Patrick Honohan: Reflections on corporate restructuring in Ireland
Address by Mr Patrick Honohan, Governor of the Central Bank of Ireland, to the Corporate
Restructuring Summit, Dublin, 27 September 2012.
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It would be an understatement to say that corporate restructuring is a topical issue for Ireland
these days, though it is worth remembering that a dynamic economy entails a continuous
process of corporate restructuring and not just in bad times. In normal times firms adapt in
part through internal reorganisations, including product and process innovation. But the
individual firm does not always have what it takes to reinvent itself in response to major
changes in technology and competition, and then its survival is subject to takeover, merger,
or, in the case it is unable to pay its debts as they fall due, to various forms of asset or
liability restructuring.
The need for corporate restructuring in Ireland today
Right now, though, an extraordinarily large number of firms in Ireland have been
experiencing financial distress typically as a result of the deep domestic and (less deep but
equally protracted) international downturn in demand, or because of their unwise property
investments. An extended period of intensive corporate restructuring has begun. This is most
conspicuous for the big property development companies, but there are many others.
Much of this restructuring has so far come through firm exit altogether. CSO surveys
covering about half of the economy, and most of the non-agricultural business sector, throw
some quantitative light on what's been happening (Table 1). The number of firms counted by
the CSO in the census of Industrial Enterprises fell from about 5600 to under 4800 between
2008 and 2010, the worst period of the crisis and the latest for which data is available.
Almost no subsector was spared. This proportionate decline, of over 14% in numbers of
industrial firms, is not too far from the decline in aggregate employment in that sector (17%).
The story is broadly similar in Construction and in Services, especially if one excludes the
large number of very small firms in these sectors. Indeed, the number of construction firms
employing more than 20 persons has almost halved, with their employment falling by almost
two-thirds.
Broadly speaking, the relatively small change in the average employment per firm seen in the
data suggests that the downturn has not favoured large firms over small, and also that the
employment decline has been driven more by firm closure than by partial lay-offs.
Even after such a big shakeout, many of the remaining firms are in a weakened financial
condition, and may need balance sheet as well as organisational restructuring in order to
survive and prosper. Recent research1 at the Central Bank has confirmed that stressed
balance sheets are clear early warning signs of subsequent loan default. But the research
also indicates that some well-run firms can ride these problems out, notably if they are being
run by an experienced owner that has been with the firm through other ups and downs.
Many balance sheets are stressed because of unwise property investments made on the
side of a viable non-property business. Restructuring these balance sheets without losing the
true value of the resources, human, technological and physical, that are now engaged in
each firm's core business, is a key challenge for corporate restructuring in Ireland today.
Overall, this is a challenge that will absorb the efforts of banks, law firms, and - that most
elusive of professions, well-represented here today - workout specialists.
The modern economy is driven by firms: they generate the bulk of employment, and the
output that supports the wages and salaries, as well as feeding directly and indirectly into the
tax revenue needed to support the social and economic infrastructure that underpins all of
economic activity. Healthy firms are a prerequisite for a growing economy that creates jobs.
Too many of even the surviving Irish firms have not yet recovered from the crash and need
restructuring.
Corporate failures in the last big downturn in Ireland
Restructuring of distressed companies is not a new phenomenon in Ireland or anywhere
else. Reflecting on Ireland's experience with corporate financial distress over the years,
many resonant names come to mind. Companies fail in good times as well as bad times, but
it is the downturns that see the vast bulk of corporate restructuring business. The last big
downturn in Ireland was in the 1980s. And I well remember some of the big names that got
into trouble in those days and were either helped or not helped by the Government of the
day.
Take Irish Shipping, for example, which got caught up in over-ambitious expansion and
over-indebtedness as it built a large fleet of leased vessels well beyond that company's
traditional goal, which aimed at controlling sufficient tonnage to avoid Ireland having to rely
on foreign companies to deliver essential supplies in time of war. Though the deficiency of
Irish Shipping - probably well under €0.5 billion in today's money - may seem dwarfed by
the banking losses of recent years, it was too much for the Government to take on (even
though it owned the firm) and Irish Shipping was liquidated.
Other high profile cases of the 1980s, such as Dublin Gas, Irish Steel, and the two big
general insurance companies ICI and PMPA, saw public money poured in to protect what
were seen as essential services.
The 1990s saw the even larger failures of the meat concern Goodman International and of
the aircraft leasing company GPA. The latter was a huge global operation, owning hundreds
of aircraft and exploiting a taxation arbitrage as well as know-how about the demand and
supply conditions in the aviation industry. But it became overstretched and over-indebted and
was unable to raise the equity capital which would have allowed it to ride out a cyclical
downturn: it was dismembered and mainly sold to a US company.
Some of these large failures reflected insufficiently controlled over-expansion; others a
process of senescence leaving the company prone to bankruptcy as soon as the next
economic downturn came along. In each case, it generally fell to the bankers to pull the plug.
It is usually they who have to refuse further accommodation, to stop the drain of
unrecoverable resources.
