Shareholder Value Creation: Corporate Distress and Restructuring | Management Optional Notes for UPSC PDF Download

Introduction

• Corporate distress, encompassing the legal procedures of corporate insolvency reorganization and liquidation, serves as a stark economic reality illustrating the downfall of businesses. Many scholars argue that each company inevitably faces fluctuations during its growth trajectory (Burbank, 2005), with corporate collapse being a foreseeable occurrence (Agarwal and Taffler, 2008). However, corporate distress is a reversible process through the adoption of restructuring strategies. Companies in financial distress typically exhibit common patterns that complicate the estimation of potential outcomes (Barniv et al., 2002). Despite variations among distressed firms, there are recurring indicators of financial weakness across different failure processes (Ooghe and Prijcker, 2008).
• Historically, the phenomenon of business failure was evident in the 1970s, with increased occurrences during the recession years of 1980 to 1982. Attention intensified during the surge of defaults and large firm bankruptcies in the 1989–1991 period, followed by unprecedented interest in the 2001–2002 corporate crisis and troubled years.
• A primary and persistent reason for a firm's downfall and potential failure is managerial incompetence. Past annual publications such as The Failure Record (no longer published) by D&B outlined various causes of failure, with management-related issues consistently accounting for about 90 percent. While most firms fail due to multiple factors, management deficiencies often stand out as the major issue. The primary cause of corporate upheaval is typically a cash shortage, but various management-related factors contribute to bankruptcies and other distressed conditions.

These contributing factors may include:

• Industries facing chronic challenges (e.g., agriculture, textiles, department stores).
• Deregulation in major sectors (e.g., airlines, financial services, healthcare, energy).
• High real interest rates during certain periods.
• Increased international competition.
• Industry overcrowding.
• Higher corporate leveraging.
• Elevated rates of new business formation during certain periods.

Some of these factors, such as high interest rates, overleveraging, and competition, are understandable contributors to corporate distress. Deregulation, for example, removes the protective barriers in regulated industries and leads to increased competition and higher failure rates. When a company faces financial distress, it often struggles to meet its debt obligations using its liquid assets, potentially leading to defaults and formal bankruptcy filings (Gilson, 1989). To avoid such outcomes, distressed firms typically respond by reorganizing assets through measures like fire sales, mergers, acquisitions, and capital expenditure reductions, or by restructuring liabilities through debt restructuring and injecting new capital from external sources. Managing the crisis situation of companies is a fundamental challenge, as it is not a spontaneous process. Moulton and Thomas (1993) emphasized that restructuring during financial distress situations is complex, with a low probability of successful exit. However, the percentage of firms that successfully navigate decline cannot be overlooked.

Corporate Restructuring strategy

• In the event of corporate distress, effective corporate restructuring becomes imperative as companies seek to enhance efficiency and profitability under expert corporate management. Government intervention may occur to support distressed companies in their recovery and revival efforts. Initially, a company must declare itself a sick unit in compliance with the Sick Industrial Companies Act of 1985, thereby placing it under the jurisdiction of the Board of Industrial and Financial Reconstruction. 
• In the company's best interest, the board may undertake revitalization, rehabilitation, or unit sale. Restructuring is essential for the company to generate funds (Rajni Sofat, 2011). In a broader sense, corporate restructuring entails changes in ownership, business mix, asset mix, and alliances aimed at enhancing shareholder value. Therefore, corporate restructuring may involve ownership restructuring, business restructuring, and asset restructuring.

Objectives of Corporate Restructuring:

• To continuously evaluate the company's portfolio of businesses, capital mix, ownership, and asset arrangements to identify opportunities for increasing shareholder value.
• To focus on asset utilization and identify profitable investment opportunities.
• To reorganize or divest less profitable or loss-making businesses/products.
• The company can also enhance value through capital restructuring by innovating securities that help reduce the cost of capital.

