‘Special sits’ or ‘special situations’ are terms often used in the investment and financing worlds but, google these terms and you will see, there is no widely accepted definition or description. One reason for this might be that these terms do not refer to a specific type of investment or underlying asset and instead cover a broad spectrum of investment opportunities or strategies. One way to describe special situations investing is that it is an unusual event or occurrence (often once off) that will trigger an investment on the belief that its value will rise but noting that it is just a belief and these transactions can be risky and complex without any guaranteed return. In other words, it is event driven investment. On this basis it could include distressed investing (where the investor will look to profit from the recovery of the asset) but, it is important to understand, it is not limited to distressed investments. Special situations investments can be structured as either debt or equity investments or a combination thereof.
Many offshore special situations investors / funds (including those in Asia and the US) are investing in a broad range of Australian opportunities. In addition, many onshore funds have investors from abroad, including in some cases from institutions that are considered to be foreign government investors (FGIs) such as state pension funds. Pursuant to the economic impact of COVID-19, changes to Australia’s foreign investment framework came into effect on 29 March 2020 (we discussed these changes here) The changes reduce the monetary screening threshold to zero for all transactions and flag that the Foreign Investment Review Board (FIRB) may need to work with existing and new applicants to extend the statutory timeframe for applications from 30 days to six months. As a result, offshore special situations investors / funds and onshore funds with foreign investors may need to be creative when it comes to the structures or strategies they implement in order to invest in current special situations opportunities or those that might arise as a result of COVID-19 especially as some investors may need to consider the FIRB requirements for the first time (notwithstanding previous investments in Australia) as a result of the monetary screening threshold having been reduced to zero.
In this article we will explore some of the general structuring options available to special sits investors, including key considerations to be taken into account in respect of the current FIRB requirements.
Debt trading often picks up during periods of economic uncertainty or recession. This can be because the performance of a borrower, or the value of its underlying assets, is impacted such that there is a risk of the borrower defaulting on its debt obligations or because the financier itself needs to increase its liquidity or simply divest of its debt investments in particular sectors or industries to comply with internal mandates. In these circumstances, the financier may consider selling the debt at an amount less than its face value which reflects a change in the value of the asset or the ability of the financier to recover the money it originally lent and presents opportunity for investors to acquire this debt at a discount.
Investors may look to acquire debt for various reasons including for the purpose of trading it at a premium when the financial performance of the borrower improves, to hold onto the debt and receive interest income with a view that the debt will be repaid later at par with a ‘take and hold’ approach or, otherwise, to ultimately implement a loan to own transaction (as contemplated below). In addition, given the relatively low political risk in Australia and also that there is generally low legal risk as Australian loan documents contain terms that lenders are used to seeing in the United Kingdom, international investors often see Australian borrowers as having relatively strong credit compared to other developed nations. The general economic uncertainty and business-related defaults that may occur as a result of the COVID-19 pandemic might result in increased activity in Australia’s secondary loan market with interest from both local and international investors.
Selling or acquiring existing debt, by itself, does not trigger FIRB issues. From a structuring perspective, the FIRB regulations contain a moneylending exemption which excludes financiers from the FIRB rules where an interest in an Australian entity, business or land is acquired solely as a result of taking, and enforcing, security in connection with a moneylending agreement (such as a loan agreement). In effect, this means that security taken as part of the provision of debt finance or other financial accommodation is not subject to the FIRB rules.
Relevantly, the exemption is likely to apply to secondary debt trades where an investor acquires debt from a financier, provided that:
the investor, their subsidiary or holding company carries on a business of lending money or otherwise providing financial accommodation; and
the original moneylending agreement was entered into in good faith, on ordinary commercial terms and in the course of carrying on a business of lending money or providing financial accommodation.
If the investor acquires debt and then enforces the underlying security, they are not permitted to hold on to the asset they have acquired indefinitely – FGIs that are banks must make a genuine attempt to dispose of the asset within 12 months after enforcing their security, whereas all other foreign investors must do so within six months.
