News tabloids carried gut churning headlines on March 20, 2018 with captions similar or equal to
“The Bank of Ghana (BoG) has revealed that 37 percent of licensed Micro Finance Institutions that entered 2018 are distressed or have collapsed. This has contributed to the GHȼ740.5 million which is owed to an estimated 705,396 depositors in distressed or folded up Micro Finance Institutions (MFIs) and Rural and Community Banks (RCBs)”
………Also, out of the 141 RCBs, 37 are active but distressed or folded up. In total, it is estimated that 272 out of the 707 institutions in the sub-sector, representing 38.5 percent, are at risk. This indicates that approximately GH¢740.5 million is owed to an estimated 705,396 depositors of the distressed or folded up MFIs and RCBs”
The passion with which Ghanaians discussed the Galamasey menace, Gitmo2, Montie 3, Ghana-US military Co-operation Agreement, Arrest/detention of Mr. Koku Anyidaho, Double salary payment to MPs and so on. I opine that the same vehemence should be allotted to the matter stated above because we can’t discuss this issue discreetly. Why? It’s because the informal sector in the Ghanaian economy constitute 85 percent and these endangered FIs (MFIs, RCBs and S&Ls) are the only institutions that financially serve the economically active poor. The well-resourced banks wouldn’t do business with this sub-sector due to their attendant risk and peculiarities. Can you imagine the outcome of events if these FIs who are willing to lend a helping hand to this unstructured sector sink or go under? Your answer is as good as mine and even better than we can ascertain. Therefore, the symbiotic relationship between these institutions when well-nurtured by all stakeholders in the financial value chain can open-up the colourful economic prospects we all aspire for.
Again, the prevailing relations between the informal sub-sector and FI’s must be deliberately boosted to expand, in order to shore-up the teeming youth unemployment in the country. We mustn’t sit down and watch our financial sub-sector take a nosedive! A wise man once said “define the problem properly and the solution will present itself”.
Why 38.5% of FIs are sinking and (or) in distress as per BoG report
- High killer interest rate
- MFIs, S&Ls and RCBs underwriting credit papers like 1st tier banks
- Anaemic or no credit appraisal plus insupportable repayment schedules
- Profligate capital expenditure (capex) such as grandeur office space, “fuel sucking” 4X4 vehicles, high perks for managers etc
- Unconscionable raise of minimum capital requirements by the regulator in an attempt to weed-out Ponzi scammers.
- Padded financial reporting by auditors whose actions and inactions deny stakeholders the true position of FIs
- Inadequate or no credit risk management practices
- Hardcore non-performing assets breeding liquidity concerns
- Scanty people development opportunities (training and development programmes)
- Poor street and house naming system which in the long-run negatively affect credit risk profiling and credit pricing.
How to Swim ……and not Sink
Solution 1. Lean & Mean Lending Machine also known as “straight-through processing”
What is the best way for FIs to swim and stay afloat in this lending landscape? At a time when management is minded to focus on risk as never before and where the volume of credit applications has dwindled, there exists the opportunity to set-up good, sound, lean and mean systems that will enhance your ability to thrive in the future. A state-of –the-art consolidated data repository must be created which will turn raw data into knowledge. This repository must have integrated systems to allow for greater interoperability between departments and across lines of business. Retrieved information from the repository is used for the purposes of managing credit, marketing, segmenting, managing risk i.e. risk scoring, financial forecasting, stress testing processes, establishing capital goals, challenger banks and so on. Straight–through processing (STP) as it’s also known enables all employees involved in a particular loan project to access updated information. Pre-configured workflow allows continuous monitoring of credit related activities and maintain a central data repository which ensure that the underlying information supporting the credit approval process is the most up-dated data available.
At a higher level, firm policy generally includes periodic enterprise reporting to enable management monitor business processes, identify any lending bottlenecks, appraise efficiencies and detect discrepancies. Discrepancies can be negative risk rating trends, unusually lengthy turnaround times in processing credit applications, as well as out-of-date documentation.
