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In This List
COMMENTS

U.S. Leveraged Finance Q1 2020 Update: Recovery Ratings Face Limited COVID-19 Disruption

COMMENTS

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U.S. Leveraged Finance Q1 2020 Update: Recovery Ratings Face Limited COVID-19 Disruption

The fallout from the coronavirus pandemic has sent the U.S. and global economy to a rapid tailspin. With over 90% of the U.S. population under quarantine, the U.S. economy has virtually come to a standstill. S&P Global economists forecast a decline of 5.3 % in U.S. GDP for 2020--down from 1.9% growth that they forecasted in the beginning of the year. With a recession underway, it might take several quarters, if not years, for the most-impacted companies to restore their credit metrics to the pre-crisis level. Against this backdrop, leveraged finance issuance essentially seized up in March, after seeing robust levels of issuance in first two months.

In this quarterly installment, we analyze the following topics:

  • The pandemic's repercussion on recovery ratings (which has been limited thus far, as expected given original default assumptions);
  • Additional light shed on recovery for the oil and gas sector;
  • Recovery outlooks of the latest cohort of first-lien new issues, to help frame where the market stands today with respect to expected recovery in the event of default; and
  • Review the trend of entry of smaller new issuers in the recent years; for many, the ongoing business disruption is placing added pressure on their long-term viability.

Recovery Ratings, Already Forward-Looking At A Default, Should Be Relatively Stable In The Face Of Pandemic-Fueled Volatility

While the long-term effect of the spiraling health crisis has not yet materialized, its impact on recovery ratings has been limited. Such stability around recovery ratings is expected as our recovery ratings' analysis by design already looks through to a company-specific default scenario. It assumes a drop in an enterprise's revenue and earnings to a point at which it is unable to meet its interest and scheduled principal payments along with a nominal maintenance capital expenditure (capex), causing the entity to default. An economic downturn that led to steep demand declines was commonly envisioned in a hypothetical default. For instance, in oil and gas, the majority of past defaults occurred during periods of sustained low oil and natural gas prices. Hence, in estimating recovery, we bake in lower hydrocarbon prices than normal as a major element in the path to default. For this reason, slumping revenue and cash flows by themselves should not materially change the recovery prospect of a debt instrument.

Impact Of Revolver Draws And New Loans To Recovery Ratings

In the limited cases where we lowered recovery ratings recently on account of the credit impact of the pandemic, the reassessment was mostly driven by changes to the capital structure (as would typically be the case regardless of the economic environment). Specifically, companies at the initial onset of coronavirus containment measures, started tapping into their revolving credit facilities and/or securing new financing, such as 364-day facilities, to raise cash. For many speculative-grade companies, the desire to shore up liquidity was an imperative as their revenues declined steeply. While this borrowing could increase leverage, as long as the companies did not have a weak or vulnerable business profile our view of the increase in revolver draws for liquidity purposes was neutral because the increase in leverage was offset by additional cash or liquidity. However, from a recovery rating standpoint, to the extent the revolver drawdowns exceeded our prior assumption thresholds (based on our recovery methodology, we assume 85% of committed cash flow will be drawn for revolving credit facility and 60% of committed asset-based loans will be outstanding at the time of default), we could revise our draw assumption to reflect the higher usage than was originally anticipated.

In our analysis, we assume any new financing arrangements, including short-term term loans and notes, to be rolled over on similar terms at maturity, unless there is clear visibility on the company's willingness and ability to repay the debt at maturity. This treatment is consistent with how we adjust for most debt maturing before our simulated default year, as we are more conservative in our assumptions in a distress scenario than a base-case assumption in an otherwise heathy environment.

According to report by S&P Global's Leveraged Commentary & Data (LCD), as of mid-April, roughly $228 billion has been drawn from revolvers since the onset of this pandemic. The volume of drawings seems to be slowing likely because companies that needed to draw have already drawn. The announcements of Federal Reserve stimulus programs aimed at improving liquidity in the corporate credit market may have also contributed to this.

Stable Recovery Outlook For Oil And Gas Despite Plunging Issuer Credit Ratings

Plummeting oil price and pandemic-related strain have once again thrust the oil and gas sector into the downgrade and default spotlights. We expect the sector, though representing a relatively small slice of total outstanding leveraged loans (more debt is in speculative-grade bonds), to have a disproportionally large share in the issuer default tally. Oil and gas, together with the media and entertainment, consumer products sector lead weakest links (issuers rated 'B-' or lower with negative outlooks or ratings on CreditWatch with negative implications), accounting for 45% of total weakest links as of March end.

