The “insolvency” zone: a D2D score <1
Default risk (or insolvency) is the uncertainty surrounding a company’s ability to service its debt as and when it falls due. Prior to default, there is no way to discriminate unambiguously between companies that will default and those that will not. At best, we can only make probabilistic assessments of the likelihood of default. One way of assessing this is ‘distance to default*’.
A striking trend in the findings of KPMG’s latest Distance to Default (D2D) report is 1 in 5 companies on the ASX have a D2D score that remained below 1 for three or more half year periods. Although a D2D score below 1 doesn’t mean a company will enter insolvency, our analysis shows these companies may already be experiencing financial distress or working through restructuring strategies. We call them ‘D2D Zombies’.
Our historical analysis tells us that at the time a company goes into insolvency their D2D score was between 0.5 and 1 – effectively the ‘zone of insolvency’. So many of these companies are at risk.
$8.8 billion in stranded shareholder funds?
These companies have a combined market capitalisation of $8.8 billion. Whilst this represents but a fraction of the total ASX market capitalisation, one conclusion is that $8.8 billion in shareholder funds remains stranded until capital providers are able to restructure this capital and deploy it for better or higher return use.
Mining and oil & gas companies make up 70 percent of Zombies
Materials, energy and Information Technology companies continue to make up the majority of Zombie companies. Of these, exploration companies in the oil and gas, and mining and materials sectors are the largest group. Many of these companies rely on capital raisings via equity markets to continue operations / exploration and do not carry debt. Our analysis indicates that only 21 percent of mining companies carry Net Debt. This indicates that to the extent that Zombie exploration mining companies are able to continue to raise equity to fund operations they will likely remain Zombies (and not go into default) since, for the majority, an impending debt refinance (often the cause of a default) is unlikely to be required.
There is a significant shifting of performance across the ASX. Fifty percent of the companies analysed displaying an improved D2D score whilst 46 percent of companies showed a decline in D2D score.
Real Estate continues to be a strong performing sector (highest D2D score) and also displayed the greatest improvement in D2D score (increase by 8.9 percent), while Utilities had the largest decline (decrease by 9.2 percent).
Changes are coming – will you be impacted?
From 1 July 2018 ipso facto changes will have an impact on contract performance obligations when contracting with a distressed counterparty.
Ipso facto clauses are provisions in contracts that allow one party to terminate or modify the operation of a contract on the occurrence of an insolvency event, such as the appointment of an administrator.
Due to the potential value destruction by the enforcement of ipso facto clauses in any restructure, the Australian Government has introduced reforms, commencing on 1 July 2018, which limit the enforceability of ipso facto clauses in certain insolvency events.
What about contracts?
The new provisions will only apply to contracts entered into or amended after 1 July 2018. Under these changes, an express right in a contract is not enforceable if the sole reason for the enforcement is that either:
- the company enters voluntary administration
- the company has a receiver appointed over substantially all of its assets
- the company is undertaking a creditors scheme of arrangement
These changes, in effect, implement a stay on enforcement under the above scenarios.
Companies should review and amend their contracts to ensure they are adequately protected in the event of a default, including appropriately managing their counterparty risk. Directors should be aware of their obligations and the impact that this reform will have on options available in the event that their counterparties seek insolvency protection.
* D2D is a metric used to assess a company’s ‘distance-to default’. The metric takes into account financial information and market data. The closer to zero, the more likely a company is to default. In contrast, the further a company is from zero, the less likely it is to default. In this analysis, released every 6 months, we analyse the D2D score movements of ASX listed companies (following reporting season of full year and half year results) to draw insight as to corporate health across the Australian economy