Solution 2. Turnaround Management
Turnaround management (aka Distressed Business services) is simply assisting under-performing businesses and providing support and resources for recovery, rapid growth in challenging situations. A successful turnaround depends on developing an appropriate turnaround prescription (rescue plan) and effective implementation. The first point to address is ‘what’ needs to be done and the second is ‘how’ to do it. The approach for achieving a successful turnaround consists of 7 essential ingredients and an implementation framework also consist of 7 key workstreams. The recovery of sick FI depends on the implementation of an appropriate rescue plan. The features of the appropriate remedy are that it must;
- Address the fundamental problems
- Tackle the underlying causes (rather than the symptoms)
- Be broad and deep enough in scope to resolve all the key issues
7 Essential Ingredients
The turnaround strategy consists of the following, and may occur concurrently and in any order:
- Crisis stabilization – taking control, cash management, short term financing, first step cost reduction.
- New or improved leadership – due to inadequate skills, instability in management, need for fresh ideas, or to bolster a tired team.
- Stakeholder focus – advising and engaging stakeholders dependent on the outcome and includes financiers, creditors, employees, customers, industry associations and even government officers (sometimes a source for grants). The benefit of this aspect is often underestimated and often provides the greatest source of solutions and support.
- Strategic focus – redefining the core business, restructuring, M&A, divestment.
- Organizational change – engaging key staff, improving communication, improving morale.
- Process improvements – operational improvements that provides low hanging fruit, and focus on key issues that may be key risks.
- Financial restructuring – implementing tighter control and monitoring of cash (implementing a rolling 13 week cash flow forecast), equity injection, asset reduction or selling under-utilized assets to generate cash or use as security for short term funding.
One of the challenges for any turnaround leader is to ensure that the rescue is built on a robust plan. Plans that try to tackle every problem of a troubled company, no matter how big or small, will fail as limited resources are wasted on tackling ‘non-mission critical’ issues. The key is to focus on tackling the life-threatening problems. A recovery strategy that is based on the symptoms rather than the underlying causes may make the patient feel better temporarily but any long-term recovery strategy must be based on scoring out the underlying causes of distress. Turnaround plans must be sufficiently broad and deep to ensure that all the mission critical issues are addressed. Turnaround management involves radical rather than incremental change and can only be tackled through fundamental, holistic recovery plans. In my experience, I have seldom encountered a turnaround plan that was too drastic. The chief danger to avoid is doing ‘too little too late’. It is a great letdown about the lack of funds or institutions, providing readily available equity and loan financing for turnaround in Ghana. This may be partially due to nascent state of our financial service industry. When some widely diversified companies dominated the private sector in Ghana they provided their own turnaround funding and resources. This situation has changed and, I believe profit opportunities are being missed. Turnaround funds sometimes outperform venture capital funds from Europe and the US. I am sure that a better application of turnaround management would make a meaningful contribution towards better growth rates in the industry and hence employment.
Solution 3. Mergers and Acquisitions (M&A)
M&A is subset of strategic focus under the 7 essential ingredients of turnaround management. A merger is a combination of two or more companies in which all but one of the combining companies legally ceases to exist and the surviving company continues in operation under its original name. A consolidation is a combination in which all of the combining companies are dissolved and a new firm is formed. The term merger is generally used to describe both these two types of business combinations. Acquisition is also used interchangeably with merger to describe a business combination.
Types of Mergers & Its Functionalities
Mergers are generally classified according to horizontal, vertical or conglomerate dimensions.
Horizontal Merger: In horizontal merger two or more companies which are engaged in similar lines of activity are combined. One of the motives advanced for horizontal mergers is that of economies of scale can be achieved. Another major motive is the enhancement of market power resulting from the reduction in competition. For example FIs with same balance sheet and worth in scale can merge horizontally for mutual benefit.
Vertical Merger: Vertical merger occurs when firms from different stages of production chain come together or amalgamate. The major players in the oil industry tend to be highly vertically integrated. They have exploration subsidiaries, drilling and production companies, refineries, distribution companies and fuel stations. Vertical integration often has the attraction of increased certainty of supply or market outlet. It also reduces costs of search, contracting, payment collection, advertising, communication and co-ordination of production. There is also increased in market power. In this instance, 1st tier bank can swallow or merge with under or non-performing entity.
