Many experiences with distressed businesses in Kenya culminate in a lose-lose scenario in which both creditors and business owners register substantial losses. Despite the attempts by the Insolvency Act 2015 to cure such outcomes by introducing novel approaches such as administration and Company Voluntary Arrangements to rescue distressed companies, the intended effect has proved elusive.

One solution that is prevalent in more mature markets is distress investing. This, in a nutshell, refers to the act of buying a stake in the equity or debt of a company careening towards winding up. Seasoned distress investors usually identify inefficiencies that occasioned the debt overload, which they then remedy to restore the company to profitability.

The first type of distress investing, where the investor purchases a substantial share of equity in the failing company, allows it to play an active role in decision-making. By bringing the technical competence and commercial expertise it boasts, the investor can make innovative strategic decisions to improve the company’s performance and slash costs. Furthermore, with the benefit of a dispassionate perspective the investor can take the hard decisions that the previous owners may have sentimentalized like staff layoffs and sale of prized non-core assets.

Due to the debt-laden nature of insolvent companies, the distressed equity investors can acquire the shares at a bargain-basement price and enjoy the upside once the company rallies again. In reality, it can be difficult for investors to achieve a rapid turnaround under our local conditions because target companies tend to get embroiled in litigation disputes with creditors and battles with the taxman, which bode ill for speedy resolution. Distressed equity investors may be unwilling to deploy “patient” capital and adopt a long-term outlook as they have the option to redirect their capital to distressed targets in jurisdictions where legal disputes are quickly determined.

One of the conditions for distressed equity investment transactions is the debt haircut typically required of the existing senior creditors, where they write off a portion of their debts to relieve the balance sheet.  The challenge with the written off debt is that it is taxable on the debtor company which is usually too cash-strapped to meet the tax costs. Unsurprisingly, most investors will be reluctant to fund the tax element, thus discouraging distressed equity investments.

The second type of distress investing is the purchase of a company’s distressed debt. This entails purchasing the entirety or a substantial portion of the ailing company’s debt, typically at a steep discount. The appeal for the distressed debt investor is the opportunity to recoup the par value of the debt through a turnaround of the company or by realizing the securities. This implies that the distressed debt investors will only be motivated to acquire sub-par loans where they are assured of taking over airtight securities which can be readily enforced. Commonly, attempts to sell charged assets face resistance in the form of court proceedings instigated by the chargor or other creditors. The resulting delay in realizing securities means that the secured assets will fetch lower prices, thus necessitating the sale of extra assets to repay the full debt, which leaves the company in a poorer state.

With this in mind, it would be worth considering incentives for distress investing, such as tax exemptions for distressed debt write-downs and strict timelines for dispensing with litigation for distressed entities, to create an enabling regime for sinking businesses to be resuscitated by new investors in a timely fashion.

The article was published in the Business Daily on 21 November 2023.