Kuwaiti investment companies have been hurt much by the global economic downturn - with fragmented portfolios and a sub-optimal capital structure when cash is limited. As lenders retreated and limited access to new debt, investment companies have been left vulnerable and have to adapt to these new conditions and make significant changes to recover, found a new report by Booz & Company.
In the short-term, investment companies should focus on improving cash positions by rationalizing their portfolios to focus their efforts on fewer companies. They should also improve cash management at their holding and investee companies, as well as work with lenders to ease existing debt obligations. In the long-term, “they must develop an explicit strategy to create value, and improve their governance and risk management practices to support the implementation of this strategy”, explained Peter Vayanos, a partner at Booz & Company. They also need to set long-term targets for their portfolios and align their corporate finance capabilities to these targets.
The financing squeeze
In Kuwait, investment companies are prevalent; with around 100 registered investment companies (46 of which are listed on the Kuwait Stock Exchange) and several other industrial and real estate companies with large investment portfolios. Alone, listed investment companies constituted around 20 percent of the market capitalization of listed Kuwaiti companies (end of Q3 2008) and around 15% in early 2009, a higher share than in most industrialized economies.
“The crisis stemmed from a belief in perpetual growth and unlimited access to liquidity. Investment companies invested opportunistically in a large number of portfolio companies, with no set strategy, liquidity measures or target risk-return profile” stated Ahmed Youssef, a principal at Booz & Company. Two of the largest listed Kuwaiti investment companies for example have a combined total of around 120 portfolio companies; this excludes investments in real estate projects, companies where they have less than 20 percent ownership, and fund investments. Many are comprised of small stakes – with carrying values as low as KD 5000 in some instances.
Fragmented portfolios make investment companies’ access to and monetization of cash less flexible; It also increases transaction and management costs. Investment companies have limited ability to immediately monetize these companies; and investors have little interest in purchasing minority shares in unlisted equities. Portfolio managers further reduced the flexibility of their portfolio by investing in relatively illiquid investments, which will prove more difficult to monetize.
More importantly, investment companies had to raise additional capital, mainly debt, to meet their obligations in 2008. “Companies raised new debt and equity to pay other shareholders through dividends and interest charges” Youssef commented.
The average debt-to-equity ratios of Kuwaiti investment companies may look adequate, but their ability to cover financing charges is challenged. Finance charges for listed Kuwaiti companies totaled KD 290 million in the nine-month period ending September 2008, while cash flow from operations and investing activities was negative.
“Furthermore, around 75 percent of listed investment company debt is short-term, which accentuates the problem given the long-term nature of their assets,” explained Youssef. More than 40 percent of investment companies have a current ratio below 1 and a cash ratio below 0.1 (excluding marketable securities). This could be dangerous if banks put pressure to recover short-term debt, especially with limited opportunities to divest portfolio companies and limited cash-on-hand. It could also lead to further declines in the stock market as pressured investment companies seek “fire sales” to raise cash.
Immediate steps to stabilization
Kuwaiti investment companies should act now to stabilize cash flow, right-size their capital structure, and build a foundation for sustainable profit growth. Companies can take several short term actions to alleviate the cash squeeze and allow them to consider longer-term fixes.
Rationalize the portfolio: Kuwaiti investment companies should focus human and capital resources on the portfolio companies in which the investment company can create long-term value, and generate cash. They must identify underachieving companies that are ripe for lower levels of investment, closure, or divestiture. “Sale proceeds can be used to pay debt or support more valuable investments. Companies should not be deterred by the possibility of exiting at low valuations if they can put the proceeds to better use,” Vayanos stated.
Improve cash management: Kuwaiti investment companies have to improve cash management at the holding and investee company levels. They can work directly with investee companies to establish cost-cutting targets that enable them to extract more cash from operations, especially where portfolio managers have specific insights. Investee companies often do not have the necessary tools or incentives to effectively manage their capital.
Reducing or halting dividend payments in the short term is another viable option – especially now. “More understanding investors will likely see such a move as a responsible and necessary step to fortify the company’s financial position in a difficult economic environment,” said Youssef.