Loan to own transactions
A “loan to own” or “debt for equity swap” structure is a method of restructuring whereby financial investors gain control of a borrower or group of companies by converting the existing debt obligations owed to that financial investor into equity investments in the post-restructuring entity and, as such, delevering the borrower and returning it to a position of financial health. These structures can be implemented consensually or non-consensually or following the appointment of an insolvency practitioner.
A consensual restructuring is typically effected through a series of contractual arrangements as between the relevant borrower or group member, its secured lenders, its shareholders and any other key stakeholders.
Non-consensual restructurings can be implemented in a number of ways but are most often effected through a creditors’ scheme of arrangement pursuant to Part 5.1 of the Corporations Act 2001 (Cth). This creditors’ scheme is a court approved compromise or arrangement between a company and its creditors. In short, this involves:
an application to court to convene a meeting of creditors (with notice of such meeting being given to the Australian Securities and Investments Commission);
holding the meeting of creditors to vote on the proposed compromise or arrangement; and assuming the creditors in their relevant classes approve the proposed compromise or arrangement, a further court hearing whereby the court decides whether or not to approve the scheme.
In order for the compromise or scheme to be approved, a majority in number and at least 75% by dollar value of the creditors voting (in person or by proxy) in each class must vote in favour of the scheme. Dissenting minority creditors (including secured creditors part of a lending syndicate that might not want to take an equity position in the borrower) are bound by the decision of the requisite majority and can be ‘schemed’. Put another way, it means dissenting creditors are subject to the restructure even though they did not vote in its favour. It is for this reason, and given a formal insolvency process is avoided, that schemes of arrangement are one of the preferred methods to implement a non-consensual restructure.
Non-consensual restructures can also be effected through formal insolvency. The voluntary administration process and use of deeds of company arrangement provide sufficient flexibility for debt for equity transactions to occur. Common methods to achieve this include the issuance of new shares in the company to dilute existing equity, a credit bidding for the assets of a company or a transfer of shares pursuant to section 444GA of the Corporations Act 2001 (Cth) where there is no material prejudice to the existing shareholders because the value of the company breaks in the debt.
From a FIRB perspective, the conversion of debt-to-equity by foreign creditors or funds with foreign investors is unlikely to qualify for the moneylending exemption discussed earlier unless it is the case that the equity has been acquired by way of enforcing security. If that is not clearly the case, then the acquisition of equity as part of a loan-to-own transaction will almost certainly be a notifiable action and require FIRB approval in light of the zero screening thresholds because the nature of a loan-to-own transaction involves acquiring a controlling stake.
Board appointments or observers
If an investor provides debt or other funding to a company in distress or in other risky scenarios, they will generally want some level of control over the day to day operations of the company so that they can, to the extent possible, protect their investment.
One way of gaining such control is having the ability to appoint one of more directors to the board of the company. If the investor has no equity stake in the company, this can be reflected in the debt documents but if it does own a majority or otherwise significant portion of the shares, the right to appoint directors is generally negotiated, and the regime reflected in, the shareholders agreement.
Alternatively, if an investor has only provided a debt investment or only holds a small portion the shares but still requires an element of control (and the company has not agreed to it appointing directors to the board) they will at the very least require the right to appoint a board observer. A board observer is a person that has the right to attend board meetings but cannot vote on board matters. This way, the investor will have access to company decisions and have some say in the management of the company as the observer will be able to speak at board meetings and provide advice and guidance to the board.
In most situations, a financier appointing a director to the board of a borrower will not trigger FIRB issues if there is no current or potential equity interest held by the financier in the borrower. In short, this is because an interest must be acquired for an action to fall under the FIRB framework, which involves holding securities or controlling voting power at a general meeting of shareholders (rather at board level).
However, financiers who seek control through board appointments or other mechanisms in the loan documentation and hold any equity or have a right to be issued equity in the future (such as through convertible notes or warrants) should exercise caution. This is because:
(FGI) a notifiable action will occur where a FGI that holds any current or potential interest in a borrower obtains the ability to influence the central management and control of the borrower (such as through a director or under the loan documentation);
(agribusiness) a notifiable action will occur where the borrower is an agribusiness, the financier holds any current or potential interest in the borrower and the financier can influence the central management and control of the entity;
(change in control) a significant action may arise where the financier acquires a substantial interest in an entity (which is at least 20%) and the financier has the ability, either through the directors or under the loan documentation, to determine the policy of the entity (because this may result in a change in control of the borrower).
