Having briefly analyzed the main determining factors of the companies' capital structure and the problems that such structure may create in the context of a PPP, we are now ready to move on to the discussion of the conditions under which the company can face a situation in which it cannot repay its debt (principal and/or interest) or has limited access to capital markets to raise fresh funding. This condition is what is usually known as financial distress.
Based on the classification explained in Section I, financial distress situations can be classified depending on whether they originate in aspects that are internal or external to the company. In turn, the latter group is subdivided into natural events and political factors. Table 34 provides a brief summary of the different types of distress to be taken into consideration.
Table 34: Financial Distress by Origin
| Origin |
| |
| Internal | Inefficiency of the company in financial structure decisions | |
| External | Political | Restrictions caused by direct government action affecting the company's capacity to repay its debt or access new financing funds |
| Natural | Change in capital markets affecting the economy as a whole and restricting the companies' access to credit | |
Another relevant distinction to be taken into consideration in the analysis of financial distress situations is that such situations can affect the capacity to repay existing debts - the most serious ones - or become evident only as a limitation of the company's capacity to raise additional funding. This distinction becomes particularly important in developing countries, as the financial market limitations that are typical of these economies may cause serious credit rationing affecting the companies in spite of their satisfactory indicators and their timely and adequate fulfillment of existing financial obligations.
Even though a restriction limiting access to new loans appears to be less serious, it is worth noting that many companies have a medium- and short-term debt structure that is to be periodically refinanced. This is a common occurrence in developing markets ordinarily lacking long-term debt instruments (20 or 30 years). In these situations, the impossibility to access new loans translates into the impossibility to repay existing debt, as the company would have refinanced such debt in normal situations.
Financial distress situations that are internal in origin have to do with poor decisions made by the company in connection with its financing structure or any debt component (see BOX 44). Assuming exchange rate risks (through debt denominated in a currency other than the currency of their revenue without proper insurance) is a typical example of an internal decision which, in a scenario of devaluation of the exchange rate, can create a situation of distress due to reasons attributable to the company itself. For example, in order to preserve the incentives for efficiency, usually one of the main goals pursued by PPPs. In such cases, the company - or, basically, its shareholders - must bear the cost of insolvency, including, in extreme cases, the costs of potential bankruptcy.
BOX 44: Internal financial crisis
| From its privatization in 2000 and until August 2002, the Companhia Energética Do Maranhão (CEMAR) showed a positive trend in its service quality indicators. Moreover, in 2000 CEMAR developed an action program tending to decrease its level of losses. However, the internal management of the company's financing structure gave rise to some doubts. By the end of 2001, CEMAR faced liabilities for R$ 640 million in total. In August 2002, the National Electric Power Agency (ANEEL) ordered the administrative intervention in CEMAR arguing that the economic-financial feasibility of the company was doubtful in the short and in the medium term. The intervention's purpose was to protect the public interest and to preserve a proper service for users, thus ensuring concessionaire's compliance with statutory and contractual obligations. The administrative intervention lasted 21 months until April 2004, when, finally, the concession was transferred to a new management. This way, ANEEL intervened to shorten the distress cycle and prevent that the initial financial distress adversely affects the maintenance and expansion of the electric power distribution system, thus triggering operational distress. |
On the other end of the spectrum, a change in the tax rules adversely affecting the cost of financing and leading to insolvency would be a clear example of an external cause of political origin. Another example of the same kind is found in prohibitions to remit funds abroad that keep the company from repaying interest or principal on a debt obligation undertaken abroad. Clearly enough, in those cases, the situation is the result of causes that are entirely unrelated to the company and, accordingly, the company should not be punished for them.
A middle-ground case would be that of situations of financial distress brought about by natural external causes such as a financial or macroeconomic crisis (either domestic or international) hitting the economy as a whole (see BOX 45).
BOX 45: Financial Crisis in Argentina
| The financial crises that affect the country's economy as a whole are an example of a natural external factor. In crises scenarios, such as the one experienced by Argentina in 2001-2002, companies suffer an extremely quick and deep financial deterioration. The Table shows the steep fall in the interest coverage ratio for the three electricity distribution companies serving in the Greater Buenos Aires, before an after the crisis. Interest coverage ratio: EBIT / Interest expense
As it can be noted, the strong devaluation and default of public debt at the beginning of 2002 resulted in a severe deterioration of the firms' financial situation, which turned from showing ratios with highly acceptable values before the crisis to showing ratios with critical or even negative values after devaluation. |
Given the nature of financial markets, it is often difficult to clearly identify the cause of a particular distress situation. In the face of changes in financial markets that keep the company from refinancing its debt obligations, identifying the extent to which this is the result of the company's inefficiency (by taking short-term debt) or external restrictions (inexistence of medium- and long-term markets) is not always a possibility.
The manner in which each company will be affected by the crisis is also dependent on the company's degree of leverage. Faced with a restriction on access to capital markets, highly-indebted companies have less flexibility to finance their investments using equity capital, as an important portion of their revenue is already set aside to repay debt obligations. Equity financing allows greater flexibility through an adjustment in the timing of dividend payments.166 The situation of financial distress then relates to the external occurrence and the company's financing policy, which makes it difficult to attribute responsibility therefore to a single cause.
Regardless of the origin of the distress situation, it is important to remember the need to minimize the impact on the service and the users that may be associated to the spread of the financial crisis to the rest of the aspects (operative and economic) of the service. Many issues are important in order to prevent and limit the prospective negative effects of possible financial unbalances.
The first issue is the role of creditors during the crises. Particularly, there is a concern about the rights that they may exercise to limit the actions of management and, even, to take over the business control. The key point consists in prioritizing the continuity of the service over other economic or financial considerations.
Another point that must be pointed out is the need to adopt a cooperative attitude between the public and private parties that allows them to efficiently overcome the financial problems. In this respect, it is important to remember the residual nature of many of these risks for the public sector, which in most cases retains the ultimate responsibility for the provision of the service. This calls for the need to adopt a cooperative approach to cope with the crisis in line with the idea of "partnership" that must always prevail in PPP projects.
The cooperative approach must be adopted but shall not mean that the private sector is released from its liability and the associated costs. This approach must consider all possible measures that may lead to the solution of the financial distress situation. In this sense, it is worth taking care that as a consequence of the measures adopted towards a solution of the financial crisis, the government does not assume more risks than the ones originally contemplated in the contract. In case that the public sector takes greater risks, this situation should be necessarily reflected on the private sector's compensation (see BOX 46).
BOX 46: Renegotiation of roads in Chile
| Due to the highway traffic decrease resulting from the economic recession undergone by Chile during the 1998-2000 period, the firms that held the highway concessions asked the Chilean government to renegotiate their contracts. The government offered them contracts that guaranteed an annual growth in traffic of x% (where x = 4, 4.5 or 5% at the concessionaire's option) over the contract's life. In case that traffic did not grow by that X%, the concessionaire was entitled to extend the concession period for up to 10 years to collect the guaranteed earnings. Then, the firm could benefit from diversifying the risk with the Chilean government by paying an "Insurance Premium". In return for these guarantees, the government received $171 million, or 7.8% of the guaranteed revenues, as additional infrastructure funded by the concessionaire. |
A final issue that must be considered is the need to monitor the companies' financial health and to try, whenever possible, to prevent finance distress situations from taking place by anticipating measures that may help companies to cope with the problems as soon as they arise.
The possibility of foreseeing situations of financial distress plays an important role in the financial literature and in the professional life of risk analysts. Next section presents the methodology generally used for this type of analyses.
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166 This option entails costs in terms of a higher cost of capital and a lower external supervision (associated to the leverage).