"YOU CUT OFF HIS HAND": HOW TO MAKE MONEY ON DISTRESSED ASSETS IN RUSSIA
What you need to know about investing in distressed assets and situations

Vladimir Putin in one of his interviews, speaking about US President Barack Obama, said: "Many underestimate this person. But in fact, they say about such people: "With balls". The same can be said about investments in distressed assets – you can only make money on this business "with balls". Today I want to talk about the specifics of working with distressed assets in Russia; This may be of interest to business owners, bank management, and private investors.
What are "distressed assets"? The name "distressed assets" or "problem situations" can hide a very wide range of objects for investment. These can be both individual physical assets (usually real estate objects: residential or industrial unfinished construction, plots of land or industrial premises where a troubled enterprise conducts business), and liabilities - debt on credits and loans or trade debt. Sometimes an investor acquires a stake in a company or a "situation" in its entirety, i.e. 100% of the shares or stakes (usually at par or notional value) and buys back the liabilities.
The reasons for the problem of assets can also be very different. They can be grouped into three categories.
Problems with management. More than half of all problem situations (and according to the Turnaround Management Association, more than 85%) have internal causes and, first of all, are associated with ineffective management. Planning errors, an opaque reporting system, unwise investments or over-indebtedness, the lack of a risk management system, problems with personnel – all this can lead to serious problems in profitability and to the inability of the business to generate cash flows.
Problems with valuation - "undervalued assets". Some assets are significantly dependent on market valuation (real estate, tradable goods, individual industries and niches). If the price for them is in the lower phase of the cycle (as, for example, with exchange metals), they also become problematic.
Problems with owners. This category is associated with conflict situations that arise when one shareholder cannot agree with another, for example, on the ownership structure or dividends, or disagrees with him on the future of the business. As a result, a corporate conflict arises, which develops into litigation.
Obstacles at work. In addition to the obvious complexity – the need to correct the situation, solve problems and ensure cash flow – there are still many obstacles in working with distressed assets in Russia that must be taken into account in order to achieve success.
The first obstacle. Absence of a market. There are individual players, individual transactions and a certain state in which potential buyers and sellers are, but there is no consistency and organization at all.
Who can sell distressed assets? A) Foreign owners who, for economic and/or political reasons, want to go out of business in the region. B) Banks that have accumulated large portfolios of pre-problem and problem debts. C) Managers of companies that want to sell part of non-core/non-strategic assets as a source of additional cash flow. D) Russian owners who want to sell non-performing, that is, non-operating parts of the business.
Who can invest in distressed assets? There are quite a few specialized "buyers of problems". There are many more investment funds, banks and private investors who, having experience in specific industries and free financial and managerial resources, are ready to take risks in a low market. At the same time, the required profitability can reach 200% or more, and the payback horizon can be 3-5 years. Despite the presence of such an extensive list of potential sellers and buyers, the formation of the market is difficult: in practice, there are very few transactions, and even less information gets into the public space.
The second obstacle. Underdeveloped infrastructure. In this case, the infrastructure is professional market participants who ensure its effective operation: first of all, the preparation and execution of transactions, the recovery of assets and the solution of problems. Such professional participants are financial, legal and management consultants. And while there are many legal consultants, both international and Russian, on the market, only a limited number can provide professional financial and managerial assistance: two of the four companies of the "Big Four", one of the three companies of the "Big Three" strategic consultants, and one crisis management consultant company. Of course, there are Russian companies, but it is difficult to compare them with international ones in terms of independence and business reputation.
The third obstacle. Lack of trust. This is perhaps one of the biggest problems in Russian business as a whole. While the United States and Europe have developed special rules of conduct in the face of the need for restructuring, and the participants in the process adhere to these rules (not always formally fixed between the parties), in Russia there is still a strong temptation to be the first to "run" to the asset, withdraw cash flows, and "secure" collateral. Such a practice has developed, of course, as a response to fraudulent actions on the part of both companies and banks in the use of credit funds and in the process of multiple fictitious restructurings. However, even now, when honest and responsible bankers and creditors gather at the negotiating table, it is extremely difficult to overcome the barrier of distrust.
What to do? The following steps will help maximize the value that both the seller and the investor receive in distressed assets.
1. Develop a strategy. If you are a buyer of a distressed asset, you need to clearly understand what the reasons for the problematic asset are (usually these are several interrelated reasons) and to which category each of the reasons belongs. The study of reasons is called Independent Business Review (IBR). It should show which strategy for working with the asset will be the most effective; whether it is enough for the investor to have industry expertise or whether it is also necessary to look for CRO (Chief Restructuring Officer); whether it is necessary to involve specialists in investigating financial fraud or lawyers with experience in corporate disputes; whether it is necessary to take care of the physical safety of the asset and the continuity of activities in the first place. The answers to these questions should be contained in the IBR report. Based on the results of the study, a strategy for the best recovery of the asset and exit from it should be developed.
If you are a seller of a distressed asset, then it is better for you to do the same work yourself in order to understand what the prospects for the sale are and which buyers you should focus on in the first place.
2. Financial model. At various meetings of professional communities, I often argue with my colleagues about how much the portrait of a troubled company and the competencies of its managers have changed over the past (and ongoing) crises in Russia. My opinion: they have not changed much. This is especially evident in the example of such a tool as a financial model. The model of the company's projected cash flows for the next 3-5 years is a mandatory attribute of any company in times of crisis, and even more so for a company in a problematic situation with assets, debt or shareholders. Both the investor and the seller greatly reduce the risk of making wrong decisions with a financial model in place. It can show various scenarios of the company's development, which provides the ability to conduct sensitivity analysis, simulate the restructuring of assets, debt and capital, and at the same time is not too detailed or cumbersome to work with and regularly update. In practice, too many banks and troubled companies still use multi-line Excel "spreadsheets" to make important strategic decisions.
3. Company management. And, of course, the asset must be managed to obtain a sustainable positive result. As noted above, a significant part of the problems lies in ineffective leadership. An investor in a distressed asset needs to ensure either a complete replacement of the key management team, or a significant strengthening of it, where it is required by the results of the IBR. The best practice is also considered to be the involvement of a specialized crisis manager – CRO, the restructuring director. Such a director must have, on the one hand, experience in crisis management (prompt decision-making, project management, orientation towards the earliest possible exit from the crisis), and on the other hand, industry expertise, work experience and contacts in the industry where the troubled business operates. It is quite difficult to find such people: with a large number of industry specialists, very few can act as independent crisis managers, either because of their affiliation or because they do not know how to carry out financial recovery. In this case, you should contact professional consultants.
Wind of change. Working with distressed assets is one of the most controversial ways to make money in the Russian market. But the number of potential investment objects is very large, the range of potential investments is wide and the growth opportunities are unlimited. The most difficult thing in this process is the need to change. One of my clients, the owner of a troubled business in the south of Russia, discussed with the manager of the recovery project the main problems in the company's business model. The manager gave many reasons why the current business model no longer works. The owner asked the manager if he had children? "Yes, there is," replied the puzzled manager. "And for me," the owner said, "my child is my business. And now [talking about why the business is not organized] you are cutting off his hand." Obviously, the owner did not want to change very much. He did not implement the recovery program we proposed and lost his business a year later.
Source (in Russian): https://big-i.ru/management/upravlenie-izmeneniyami/p18272/
25 October 2016