Kenya’s economic slowdown and its impending contraction due to COVID-19

Prior to the coronavirus, Kenya’s economic expansion slowed down from 6.3% in 2018 to 5.4% in 2019. The slower growth was associated with underperformance in agriculture (due to poor rains) and private investment which weakened due to crowding out from widening fiscal deficits and limited private sector credit growth. On a positive note, strong performance in the services sector helped overcome a slowdown in agricultural output.

Upon the incidence of the coronavirus in the Republic of Kenya, the economy has been hit by numerous systemic shocks that are projected to undermine Kenya’s economic growth even further. Though some of the effects are an exacerbation of preexisting negative economic ailments, the coronavirus has plunged Kenya into a new economic reality that threatens to injure most enterprises, regardless of scale or size.

Notably, economic activity has been weighed down by a combination of supply and demand shocks originating from both the external and domestic fronts. On the external side, supply and demand shocks are being transmitted through several channels:

• Due to global supply chains being disrupted, the availability of intermediate and capital goods, as a result of shutdowns in the source countries and transport disruptions is limited. Kenya’s monthly imports, notably from China, contracted sharply in the months of January-March 2020. A large share of retail goods in Kenya are shipped in from China and shortages of these goods are predicted to raise consumer prices.

• Kenya’s good exports (horticulture, tea and coffee) are coming under pressure. Flower exports are already hit hard, particularly due to the disruption of what would normally be peak Mother’s Day demand in Europe.

• Reduced tourism earnings. Kenya’s tourism economy was already in decline prior to the COVID-19 pandemic and it continues to contract further.

• A slowdown in remittance inflows: Although counties remain broadly steady as of January-March 2020, remittances could come under pressure due to adverse effects on the economies where the Kenyan diaspora is working. Kenya recorded remittances of USD 2.9 billion in 2019 (2.9% of GDP), with the bulk of remittances coming from Britain (34%) and the United States of America (30%). Remittances had been growing rapidly (doubling since 2014).

The external shocks have been further exacerbated by the policies that are needed to contain the spread of the virus, such as social distancing, home confinement, travel restrictions, closure of bars and restaurants, suspension of public gatherings and conferences and a nightly curfew. The latter measures have resulted in strong domestic demand and supply shocks. Currently, households have ramped up their precautionary savings, while firms are wary of investing until the crisis abates. Moreover, firms that are dependent on cashflows are at risk of lacking liquidity to fulfil commitments (pay salaries and suppliers) due to falling demand and could end up closing down due to insolvency.

According to mobility trend reports published by World Bank- Kenya, consumer mobility has contracted by up to 45%. This has significantly affected small businesses such as groceries and farmers markets, public transport kiosks and tertiary service providers who depend on face-to-face sales so as to generate revenue.

What these metrics could mean for your business:

The above observations may spell doom for various businesses. As local supply and demand drop, businesses are forecasted to experience substantial drops in sales turnover which will have negative consequences in their revenue and cashflow. The effects of the latter can be agonizing as the financial obligations of these firms continue to reflect on their balance sheets. Employee benefits and salaries, supplier payments, tax, utility bills and other costs of doing business will continue to bite into the cash reserves of every enterprise. As such, numerous firms have been forced to make numerous painful but necessary decisions as their economic future remains obscure in the wake of the pandemic.

For a select few firms, the economic impact of the coronavirus pandemic may lead to a series of powerful but recoverable blows to the financial body of their enterprise. The latter is largely due to their deep cash reserves, investment in business continuity, vertically integrated supply chains, digitized transactions, and other essential factors. However, for a significant portion of enterprises that are reliant on credit or laden with debt, the negative consequences of the pandemic could be the knockout punch that sends their entire enterprise into insolvency.

Business Rescue and the Insolvency Act, 2016:

Thankfully for Kenya’s economy, insolvency policy underwent essential reforms in the wake of the 2008 financial crisis. The widespread assessment of global insolvency laws and comparison of effective tools available for financially distressed companies led to the introduction of restructuring options within existing insolvency laws in order to give failing companies the necessary instruments to achieve solvency. The positive influence of these reforms is well-documented as numerous studies directly attribute insolvency law reform to job preservation, survival of distressed firms and creditor compensation.

In Kenya, the latter insolvency reforms were ensconced in the Insolvency Act, 2016 which provides for the rehabilitation of insolvent companies. In order to create alternatives to insolvency proceedings, the Act provides for two new procedures; administration and company voluntary arrangements (CVA) commonly referred to as out-of-court restructuring.

Restructuring can be defined as the process of restoring distressed or insolvent companies back to solvency through the reorganization of the assets and liabilities of debtors in financial difficulty. The process encompasses a wide variety of mechanisms to reduce financial distress, including the renegotiation of existing contracts with creditors, raising of additional financing and sale of assets.

Due to the inequities present in the liquidation process stated in the Insolvency Act, such as the immense economic losses occasioned by creditors and consequent layoffs, firms facing bankruptcy have recently shown a preference for restructuring their organizations in a bid to create win-win outcomes for employees, business owners and creditors alike.

A lesson in successful debt restructuring: Kenya Airways

Kenya Airways, a business with historic significance

The economic history of Kenya and the manifestation of Kenya’s financial maturity are best mapped by certain enterprises whose business philosophies and transactional history reflect the state of the nation’s economic growth and capability. These enterprises bear immense influence over the ebb and flow of Kenya’s larger economy as they are considered national symbols of prosperity and titans of Kenya’s economy.

Kenya Airways is one such enterprise. Through the sale of 26.7% of its equity shareholding to KLM Royal Dutch Airlines in 1997, the firm piloted the largest privatization exercise in East Africa’s history and introduced the world to the Nairobi Stock Exchange. The strategic partnership with KLM yielded efficiency gains, an improvement in service standards and an increase in airline profits. These factors culminated beautifully to create a 61% growth in flights in a period of six (6) years after its privatization and a doubling of cargo and passenger traffic in a decade.