The majority of issuers in the oil and gas sector are exploration and production (E&P) companies, for which recovery analysis anchors around the value of a company's hydrocarbon reserves. To estimate the impact of low commodity prices on recovery outlook, it is important to understand that recovery analysis does not attempt to identify the exact price levels that would trigger an individual E&P company to default. Rather, the focus is on valuing its reserves when the company emerges from bankruptcy, based on an estimate of the commodity price levels that might persist during a period of weak demand for crude oil and natural gas. These price assumptions reflect our view of the long term, all-in breakeven costs for the industry. While they are generally more stable than our benchmark prices used for issuer-level credit analysis, a severe supply/demand mismatch that stretches out for a long period could lead us to revise our breakeven cost assumptions. Additionally, in situations where an E&P company is in the 'CCC' rating category and there appears to be a possible near-term default, we will sometimes use an alternative deck that is closer to current hydrocarbon prices. That said, first-lien new issuance in this sector has enjoyed a favorable recovery outlook in recent years, benefiting mostly from higher-than-average junior debt cushion in the capital structure as lenders demand more structural protection given the very cyclical nature of the industry. For new first-lien term loans rated by S&P Global Ratings in 2019, the average estimated recovery for oil and gas is 76%, meaningfully above the cross-sector average of 65%.

Recovery Prospects For First-Lien New Issues Remains At The Lower End Of Mid-60s

While we don't expect recovery ratings to change on account of the general deceleration of the economy, aggressive capital structures with high leverage seen in the last few years has caused our expectations around recovery rates to be meaningfully lower. The chart below illustrates the downward migration, dating back to early 2017 when the U.S. leveraged loan market saw record levels of new issuance. In Q1 2020, the average recovery estimates of first-lien new issues deteriorated marginally, down to 64% from 67% in 2019 Q4. We believe this decline is more likely a reflection of the fierce risk appetite in the first two months of the year rather than something worse. Unsurprisingly, only a handful of new tranches debuted in March, resulting in the month being under represented in the average.

In considering these numbers, it is worth nothing that a cross-time comparison with previous default cycles would put recent estimates below historical norms. On a full-year basis, our first-lien recovery estimates averaged about 66% in 2019 and 65% of 2018. In contrast, the actual recovery rates for first lien averaged 80% in review of 241 U.S. companies that filed and emerged from bankruptcy or liquidated between 2008 and 2017. Although these metrics do not account for distressed exchange transactions, based on what we observed, enough borrowers doing distressed exchanges still ultimately ended up in bankruptcy (see "A 10-Year Lookback At Actual Recoveries And Recovery Ratings," Feb. 4, 2019)

Chart 1

image

Recovery rating distribution, another gauge of recovery prospects, reveals a more dramatic shift. The quarter-to-quarter breakdown of recovery ratings show that about 70% of first-lien new issuance in Q1 2020 had a '3' recovery rating, or 50%-70% recovery in an event of payment default. This exceptionally large concentration in '3' is the highest we have seen since Q1 2014, the start date of our underlying data, and dwarfs other categories by a consideration margin. At the same time, higher assessments, namely recovery ratings above '3' (indicating 70% plus recovery) are attenuated these days, with a far smaller share of 27%, a considerable slip from 41% just one quarter ago. This shift in Q1 is partly attributable to its outsized exposure of middle-market-esque private-equity-sponsored borrowers that rely heavily on first-lien financing.

Chart 2

image

The Music Stopped For The Smaller And More Vulnerable Issuers

We have seen an increasing number of smaller new issuers enter the ratings universe to access the leveraged finance market. This influx has reflected investor's growing tolerance and comfort for higher risk in period of low default and low interest. However, given the impact that social distancing has with sectors at the frontline of consumer spending (retail/ restaurants, leisure/gaming, media/entertainment, transport), we expect many smaller companies in these sectors to be especially vulnerable as the economy decelerates. The duration of the quarantines and social distancing will influence the viability of smaller enterprises. Further, these companies may not have the same breadth and depth of banking relationships that their larger counterparts have--something would serve them well at a juncture like this. They also tend to have narrow product or business lines and customer concentration, making it a challenge to get through economic chaos and unfavorable business conditions.

