The ins and outs of business rescue through the lens of the construction industry downturn

by Wanya du Preez (Deloitte) and Trevor Murgatroyd (Nimble Group)

In recent times, a spate of local construction companies has been featured in the news due to financial pressures. Due to the slow rate of fixed investment and many construction companies experiencing financial difficulties, one is led to believe that the industry is in distress and that many companies face the possibility of financial collapse.

Construction companies globally have been affected by the global financial recession, however due to the fact that South Africa was hosting the 2010 FIFA World Cup, government spending contributed to infrastructure development probably being at its highest leading up to the 2010 FIFA World Cup. Following the World Cup, the effects of the global recession and reduced government spending on infrastructure development filtered through to the construction industry.

When a construction company underperforms, it is not only the company itself that is in distress, but the ripple effect is also felt by the ecosystem that is served by the company. This includes all the smaller local suppliers to the industry and the more than 1 204 000 (according to Stats SA) people being directly employed by the construction industry.

In the recent Deloitte Restructuring Outlook Survey 2014, Construction was listed as one of the top 3 industries predicted to be in distress in 2014.

In the past, companies in financial distress faced liquidation or judicial management, with little likelihood of survival and/or recovery for such companies. However, the new Companies Act (Act Number 71 of 2008) came into effect on 1 May 2011, which includes a chapter on business rescue, Chapter 6. This provides a potential solution and help to companies in financial distress. This entails a company filing for business rescue and with the help of a Business Rescue Practitioner (“BRP”) returns the company to a profitable and/or sustainable operating position, if identified early enough.

1. Overview of the current state of the construction industry

Since the introduction of the Act in May 2011, a number of sizeable construction companies have commenced business rescue proceedings. The success rate of these business rescues remains disappointing, rendering the question whether the objectives of business rescue has assisted the construction industry to protect their businesses or alternatively whether it has provided a better return to their creditors by not filing for liquidation immediately.

One of the prominent cases to date has been the business rescue of Sanyati Holdings. Sanyati Holdings and its wholly owned subsidiary Sanyati Civil Engineering and Construction filed for business rescue in June 2012. One of the contributing factors to their financial distress was long outstanding payments from provincial governments totalling approximately R79 million. In July 2012, the operating company was liquidated due to the lack of post commencement finance to continue operating and continued to incur substantial losses. Unfortunately, in excess of 2,000 jobs were lost as a result of the liquidation.

Subsequently, a host of other construction companies have filed for business rescue. These include Civcon (including Erbacon) who filed for business rescue on 20 June 2013. Fortunately, on 15 November 2013, they announced that they have terminated business rescue as the approved plan had been substantially implemented and that 772 jobs were saved.

Others include Rainbow Construction (filed September 2012), Stedone Group of Companies (filed April 2013), Cosira (filed in July 2013), and hot off the press, Protech Khutele (filed for business rescue in the first week of June 2014). Business rescue for Stedone is ongoing and proving to be problematic, while Cosira was subsequently liquidated. This is an indication of the level of distress in the industry.

1. Reasons for distress in the industry being   

One of the key ways to avoid the failures and liquidations experienced in the industry is to understand the reasons why companies in the construction industry become distressed. Following this, plans can be put in place early enough to ensure the company’s return to financial health.

As with most other companies in distress, cash constraints are often the number one signal that a business is in financial distress, signalling that action is required to bring the business back on course.

However, if key stakeholders of the business are on the lookout for some of the early warning signs, there is still time to save the business. Some of these signs include:

• Poor quality, insufficient or “layered” management information that loses key messages between the site and the Board
• Consistent underperformance and failure of management to address below target divisional performance
• Operating profit not translating into cash
• An over-recognition of contract revenue and expenses not being matched to the appropriate period
• Management incentives focused on P&L performance, rather than cash flow

• Market rumours around project performance and supply chain payment complaints
• Increasing advance payment requests from the supply chain
• Signs of key clients making significant reduction in supplier numbers
• Evidence of reputational damage emerging from press coverage
• Reducing staff numbers across management and delivery functions
• Increasing numbers of claims (for or against the business)

Contractors and other key stakeholders face increased financial and operational risks if mitigating controls are not implemented to counter the effects of deteriorating market conditions.

