Restructuring in Saudi Arabia: Imperative or an opportunity?

06 May 2020 Consultancy-me.com

Regardless of which school of economics you belong to, the consensus in the 21st century is that the economic prospects of a country lie primarily in its ability to offer entrepreneurs and business owners an enabling environment to take risks and create jobs. 

In one respect, entrepreneurship is an almost heroic activity and deserves much recognition by society. Similarly, but to a lesser extent, the capital deployment by business owners, or investors, is a necessary and imperative activity for the growth and survival of an economy. 

Saudi Arabia and other countries in the region have developed new legal frameworks to protect the private sector, recognising the need to create wealth by encouraging local businesses and attracting foreign capital. Local companies, entrepreneurs, and international investors should feel safe taking financial risks.

Banks play a fundamental role in the development of the private sector and the economy. Like investors, lenders assess the risk of lending and demand a fee in return. But unlike the return on capital injected by entrepreneurs, investors and shareholders who have all their capital to lose and must wait in line before receiving a dime of profit, lending returns (interest) are naturally lower as they bear significantly lesser risk. Interest payments are senior in the capital structure, they are due on specific dates irrespective of business performance and are very often along with loan principal secured by assets. 

Restructuring in Saudi Arabia: Imperative or an opportunity?

When business is doing well, investors are eager to invest, and banks rush to lend. Good economic times induce complacent behaviours while stakeholders – banks and shareholders – undervalue the risks and drop their guards. Banks tend to extend under-collateralised loans and misprice assets or risks, hungry for fees and eager to further grow their portfolio and market share. Bankers get paid high commissions for originating loans, but never for collecting the loans back.

As soon as the cycle turns the peak, demand for goods drops, margins tighten, firms become under pressure, and repayment of borrowed money becomes at risk. Only then does a company start realising it is in distress, but also, only when a loan payment is missed or delayed, does the bank formally recognise its client is facing serious issues. 

The reality is that businesses rarely go from prosperity to failure in one step. Companies’ boards and the management must work together with banks to recognise early signals of commercial and financial distress. The sooner the company recognises patterns of inefficiencies and disruptions, acknowledging its current or potential underperformance and takes aggressive measures accordingly, the more likely it is to survive the downturn, and grow stronger afterwards.

Management and shareholders must have the courage to look the tiger in eye and embrace the need for a turnaround early, including a drastic change in business or operating model. They must consider pre-emptive disruptive market force and use certain short term and longer-term restructuring and turnaround tools to transform the business from an under-performing company into a potentially top performer. While recognition is the business’ responsibility, banks and advisors have a role to play through their close relationships with decision-makers. 

As such, following the recognition phase, companies must carry out three main restructuring tasks: 

1. Diagnosis

The prerequisite to any such step carries a change or adjustment of stakeholders’ attitude, a resolve to act in good faith for the sake of the company, and a strong focus on one goal; that of saving the company and overcoming the current and upcoming challenges. Egos must be put aside. Management and board of directors must act in full transparency by articulating and confronting the problems. A culture of honesty, empathy should reign in, replacing one of reprimand and blame. 

The diagnosis is built primarily on the identification of (i) internal factors such as working capital mismanagement, underperforming sales, etc. and (ii) external factors such as change in regulations, recession, litigation, new market forces, etc.

An advisor’s most important role in this step is to get the truth about the underlying issues and deal holistically with the complexity of restructuring a business, by asking deep and sometimes embarrassing questions, by determining whether an observed difficulty or problem is cause or effect, by deploying diagnosis tools such as cross-sectional analysis, financial ratios assessment, dashboard cash-flow models, tailored interviews with team leaders, by reviewing internal policies and procedures, by appraising the decision-making processes, and by mapping the business and operating models processes to the existing business capability (capacity, infrastructure, team sizes, governance). The sooner the recognition and diagnosis, even if it is believed to be preventive, the quicker the causes of financial distress are identified. 

2. Design and implementation of solutions

The optimal solutions to the diagnosed problems would typically include a combination of top-down and bottom-up approaches. A top-down approach could include a design of large-scale quarterly objectives such as a costsaving and efficiency program (e.g. cost cutting by 45%), a shift in strategy (e.g. focus on younger customer segment), an adjustment or transformation of the business model (e.g. digitisation of sales, asset light model), a simplification of the operating model (e.g. outsourcing of procurement).

Considering recent changes of the regulatory and taxation landscapes (e.g. Saudi markets opening to global investors, privatisation reforms, VAT implementation, increased labour and energy cost, etc.) such objectives must ensure the company is able to develop economy of scale and compete with global players. A bottom-up approach typically includes highly impactful initiatives such as the layoff of non-performing highly paid staff, or the reverse engineering of sales numbers of a loss-making product, resulting in a required sales target which, if not achievable, would trigger the prompt exclusion of such product. 

What is also required is a balancing act between meeting short-term saving and investing in long-term performance. Cutting staff across a highly performing sales team is suicidal for the business especially if sales targets were not met in the past due to shortage of products. The immediate closure of an under-utilised cash bleeding plant, the sale-lease-back of warehouses, and the focus on working capital enhancement are all short-term wins and great sources of much needed cash in the initial turnaround phase, while the capital investment in the expansion of a profitable product line should be implemented as soon as the funding source is identified. 

As solutions are designed and implemented, the stakeholders must not lose sight of their customer value proposition and should maintain an outward view towards their client base and competitors. External disruptions are far more lethal and inflict permanent damage. 

3. Identification of funding sources

It takes money to sustain operations and time for transformation to take effect. A major challenge is finding resources to keep a business going while it is being transformed and restructured. Raising capital for a company in distress can be difficult, time consuming and expensive. The advisor and the stakeholders would need to race against the clock to find more creative solutions that can come in the form of fixed assets divestiture, aggressive receivable collections, inventory liquidation, or more generally cash cycle optimisation. 

The advisor must identify the excess assets and implement an efficient use of the remaining ones. To the extent such assets were funded by debt, their liquidation is a great relief. As the company progresses in taking corrective measures and achieving planned milestones, the advisor would help showcase the future re-birth of the business to equity investors for new capital injection and/or to banks for existing debt rescheduling or restructuring, renewal of working capital facilities, and potentially new lines of financing.

 “A successful restructuring is a win for everyone: businesses, banks and other creditors.” 
– Firass Hathout, KPMG Saudi Arabia 

Conclusion

A successful restructuring is a win for everyone, and an unorganised collapse and liquidation on the other hand is certainly an outcome the banks wish to avoid at any price. The current and recently enacted bankruptcy law in Saudi Arabia levelled the playing field by offering businesses some protective options and room to work out agreeable restructuring solutions with banks.

An unprecedented collaboration amongst all stakeholders through the formation of restructuring team or committee, comprising of representatives from the company’s management, its shareholders, the banks and the restructuring and turnaround advisors who come with commercial, financial and technical know-how, is of vital importance, starting from the early recognition of distress signals, to the implementation of solutions and finally the rehabilitation or rebirth of the business.

An article by Firass Hathout, Head of Deals Strategy, Structuring and Restructuring Solutions for KPMG in Saudi Arabia and the Levant cluster. This article was previously posted in KPMG’s ‘Kingdom of Saudi Arabia Banking Perspectives 2020’.