Convertible notes are a very popular fundraising or investment option and are a hybrid of debt and equity financing (being a short-term debt instrument that converts into equity upon certain events occurring). The instrument generally gives the investor the ability to convert their debt into equity to take advantage of upside returns but also protects them against downside losses as the full amount of the debt remains outstanding before a trigger.
For so long as the note is outstanding and has not been converted, the notes are a debt instrument with the aggregate face value accruing interest at an agreed rate (which can either be paid in cash or capitalised depending on the commercial agreement). Like a loan agreement, the notes will also typically have a maturity date for repayment of the debt. In addition, and if required by the investor, these notes can be secured by the assets of the company or have the benefit of any third-party credit support (such as guarantees).
When it comes to conversion, at the time of the trigger event, the aggregate amount outstanding under the notes (including any capitalised interest) is converted to equity in the company. There are three main circumstances that will typically trigger the conversion to equity. These are:
reaching the maturity date, pursuant to which the investor can either request that the loan be repaid or that the outstanding amount be converted into equity;
an exit event occurring, the business or the shares in the company being sold pursuant to a trade sale or there is an initial public offering of the company (or a holding company); or
the closing of a future equity raising of at least an agreed amount.
At the time of conversion, the investor generally receives the same class of shares as the existing equity investors and it is the number of shares that is typically subject to commercial negotiation and can either be at par or at a discount. It is also typical for the parties to enter into a shareholders agreement or require the investor to accede to an existing shareholders agreement so as to regulate the relationship between all equity holders in the company.
The main benefits of these convertible note investments is that:
they are relatively quick to implement once commercial agreement is reached (including as to interest rates, security and conversion triggers and mechanics) and, given it is not an outright equity investment at the start, the need for detailed valuations is avoided for the time being; and
the founders or existing shareholders maintain control of the company for a longer period as the investor is only afforded voting rights upon conversion once it has an ownership stake in the company.
The position under the FIRB legislation is that convertible notes – and any other options or right to future equity - are treated as though they have been converted into securities and investors are deemed to have acquired those securities at the time the convertible notes are issued to them. This is the case even if the conversion of the notes is contingent on certain events or triggers occurring in the future.
As a result, the starting point for investors is to view a convertible note investment through the same lens as an equity investment. The recent threshold changes mean that acquiring convertible notes in an Australian entity or business is likely to be a notifiable action if, for example:
the securities into which the notes could convert represents a substantial interest (20% or more) in the borrower;
the investor is a FGI and the securities into which the notes could convert represents an interest of at least 10%, or any percentage interest if the FGI can influence or participate in the management and control of the borrower;
the borrower is an agribusiness and the securities into which the notes could convert represents at least 10%, or any percentage interest if the investor can influence or participate in the central management and control of the borrower (for example, by appointing a director); or
the borrower is an Australian land corporation (unless, for example, the exemptions for listed or unlisted REITs are available).
The requirement to obtain FIRB approval will add time and cost to investors looking to finance distressed businesses through convertible notes. FIRB may prioritise the application if the financing is urgently needed to support Australian jobs. However, failing that, an alternative approach might be to make the provisions around the conversion of the notes conditional on FIRB approval being obtained. This may not be palatable to the investor because there is a risk that the notes may not be able to convert if FIRB approval is not granted, but it may offer a workaround if the raising is urgent and the risk of not receiving FIRB approval is low (when the national interest test is considered).
Warrants are contractual arrangements between a company and an investor pursuant to which the investor is given the right to acquire shares in the company at a later date at a pre-agreed exercise price and also often include a right for the investor to cash in on the warrants for an agreed cash price (which might take into account the valuation on an equity raising).
Warrants are often a feature of debt transactions where investors are lending into higher risk borrowers and, as a result, require an equity upside or ‘kicker’ in addition to earning interest on the loan.