Conglomerate: A conglomerate merger is the combining of two firms which operate in unrelated business areas. Some conglomerate mergers are motivated by risk reduction through diversification, some by opportunity for cost reduction and improved efficiency.
M&A Intrinsic Motivation
Merger/acquisition is profitable because it increases revenue or decreases expenses or both, and results in a net gain to the acquiring firm. Firms may decide to merge with other firms for variety of reasons as shown in the table below:
- a) Synergy
The two firms together worth more than the value of the firms apart. Synergy is often expressed in the form 2 + 2 = 5
– Market power
– Economies of scale
– Internalization of transactions
– Entry to new market and industries
– Tax advantages and diversifications b) Bargain buying
Target company can be purchased at a price below the present value of the target company’s future cash flow when in the hands of new management. This can come about as a result of:
– Elimination of inefficient and misguided management
– Under-valued shares and stock market inefficiency c) Managerial Motives
– Empire building
– Hubris – arrogance or self confidence by management
– Survival – speedy growth strategy to reduce probability of being takeover target
– Free cash flow – management prefer to use free cash flow in acquisitions rather than return it to shareholders d) Third party motives
– At the insistence of customers or suppliers
- a) SYNERGY: – The idea underlying synergy is that the combined entity will have a value greater than the sum of the two parts. The increased value comes about as a result of boosts to revenue and/or the cost base. If two firms, A and B, are to be combined a gain may result from synergistic benefits to provide a value above that of the present value of the two independent cash flows as shown below:
One of the most important forces driving mergers is the attempt to increase market power. This is the ability to exercise some control over the price of the product. It can be done through either monopoly or dominant producer positions. If a firm has large share of a market it may be able to push up the price of goods sold because customers have few alternative sources of supply.
Market power is a motivator in vertical as well as horizontal mergers. Downstream mergers are often formed in order to ensure a market for the acquirer’s product and to shut out competing firms. Upstream merger often leads to the raising or creating of barriers to entry or are designed to place competitors at a cost disadvantage.
Economies of Scale
Larger size often leads to lower cost per unit of output. Economies in marketing can arise through the use of common distribution channels or joint advertising. There are also economies in administration, research and development, purchasing and finance. Financial economies, such as being able to raise funds more cheaply in bulk, are also alluded to.
Internalization of transaction
By bringing together two firms at different stages of the production chain, an acquirer may achieve more efficient co-ordination of the different levels. Vertical integration reduces the uncertainty of supply or the prospect of finding an outlet. It also avoids the problems of having to deal with a supplier or customer in a strong bargaining position.
Entry to new markets and industry
If a firm has chosen to enter into a particular market but lacks the right know-how, the quickest way of establishing itself may be through the purchase of an existing player in that product or geographical market.
Notably in the USA, if a firm makes loss in particular year these losses can be used to reduce taxable profit in a future year. Past losses of an acquired subsidiary can be used to reduce present profits of the parent company and thus lower tax bills. Thus there is incentive to buy firms which have accumulated tax losses.
One of the primary reasons advanced for conglomerate mergers is that the overall income stream of the holding company will be less volatile if the cash flows come from a wide variety of products and markets.
- b) Bargain buying
Elimination of inefficient management
Inefficient management may be able to survive in the short run but eventually the owners will attempt to remove them by, say, dismissing the senior directors and management team through a boardroom coup. The shareholders might invite other management teams to make a bid for the firm, or simply accept an offer from another firm which is looking for an outlet for its perceived surplus managerial talent.
Under Valued Shares
Many people believe that stock markets occasionally underestimate the true value of a share. It may well be that the potential target firm is being operated in the most efficient manner possible and productivity could not be raised even if the most able managerial team in the world took over. Such a firm might be valued low by the stock market because the managements are not very aware of the importance of a good stock market image.
- c) Managerial Motive
One group which seems to do well out of merger activity is the management team of the acquiring firm. When all the dust has settled after the merger they end up controlling a larger enterprise. And, of course, having responsibility for a larger business means that the managers have to be paid a lot of more money. Being in charge of larger business and receiving higher salary also brings increased status.
Hubris – this means over-wearing self-confidence, or less kindly, arrogance. Managers commit errors of over-optimism in evaluating merger opportunities due to excessive pride or faith in their own abilities.