Types of Corporate Restructuring Strategies

• Mergers/Amalgamation: A process in which at least two companies merge to form a single firm, often expanding the firm's operations in the same industry. Horizontal mergers aim to achieve economies of scale and reduce industry competitors, while vertical mergers occur between companies operating in the same industry but at different production or distribution stages.
• Acquisition and Takeover: Common processes in the business realm, where takeovers involve one company taking control of another without the target company's consent, while acquisitions occur with the target company's board approval.
• Divestiture: Involves a firm selling a portion of its assets or a division to another company, representing a form of contraction for the selling company and expansion for the purchasing one.
• Demerger (spin-off/split-up/split-off): Involves segregating a company's business operations into one or more components to enable smoother operation, with spinoffs offloading underperforming or non-core divisions.
• Joint Ventures: New enterprises owned by two or more contributors, typically formed for specific purposes and durations, representing a combination of assets contributed by multiple entities.
• Securities Buyback: Significant for companies seeking to decrease their share capital.
• Franchising: An arrangement where one party grants another the right to use its trade name and business systems to produce and market goods or services.
• Leveraged Buyout (LBO): An acquisition of a company that leaves the acquired entity with a higher than traditional debt-to-equity ratio.

A corporate restructuring strategy involves dismantling and renewing areas within an organization requiring special attention from management. This process often follows buyouts, acquisitions, takeovers, or bankruptcy and can involve significant movement of organizational responsibilities or assets. Organizational restructuring entails making various transformations to the organizational setup, impacting the flow of authority, responsibility, and information. Reasons for restructuring range from diversification and growth to reducing losses and cutting costs, driven by both external factors such as mergers or internal factors like high employee costs. 

Restructuring strategies may involve reducing manpower to control employee costs. When management formulates and implements restructuring strategies, several changes may occur in the company's organizational structure, product mix, financing strategies, and overall operations. These modifications address specific problems or opportunities and help the company gain a competitive edge by reducing costs and redirecting resources toward core products and services (Rajni Sofat, 2011).

Corporate restructuring process

• Corporate restructuring is accomplished through product differentiation, enabling companies to make significant changes to existing products based on current market demands (Rajni Sofat, 2011).
• Companies can also focus on enhancing the quality of their products at every step of the production process, thereby adding new dimensions and improvements to their existing products or services (Rajni Sofat, 2011).
• Some restructuring strategies necessitate organizational changes. For instance, when a business enters a new market, separate business units may need to share administrative functions, or a corporate headquarters may need to oversee independent divisions. This may require forming a new management team or bringing on new partners or associates. In some cases, a company that previously outsourced administrative functions may opt to bring them in-house. Alternatively, a product dealer may transition to manufacturing products instead of purchasing them. Mergers may lead to the elimination of redundant layers of management, resulting in mass layoffs.
• If a company faces capital shortages, it may opt to sell stock or attract investors. This enables the business to acquire other companies, expand into new locations, or diversify its product offerings. These changes necessitate adjustments to the company's financing strategies based on its new debt burden and long-term financing requirements. 
• If a company is burdened with excessive debt, it may restructure by obtaining new loans with higher interest rates but lower monthly payments. Selling stock or divesting part of the business are options to reduce debt. Some restructuring efforts focus on cost containment, leading to changes in the mix of in-house and outsourced functions, as well as adjustments to the product line, labor utilization, and operations. This may involve renegotiating contracts with vendors, suppliers, contractors, lessors, creditors, and employees.
• During the restructuring process, a corporation may enter new markets. If the new products or services require different skill sets, the business may need to restructure accordingly, such as adding a new division or establishing a new production facility.
• Another aspect of restructuring involves devising a different distribution strategy. Companies may sell through various distribution channels, requiring operational changes to accommodate direct sales alongside sales through intermediaries. This could involve adjustments to the sales force, order-taking processes, product fulfillment, accounting services, customer service, and information technology. An effective restructuring strategy for distressed companies is rebranding. When a business undergoes restructuring due to changes in its product mix or distribution strategy, it may need to revise its marketing message and brand management policies to align with the new direction.

Conclusion

Corporate distress can stem from intense competition, high-interest rates, and drastic changes in the marketplace, potentially leading to bankruptcy. Financial distress has a significant impact on domestic economic activities (Papa M'B. P. N'Diaye, 2010). In such situations of corporate failure, restructuring strategies are essential. Restructuring a business can help struggling companies improve their position or enable successful businesses to expand further. This may involve significant changes in administration, marketing, distribution strategies, debt service, financing strategies, market entry, or product/service modification.