Interestingly, in several of the large historic cases mentioned, Irish banks did not find
themselves as heavily exposed as one might have expected. Perhaps the Irish banks had a
closer view and a better understanding of the potential risks back then, or perhaps there
were other reasons, but other creditors, including banks abroad, seem to have absorbed or
been exposed to the largest losses in several of these failures. Perhaps that experience was
one of the ingredients contributing to embolden the Irish banks to feel invulnerable to
downturns. Perhaps one day we will fully understand just how fundamental decision-making
in the banks (during the property bubble) ended up so insulated from adequate attention to
basic risk-controls - and indeed in the end from common sense!
Optimal restructuring
When restructuring works well, the assets of the failing firm, along with the human capital
embodied in its employees, will find a good alternative use. Receivers and liquidators will
certainly have worked to get a good price for the physical assets. Aircraft and ships owned
by GPA and Irish Shipping may have been laid-up for a while, but most found employment
later. Employees did not always fare as well. The collapses often happened during periods of
weak global activity associated with levels of unemployment at home and abroad that make it
hard for displaced workers to get a job. The plight of the misfortunate former Irish Shipping
workers has rightly been highlighted.
There are inherent conflicts of interest between different stakeholders in a restructuring
though, and not all work-outs do contribute to overall economic efficiency. Indeed,
sometimes key protagonists may be aiming to build a monopoly or attempting aggressive
risk-shifting. That's why public policy, for example, competition policy, or mergers and
monopolies policy, may need to be activated.
In the past, Governments have sometimes got involved more directly. For example, when
Irish Steel looked like closing, the prospect of so many workers being displaced into the
depressed labour market conditions of the mid-1980s, perhaps to remain on the dole for
years, weighed with the Government of the time in its decision to provide funds to keep that
firm going for some years more by subsidising its activities.
But a greater awareness of the opportunity costs of Government rescues of companies has
reduced their frequency over the years. Propping up a doomed company is not always good
even for those who seem to benefit. Few now bemoan the demise of the Irish car assembly
business. Indeed, a decade after that business collapsed following the Anglo Irish free trade
agreement, manufacturers of car parts for export employed more people than the assembly
industry did in re-assembling CKD (completely knocked down) car kits.
Making sure it's done well - avoiding delay and dealing with owners
Faced with cleaning up the post-crisis mess, procrastination is an ever-present cancer.
Hoping something will turn up is a natural reaction when the alternative is facing up to the
inevitable and taking steps that crystallize losses and directly affect the stakeholders of firms
including the employees and trade creditors. But the hidden consequences of procrastination
impose costs elsewhere in the economy - costs that destroy even more jobs elsewhere. That
was the experience of Japan in the 1990s, and Ireland can't afford to suffer a similar
protracted delay. An unhealthy firm balance sheet means that access is denied to new
funding that can enable expansion, upgrading or innovative investment that could generate
output and employment growth. Indeed, especially in the current crisis which is driven by
balance sheet problems more than operating account problems, delaying the financial
restructuring is likely to threaten jobs in the distressed company itself, as well as imposing
indirect costs on those dependent on other companies.
Owners will resist restructuring, especially when it means that they stand to lose control over
some or all of the business. They have of course a large financial, and not seldom emotional,
interest in retaining their position and may also think that only they have the expertise to
make the most of the assets of the company. In some instances, creditors will agree with this
proposition. In his book,2 Professor Cahill suggests that the lending banks (most of them
foreign) may have found it a "bitter pill" to retain the CEO of Goodman International in
executive control and with a sizeable equity stake in the restructured company. Other
high-profile cases saw the more conventional presumption that the old shareholders and top
management will go. That has been the basic modus operandi of the Government in the
current banking crisis as far as the banks are concerned. In the case of NAMA, dealing as
they are with a huge number of property-owners and developers, the modus operandi to date
appears to reflect a kind of extended triage of their borrowers, with some being kept on, and
others eventually not.
Asset management companies or in-house operation of the banks?
Some may find irony in the fact the banks are among the main actors in driving restructuring.
After all, they themselves have experienced some of the most far-reaching balance sheet
restructuring, with their shareholders wiped-out and subordinated debt-holders also nursing
losses, and central bank lending filling the hole left by other departing creditors. That job
losses in the banking sector have not to date been as bad as the economy on average
reflects the Government's decision to step in and keep the operations of the banks going
because of the services they provided.
(Incurring by far the biggest ever costs seen in corporate restructuring, the Government also
tried to avoid a wider financial instability as well as the loss of credit standing that would have
accompanied losses hitting depositors and other creditors, but that story, which began
exactly four years ago today, has been the main theme on many other occasions and so I
will not dwell on it here).
Anyway, despite all of this, the banks have also had to change gear and become heavily
involved in loan recovery and the associated task of balance sheet restructuring of many of
their distressed corporate (and individual) customers.