The number of warrant shares is sometimes hardcoded at the time of documentation. Other times, it is set to be such number of shares equal to a certain percentage of share capital. In each case, one of the major concerns for investors is potential dilution through share splits, the issue of additional shares or conversion of other existing options. Each of these can be dealt with through the relevant documentation but this should be front of mind for investors in order to protect their equity kicker.
Investors often require certainty that their exit interest is liquid, especially as a rate of return may not be able to be modelled given that it might not be in a position to force insolvency proceedings should it wish to while only holding the exercise right. A common way for investors to ensure liquidity is to include a put option right to require the company to redeem the warrant for a pre-agreed price upon the insolvency (or any other exit event).
As with convertible notes, the founders or existing shareholders maintain control of the company for a longer period as the investor only becomes a shareholder at the time the warrant is exercised.
Like convertible notes, the shares that could be issued under warrants are treated as being acquired by the investor when the warrant is issued. As noted above, this is because the FIRB legislation treats the acquisition of a right or option to acquire an interest in the future, even if that right is contingent on certain triggers, as having occurred when the right is first granted.
In practice, warrants typically grant the lender a right to be issued a nominal interest in the borrower so do not ordinarily raise FIRB considerations. This means that market-standard warrants will not generally give rise to notifiable or significant actions. This remains the case even though the screening thresholds are now zero. However, lenders seeking an equity kicker should be alert to red flags where:
the warrants give the lender a right to be issued 20% or more of the share capital in the borrower;
the borrower is in a prescribed sector, such as media;
the borrower is an agribusiness and the lender appoints a director or can otherwise influence the central management and control of the borrower (in which case even acquiring a nominal stake can be a notifiable action);
the lender is a FGI, in which case acquiring 10% in any Australian entity or business or acquiring any interest but being able to influence the management and control of the entity will be a notifiable action; and
the borrower is an Australian land corporation, in which case acquiring any interest could be a notifiable action (unless the exemptions for unlisted REITs in the regulations apply).
Real property options
Direct investments in real estate often include ‘call options’ which, similar to warrants in respect of shares in a company, are contractual arrangements between buyers and sellers of real estate pursuant to which the seller offers the buyer the option to purchase the freehold property during a specified period of time for a fixed price and, for the right to this option, the buyer will pay an option premium or option price to the seller. If the buyer exercises the call option, the seller is obliged to sell the property to the buyer.
These options are commonly used amongst investors or property developers as they provide flexibility and opportunity to buyers without tying them down.
The acquisition of an interest in Australian land by a foreign person will, unless an exemption applies, require foreign investment approval on the basis that the monetary screening thresholds are currently zero. In a similar vein to convertible notes and warrants, an investor will be taken to acquire an interest in Australian land when they acquire an option to purchase that real estate – even if it is contingent on future events or triggers occurring. An outcome of the recent changes to the screening thresholds is that any options entered into by foreign investors after 10.30pm (AEST) on 29 March 2019 for the acquisition of Australian real estate will require foreign investment approval, unless one of the limited exemptions applies or the exercise of the option is made conditional on obtaining FIRB approval.
As illustrated by the examples above, the implications of the temporary reduction in FIRB thresholds can be broad and will inevitably require some parties to grapple with the FIRB process for the first time – which can add considerable cost and delay to a transaction, particularly if FIRB approval was not contemplated when a transaction was first agreed. Given this new landscape, it is important that any investor using foreign funds (even passive foreign funds) takes FIRB into consideration going forward. The Hamilton Locke team have extensive experience advising funds, investors and companies on FIRB, including FIRB applications and potential structuring solutions.
About Hamilton Locke
Hamilton Locke is one of Australia’s fastest growing law firms and now in the top 50 firms nationally. Over the past year the firm has grown 200%, from five to 16 partners, and from 13 to 50 lawyers and staff.
Hamilton Locke is a multi-award winning full service corporate and commercial law firm covering M&A, property, banking, restructuring, funds management and litigation. With talent from some of the top law firms globally, we believe in the relentless pursuit of success for our clients. That is why we have grown an organisation of energised people, propelled by class leading technology, who are freed up from bureaucracy and administration to really focus on doing what they do best – solving complex client problems.