The financial woes of Kenya Airways find their roots in the firm’s initiative to renew and expand their fleet. The latter was part-financed by the 2012 USD 175 million rights issue which provided additional capital to meet the deposits payable to aircraft suppliers on the new fleet. The additional funds needed for fleet modernization and expansion were obtained through conventional aircraft acquisition finance methods from banks and lessors.

Unfortunately, this substantial investment coincided with certain essential factors which adjusted the market structure of the aviation industry in East Africa considerably. These included: aggressive competition from international carriers particularly from the Middle East, increased terrorism in East Africa, SARS and the Ebola outbreak and a global drop in oil prices. Notably, the firm had suffered dire losses due to its fuel hedging strategy whose hedging window coincided with a drastic dip in global oil prices between 2014 and 2016.

Further, internally, Kenya Airways’ balance sheet was being substantially drained by its high operational costs, which consisted of landing fees, Airport Pax Service Charge and leasing and servicing costs of the national carrier. An equivalent of 11 per cent of Kenya Airways revenue was reportedly spent in servicing leases that are double the worldwide average of 5%.

These internal and external factors created a situation similar to that which numerous firms are facing in the wake of the coronavirus pandemic. These factors include the operational cash flows of the Company being unable to service the Company’s debt obligations (the majority of which were secured by the aircraft owned and/or leased by the Company and the remainder being unsecured corporate debt) and the overall level of debt of the Company becoming unsustainably high, meaning that the overall level of long-term debt is so high that a return of profitability for investors based on the current balance sheet structure is exceptionally challenging and thus unlikely to occur.

On 16th July 2017, the Company announced that following an in-depth review of its financial position and operations and having considered, together with its advisers, a range of proposals and alternatives from existing shareholders and third parties, its Board had secured a conditional agreement with its key creditors, including Government approval, to the terms of the Restructuring. The Company also entered into the Restructuring Agreement with certain key stakeholders and creditors pursuant to which the Company agreed to implement the Restructuring and certain creditors agreed to take all actions reasonably requested by the Company to support, facilitate, implement and give effect to the Restructuring.

The objectives of the Restructuring, as stated by the Board, were to: reduce the overall level of borrowings (leverage), increase the amount of cash available to the business (liquidity) and ensure ease of implementation of the numerous transactions needed to deliver a successful restructuring.

Key Elements of the 2017 Kenya Airways Restructuring Process

Following the signing of a Lock-up and Restructuring Agreement with the Government of Kenya, KLM Royal Dutch Airlines, KQ Lenders Company, 2017 Limited and certain Kenyan banks (the Restructuring Agreement) on 14 July 2017 and the subsequent approval of the Restructuring process by the shareholders at an extraordinary general meeting on 7 August 2017, the company successfully restructured its debt and equity in order to meet its financial objectives.

The Restructuring involved the following transactions:

• Conversion of a portion of the existing debts due to the Government into equity in exchange for an issue of USD 2.7 million new ordinary shares with USD 75 million of further indebtedness being convertible in the future pursuant to a zero coupon mandatorily convertible loan agreement.

• The issue by the Government of a sovereign guarantee of USD 525 million to the Export-Import Bank of the United States in support of the restructuring of the Company’s indebtedness to the financiers of the Company’s fleet of wide-bodied aircraft.

• The issue by the Government a sovereign guarantee of USD 225 million in favour of certain Kenyan banks who have also agreed to convert their loans to the Company into new ordinary shares through a new equity holding company, KQ Lenders Company 2017 Limited, and provision of USD 175 million of new loan facilities for company operations as backed by the Government guarantee.

• The issue of new shares to KLM Royal Dutch Airlines in consideration of in-kind capital contributions of non-cash assets to the Company.

• Securing cash-flow relief from restructuring the timing and form of payments from operating and financing lessors for the airline’s fleet of aircraft.

Certain aspects of these transactions are worth highlighting as they are a testament to the efficiency unlocked by the entire restructuring exercise:

• This transaction involves the nation’s largest debt-to-equity swap to date. With the Government of Kenya and KQ Lenders Company 2017 Limited, a consortium of 11 banks emerging as the largest shareholders at the tail end of the transaction, Kenya Airways managed to extricate itself from apparent bankruptcy through the deal and created a line of funds geared towards turning around the business.

• The incidence of financial obligations created by the fleet renewal and expansion plan of 2011-2012 was eased by the creation of a sovereign guarantee in favour of the Export-Import Bank of the United States.

• The debt generated by the high operational cash outflows due to the operating and finance lessors for the airline’s fleet of aircraft was renegotiated. The latter allowed the Company to unlock cash flow efficiencies which could be utilized in rescuing the airline’s business.

• This transaction substantially diluted KLM’s stake from 26.7% to 7.8%. This adjustment reflected the immense financial support that Kenya Airways received from the National Treasury. Despite this dilution of shareholding, KLM still received shares by virtue of its in-kind contributions to Kenya Airways via non-cash assets. This enables the airline to continue to benefit from its strategic partnership with KLM Royal Dutch Airlines as was intended by the celebrated privatization of the airline in 1997.

Conclusion

The 2017 Kenya Airways Restructuring Deal is a prime illustration of how businesses, regardless of scale can extricate themselves from painful commercial factors outside their control and reposition themselves towards profitability.

It is our ardent belief that introducing the option of restructuring through the Insolvency Act, of 2016 may be the shot in the arm which firms operating may need in order to survive in the wake of the coronavirus pandemic. Firms should utilize their potential in order to unlock immense cash flow efficiencies which may be the difference between the life and death of their respective enterprises.