Credit market participants expect to see a wave of restructuring in the wake of the coronavirus pandemic, particularly as government support programs wane amid a recessionary environment.
Prior to the crisis, signs of recession in the U.K. and Europe were already appearing. On top of that, many companies were also highly levered.
"In January I was already predicting 40% of [dealflow would be] distressed situations," one London-based lawyer said. "Now with COVID [that proportion] is more 70%."
Sources agree that many companies have been put on "life support" by state loan aids and covenant waivers. When these programs end, the landscape will be awash in a sea of highly levered companies, sporting shrunken EBITDA, lost revenue and high fixed costs, and will face troubles ahead.
But rough times for some spell opportunities for others as restructurings and the race for liquidity spurs on divestment activity.
Winners and losers
The degree to which certain sectors will struggle will not be seen until there is clarity around what the "new normal" looks like.
The most obvious winners are those operating in the grocery, technology and healthcare sectors, which have seen a surge in need for services throughout the lockdown, sources said. Meanwhile, sectors such as aviation and tourism, casual dining and retail, and commercial real estate have taken the worst hit and are going to take longer to recover.
But what a recovery looks like for each sector is uncertain. Businesses are not going to be able to claw back revenue lost during lockdown, and ongoing social distancing likely means less footfall while costs remain fixed. Achieving clarity around what consumer behavior will look like and how quickly workers will return to the office will be an important first step.
"How are people going to spend money on restaurants or transport? It will be important to assess the impact consumer behavioral change will have on companies, especially given that those people that have been furloughed will have less disposable income and will want to spend less money," said Mike Corner-Jones, head of the U.K. financial restructuring team at Alvarez & Marsal Holdings LLC.
The economy will budge
Government programs such as the Coronavirus Business Interruption Loan Scheme and the Coronavirus Large Business Interruption Loan Scheme, which have provided much-needed liquidity amid an economy on lockdown, are propping up businesses, for now. But that support may end up being something of a double-edged sword, as companies that took emergency loans will struggle beneath an even larger debt burden even as they grapple with a recession.
When government support eventually comes to an end, the pipeline of restructuring situations is expected to swell with companies that were already fragile, sources said.
Likewise, once furlough schemes come to an end, businesses that have tapped the programs will need cash to pay employees, Tristan Nagler, U.K.-based managing director at AURELIUS Equity Opportunities SE & Co. KGaA, which focuses on special situations investing, said.
"The reason people took [part in the furlough scheme] was because they didn't have the earnings, and it's just a bit optimistic to think I've taken this bridge funding and the demand in my business is back at exactly the same time as all my costs come back," Nagler added.
Governments cannot help forever, one French lawyer said. "If the economy is going bust, who is going to pay the taxes to replenish the state's pockets? It won't be possible to furlough forever, people will eventually lose their jobs and we will get in a vicious circle situation where governments are spending but are not getting anything in," the lawyer said.
"I think we've all got to be realistic that we're in a sort of recession territory for a time," Nagler said. In that environment, a big debt burn is not going to be sustainable. "So I'm sure there'll be massive debt-for-equity restructurings and refinancings, rescue refinancings and ultimately, probably a bigger opportunity for equity rather than debt," he said.
New kids on the block
One likely way to try and mitigate the pain and shore up balance sheets are divestments. The London-based lawyer expects "a lot" of balance sheet restructurings in order to balance out assets and liabilities. This can be achieved through the sale of underperforming assets, the lender added.
Many public companies will be looking to divest noncore assets in order to get a cash injection, Corner-Jones said.
"With COVID, many activist-investors will put pressure on their companies to get rid of underperforming assets and noncore ones," the anonymous lawyer said.
Carve-outs are typically well-liked by private equity funds because they represent primary deals, which are rare in mature markets, the source explained. Private equity is also sitting on record levels of dry powder and has pinpointed carve outs as one of the most attractive opportunities for deal-making as the markets emerge from the coronavirus pandemic.
In addition, this could be an interesting area for direct lenders, as carve-outs tend to have lengthy and complicated due diligence periods, and this is the type of complexity that banks want to avoid at this time, a source explained.
"It's a lengthy and technical process in which you need to understand where to make the clean cut," the same source said. "When you carve-out you can lose a license or mess with different regulations."