New issuers since 2016 across both investment-grade and speculative-grade rated issuers have, by and large, been noticeably smaller than their counterparts in prior years. We measured a company's relative size based on its reported revenue and EBITDA of the most recent fiscal year at the time we assigned the initial rating, and despite a wide dispersion around the mean, some long-run trends emerged. Average revenue and EBITDA both more than halved in 2017. Measured by medians, revenue and EBITDA shrank by roughly 30% and 36%, respectively, over the three-year period. Note that the averages are somewhat skewed by a small number of outliers such as DuPont de Nemours Inc. (formerly known as DowDuPont Inc.; the chemical conglomerate broke up into three separate entities in 2019). As such, the medians are substantially lower. To reflect performance of a spinout entity on a stand-along basis, we used its reported numbers of the first year following transaction close. We applied the same treatment to other major spin-offs including Corteva Inc. (another spun-out of DowDuPoint) and Clarios Global LP (the former Power Solutions business of Johnson Controls International PLC).

Table 1

First-Time Nonfinancial Corporate Issuers By Debut Year
Issuance Year Count of New Issuers Average Revenue ($ mil.) Median Revenue ($ mil.) Average Reported EBITDA ($ mil.) Median Reported EBITDA ($ mil.)
2016 158 2,329.8 615.3 380.9 91.6
2017 227 1,074.8 394.2 186.2 57.6
2018 247 1,015.3 441.5 148.0 60.3
2019 170 809.8 431.6 107.1 58.5
Source: S&P Global Ratings.

When breaking down the sample by EBITDA bucket (see table 2 below), 40% of new issuers in 2016 came from the top size bucket (reported EBITDA exceeding $150 million). The share has since plummeted to under 20%. Instead, new issuers last year were weighted towards the lower $0-$50 million bucket. Further down the size scale, the share of companies reporting negative EBITDA spiked in 2018, reaching 7% of total first-time issuers. This surge in 2018 has occurred in conjunction with strong merger and acquisition (M&A) and leveraged buyout (LBO) deal flows that year, when more investors were willing to snap up debt of risky companies with no established cash flows. Many have been borrowing under extremely favorable terms to support staggering growth at the cost of continuing large capital needs. One of the highest-profile fast-growing companies is WeWork Companies LLC. After a series of twists and turns (including the collapse of its late 2019 IPO), the long-term viability of the shared workspace company and sustainability of its liquidity position are now under mounting pressure. We are monitoring its cash burn rate and steps it might take to reduce capital expenditures and operating expenses (see Related Research)

Table 2

First-Time Nonfinancial Corporate Issuers By EBITDA Breakdown
Reported EBITDA
<0 0-50 51-100 101-150 >150
% of 2016 total 1.9% 22.8% 27.8% 7.6% 39.9%
% of 2017 total 4.4% 39.6% 23.8% 10.6% 21.6%
% of 2018 total 7.1% 36.9% 22.2% 10.7% 23.1%
% of 2019 total 1.5% 39.6% 27.6% 11.9% 19.4%
Source: S&P Global Ratings.

Related Research

  • COVID-19: Coronavirus- And Oil Price-Related Public Rating Actions On Corporations, Sovereigns, And Project Finance To Date, April 22, 2020
  • Economic Research: COVID-19 Deals A Larger, Longer Hit To Global GDP, April 16, 2020
  • Credit Trends: Social Distancing Boosts Weakest Links, April 8, 2020
  • Research Update: WeWork Companies LLC Downgraded To 'CCC+' On Mounting Cash Flow And Liquidity Pressure; On CreditWatch Negative, March 23, 2020
  • U.S. Leveraged Finance Q4 2019 Update: It's All About The Newbies, The New 'B's, Jan. 27, 2020

This report does not constitute a rating action.

Primary Credit Analyst:Hanna Zhang, New York (1) 212-438-8288;
Hanna.Zhang@spglobal.com
Secondary Contacts:Olen Honeyman, New York (1) 212-438-4031;
olen.honeyman@spglobal.com
Robert E Schulz, CFA, New York (1) 212-438-7808;
robert.schulz@spglobal.com
Analytical Manager:Ramki Muthukrishnan, New York (1) 212-438-1384;
ramki.muthukrishnan@spglobal.com

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