If financial distress is identified early, then business rescue is an ideal tool for a business to restructure itself under the protection of a legal moratorium.

1. Options for construction companies and their suppliers  

If you suspect that a construction company may be in financial distress, these top 10 questions should be asked of the management teams to determine the extent thereof:

• Is there confidence that commercial and financial reporting and controls are providing an accurate reflection of the business and not masking the true financial position?
• Are formal guidelines in place and are they adhered to for the recognition of turnover, costs and profit.
• What proportion of revenue is derived from government contracts and is the forward order book realistic and reflective of the impact of public sector cuts?
• Are forecasts being stretched, based on expectations that a contract will always turn the corner?
• Are realistic margins being secured against new contracts and will they deliver sustainable and long term financial performance?
• What is the business doing to diversify and counter its exposure to public sector cuts, and are delivery and contractual risks of pursuing a diversified strategy fully understood?
• Are trade insurers continuing to support the business, or are there reduced credit facilities and increasing demands for advanced payments?
• How will the business address demands for renegotiating long term contracts and what can it do to minimise this potential impact?
• What has been done to reduce overheads and “right-size” the business for future operations?
• Does the business have strategies in place for the immediate mitigation of reputational damage?

If a party has concerns as to the financial situation of a construction company, they are advised to take action and challenge management around how they plan to address the current market pressures.

In order to maintain good health of the company, the most significant issue for management is the need to balance short term cash requirements with the security of long term and sustainable turnover.

On the positive side, the infrastructure development boom across Africa has attracted investment spend totalling US$ 222.7 billion on a total of 322 projects. Currently, the top sectors, rated by investment value, are energy and power (36%), transport (25%), mining, real estate and water, followed by oil and gas.

Africa, and indeed the world, is hard at work building, modernising and strengthening the African infrastructure, which will lead to greater African self-sufficiency and global competitiveness.

New energy generation hubs are being forged, transport and logistics corridors are being built and basic social infrastructure is being invested in. Telecommunications connections are being strengthened and development is now starting to touch the commercial property sector on the continent. 

In order to increase the chances of success of business rescue for construction companies it is important that the distress is identified before it is too late. The turnaround of a construction company in a business rescue would typically depend on a white knight and/or a cash injection, failing which a turnaround will be extremely challenging with many obstacles.

Management should be alert to the potential distress in the business earlier and not wait until it is too late and the business has run out of cash. Business rescue proceedings should commence when there is still cash available for the operations to continue. Ideally a pre-packaged business rescue plan should be attempted. Once a company has identified that it is experiencing financial difficulties, steps should be taken to endeavour to secure an investor and/or additional funding, which may even be conditional upon approval of a business rescue plan. Although the business rescue practitioner will apply his/her own mind to the process, a pre-packaged option is more likely to succeed.

In order to improve the likelihood of a business rescue succeeding, the following aspects are important:

• Management should identify the financial distress and commence business rescue proceedings before it is too late;
• The choice of business rescue practitioner has a bearing on the success and should be a person with a good reputation and an understanding of and experience in negotiating with larger creditors, often the banks; and
• The business rescue practitioner should be supported by a competent and reputable financial advisory and legal firm.

Transforming the construction industry and with it, the country, is seen by the industry as a business imperative. Business rescue is a potential solution to this.

Chapter 6, Companies Act

Deloitte Restructuring Outlook Survey 2014

Deloitte publication: Construction Lending-Handle with Care June 2011

Deloitte publication: Construction Industry Outlook November 2011

Deloitte publication: African Construction Trends Report 2013

Statistics SA March 2014

If you have any questions or require a more detailed discussion relating to business rescue, contact Wanya du Preez at wdupreez@deloitte.co.za