Survival – Firms may merge for the survival of the management team and not primarily for the benefit of shareholders. Potential target managements may come to believe that the best way to avoid being taken over, and then sacked or dominated, is to grow in size and to do so quickly.
Free Cash flow – this is defined as cash flow in excess of the amount needed to fund all projects that have positive NPVs. In theory firms should retain money within the firm to invest in any project which will produce a return greater than the investors’ opportunity cost of capital. Any cash flow surplus to this should be returned to the shareholders. So instead of giving shareholders free cash flow the managers use it to buy other firms.
- d) Third Party Motives
There are many highly paid individuals who benefit greatly from merger activities. Some of these are:
Advisors, Suppliers & Customers – Advisors charge fees to the bidding company to advise on such matters as identifying targets, the rules of the takeover game, regulations, monopoly references, finance, bidding tactics, stock market announcements, and so on.
Solution 4. Corporate Governance & Leadership
On a lighter note an Anonymous wife once said “In my family, my husband makes all the major decisions. So far, there have been no major decisions”
Governance is a process by which a board of directors, through management, guides an institution in fulfilling its corporate mission and protects the institution’s assets. Fundamental to good governance is the ability of individual directors to work in partnership to balance strategic and operational responsibilities. Effective governance occurs when a board provides proper guidance to management regarding the strategic direction for the institution, and oversees management’s efforts to move in this direction. The interplay between board and management centers on this relationship between strategy and operation, both of which are essential for the successful evolution of the institution.
In exercising their governance responsibilities, board members must consider the perspectives of numerous external actors. Depending on the legal status of the FI, these actors can include providers of capital such as donors, governments, depositors or other financial institutions; regulatory bodies such as the superintendence of FIs; and other stakeholders, including clients, employees, and shareholders. In its governance role, the board also is accountable to all these stakeholders and must assess continually which of these are the most important for the institution. All board members must follow basic codes of conduct in carrying out their governance roles and responsibilities in good faith. “Duty of loyalty” requires board members place the interest of the institution above all others. “Duty of care” calls for board members to be informed and to participate in decisions prudently. Finally, “duty of obedience” requires that board members be faithful to the institution’s mission. Not all boards maintain the same level of involvement in the institution. At one end of the continuum of board involvement is a rubber-stamp board, which is generally reactive to management. At the other end is a hands-on board, which provides excessive oversight and engages directly in operations. In the middle are representational boards, made up of highly influential individuals who are not necessarily experts in the industry. These boards resemble rubber-stamp boards except that board members’ access to sources of power and funds is exercised to the benefit of the institution. Multi-type boards balance representational members with those that have expertise, and generally are better equipped to make informed decisions on a timely and efficient basis. The relationship between the board and the executive requires clarity about the roles and responsibilities of each, and about the complementarity of these roles. The board should exercise this responsibility by (1) maintaining distance from daily operations; (2) drawing on the institutional memory of the directors; and (3) making binding decisions as a group. Application of these factors results in a process of decision-making that empowers the board and adds significant value to the management of the institution. Major board responsibilities can be grouped into the following 4 categories:
# The board has legal obligations that revolve around ensuring compliance with the institution’s bylaws, procedures, and other legal requirements. The board may be held liable for the institution’s activities.
# The board must ensure management accountability by hiring competent professionals, establishing clear goals for these executives and closely monitoring their performance, and confronting weaknesses when they surface.
# The board is responsible for setting policy and providing strategic direction to the FI. The board must work closely with management in carrying out this role to ensure congruence between the institution’s strategic thinking and its operations.
# The board must assess its own performance on a regular basis. It is the board’s responsibility to maintain continuity or “institutional memory” in its ranks, to renew its membership with new directors, and to evaluate its own processes for decision-making. Diligence in fulfilling these roles and responsibilities does not in itself ensure effective governance. Other essential factors are the commitment of the directors to the institutional mission; directors’ skills and expertise; attributes of the chairperson; the presence, structure, and function of committees; clearly defined board policies and procedures; and a climate that allows for critical self-evaluation.
…continued on Friday
By Kwesi Kumah