But can one improve on having the banks as the engineers of restructuring? This question
was widely discussed around the turn of the millennium, as researchers and practitioners
tried to draw lessons applicable to the East Asia crisis (which hit half a dozen rapidly growing
countries in 1997-8 and left a debris of corporate insolvencies), and from the earlier
experience of banking crises in Japan, Scandinavia and the United States, as well as some
other developing countries cases. The broad conclusion from this debate3 was that
centralised asset management companies, as in Sweden and with the US Resolution Trust
Corporation, can work well where what needs to be restructured is mainly a class of property
companies. This is because the main assets of the companies are relatively easily
transferred and do not depend on a specialised production chain, patents, firm-specific know
how and so on. To overstate somewhat, the value of real estate may, especially in a
downturn, be pretty much independent of who manages it. In a rising market, the Swedes
managed to do well in realizing their property portfolio over time. The international literature
also warns, however, that large state-owned AMCs can become vulnerable to improper
political pressure, especially where large and prominent firms have become bankrupt.
Fortunately there is no evidence of such pressure occurring in respect of NAMA in the
current Irish crisis, and indeed the legislation setting up NAMA has built in protections
against such pressures.
On the other hand, non-property related distress may (according to the international
research) best be managed by the banks themselves. Specific company know-how can help
in devising the best solutions for maximising the value of the firm's assets - provided that the
restructuring process can be insulated from the denial and over-optimism that may have
contributed to poor loan underwriting in the first place. The banks in turn need to be provided
with sufficient capital to allow them to fearlessly accept and crystallise the unavoidable
loan-losses, sufficient liquidity to be able to provide further financing to set the restructured
firm back onto a healthy growth path, and eventually move it out of the limbo of financial
distress. As against all of this, it has to be acknowledged that few bank staff startout with the
skill-set needed to implement corporate restructuring: it is a very different business to loan
underwriting. And a bank which diverts many of its most effective staff into such activities
may not be so effective in fostering new lending relationships.
Ireland's institutional arrangements for dealing with the situation to date do seem to mirror
this international consensus about the most appropriate institutional arrangements: NAMA for
the big property loans, the banks for the remaining bad loans, and massive recapitalisation
of, and extensive liquidity provision to, the banks. The differences are ones of scale rather
than design. In particular, the losses destabilised the finances of the State, limiting its ability
to react.
There have been suggestions that further blocks of banking assets could be moved off the
balance sheet of the main banks. Certainly the banks have large blocks of hard-to-value and
hard-to-sell assets on their balance sheets which are a drag on the investability of the banks
because of the tail-risk of further losses that they embody and because they contribute to the
over-scaling of the banks.
In practical terms, though, the management of numerous SME assets is a task for a large
and decentralised operation. The operational risk of transferring this task to another agency
would be very considerable. Even if ultimate ownership of the loan assets might possibly be
shifted at some point in order to improve the balance sheets of the banks and hence their
standing in wholesale markets, I foresee that they would in practice continue to manage most
of the restructurings.
One of the recommendations of the literature is that the private sector should be involved as
much as practical in the restructuring process. Private sector restructuring specialists can
have the high-powered incentives to find quick and profitable solutions. Of course the
process is costly. Private-equity firms will buy distressed assets only at a discount to what
they think they can achieve when restructured and resold. Their time horizon is relatively
short and their return thresholds high. Where it is a question of cleaning up a privately-owned
bank, these costs simply imply a transfer within the private sector. But if the private
shareholders have already been wiped-out, it is the State that will bear the costs. Its decision
on these matters must therefore balance the prospect of a more effective restructuring by
private firms against the costs that this will impose. Private sector solutions have not been
neglected in the Irish case. To date there has been by considerable deleveraging of the
banks to the private sector: asset sales totalling €32 billion in the past three years - most of
them abroad.
Finding grand solutions that improve the situation is thus not easy. But that is not a reason
for delay. On the contrary, every month that passes for an un-restructured distressed
corporate is an energy-sapping lost opportunity for recovery. Urged by the Central Bank as
regulator, the banks have been building their internal capacities through hiring, training and
education, to deal with the situation. There is now an improved understanding of how best to
deal with the numerous cases of distressed SME borrowers. This includes such matters as
collecting adequate borrower information: adopting a realistic approach to post-restructuring
viability calculations; ensuring time-bound execution in accordance with concrete
implementation guidelines; quantified tracking of the progress in processing cases and,
procedures for quality assurance. Yet the banks know they have not made sufficient
progress in turning that understanding into a robust mechanism at scale for delivering an
adequate stream of realistic and viable restructurings.
It's often not just a question of financial (balance sheet) restructuring, but also the need for
operational restructuring, which is something which generally goes well beyond the skill-set
of the traditional lender. Often there is a personal guarantee involved, so the owners will not
be fully off the hook: the new personal insolvency legislation should provide a backstop for
that element. Thousands of cases need to be dealt with decisively in such a manner. This is
truly a daunting organisational challenge for the banks, but one to which, encouraged and
pressed by the Central Bank, they are now stepping up. But, as I am sure they will
themselves acknowledge, there is much work to be done and progress to date has been
painfully slow.
Given the large number of firms still under pressure, implementation of an effective and
speedy but surgical approach to corporate restructuring could have a big impact. By
reinvigorating the Irish business sector, it would ultimately help boost economy-wide
employment. Requiring unusual and scarce skills and judgment, this is a task which urgently
deserves heightened attention.