitution may be

required to facilitate a recapitalisation.

Listed companies are also subject to

continuous disclosure obligations underthe Corporations Actand the ASX Listing

Rules, which in broad terms require themto immediately disclose information that

would be expected to have a materialeffect on price or value to the market as

soon as the company becomes awareof that information.

Any recapitalisation proposal will become

public as soon as it is agreed (or perhapseven during negotiation). This can

increase the likelihood of a competingproposal emerging, thereby placing the

investors proposal at risk, particularlywhere the proposal remains conditional

on announcement (for example, it is

conditional on shareholder approval).

distressed investing in australia from turnaround

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