Ease debt burdens: Investment companies should try to ease their debt obligations, either through renegotiation with lenders or by shifting their debt burden closer to operating subsidiaries.
Currently, banks realize they stand a greater chance of recovering loans by working with companies to restructure their debt -especially with Kuwaiti investment companies, which represent around 40 percent of the total debt held by all Kuwaiti listed companies (excluding debt taken by listed financials institutions). The cash generated can be used to repay selected debt obligations.
“Investment companies can give banks greater confidence by providing more transparency on how the debt is used and showing a clear action plan to improve their cash position,” Youssef said. Banks gain greater insight into the company’s ability to repay by being able to more closely track cash flows.
Steps for long-term sustainability
Once these short-term fixes are in place, investment companies need to focus on long-term sustainability to reduce the impact of future cash squeezes.
Develop long-term strategy: A clear definition of the strategy and its impact on the value creation strategy, operating model, and performance-management approach is critical. Strategy needs to be tailored to each organization’s specific makeup - from conglomerates to managed investment funds.
Set portfolio targets: Based on the set strategy, Kuwaiti investment companies should define long-term targets for their portfolio mix to avoid being overwhelmed by the multitude of investment opportunities. Targets could be defined across multiple parameters and should be continuously challenged and reviewed with respect to both internal and external measures.
The investment company’s level of influence on portfolio companies should be addressed. “Many Kuwaiti investment companies have made minority equity investments in private companies in the hopes of listing them in the future. But when buyers’ interest wanes, they are trapped: They cannot liquidate the assets or influence company strategy,” explained Youssef.
Develop appropriate corporate finance capabilities: Portfolio changes mean a change in the corporate finance strategy and capabilities at the holding level. Companies need to provide more transparency to lenders in the use of financing, and isolate the cost of debt and the risks faced by individual companies. In addition, they need to match the maturity of their liabilities with that of their assets by shifting from a focus on short-term loans to the use of financing strategy and often to individual investments. Holding companies with a high percentage of unearned income should avoid having excessive debt at the holding level.
Companies need to develop a long-term dividend strategy beyond the short-term. “A decrease in dividends could have negative effects on holding companies’ share price. Kuwaiti companies should slowly educate investors about total shareholder return and reduce the pressure on holding companies to pay regular dividends,” commented Youssef. Such changes require strong talent and systems in corporate finance at the holding level, complementing the mainly accounting-focused capabilities present in many investment companies.
Improve governance and risk management: Good governance is intrinsic - particularly for investment companies: Large and frequent investment decisions, conflicts of interest, cross-ownership, and subsidization among portfolio companies are a few of the issues that need to be addressed. Clarifying the role of the board and ensuring that directors have the right combination of financial skills and industry knowledge will set an effective and realistic strategic course. Communications with the CFO and C-suite should be improved to strengthen the quality of information board members use to make decisions and manage risks. “The board should enforce the adoption of appropriate risk-management practices, forcing executives to evaluate decisions and monitor the portfolio within a predefined risk-return framework”, explained Vayanos.
Regulators should ensure investment companies are active in driving the change given their weight on the Kuwaiti economy. Listed Kuwaiti investment companies alone had around KD6.9 billion in debt (including consolidated debt of subsidiaries) as of September 2008, the equivalent of around 30 percent of the Kuwaiti domestic credit portfolio (as reported by the CBK). Around 30% of this debt is taken from local banks making a more acute crisis with investment companies dangerous for the Kuwaiti banking sector and economy as a whole.
In this context, regulators should continue to take a proactive role, starting by quantifying the depth of the problem and prioritizing the challenges to be addressed. In the short-term, they should work closely with the relevant investment companies to stabilize the situation and address the current cash squeeze. For the long-term, the regulator should formulate a long-term strategy for the sector defining its role within the Kuwaiti economy. More importantly, regulators should enhance their policies and supervisory capabilities to avoid a repeat of the problem.
