Unlike the GFC, which was essentially a liquidity crisis, Australia is likely to face a gradual increase in business insolvencies, rather than the feared 'insolvency cliff', as the Federal Government's COVID-19 stimulus measures are wound down at the end of March.
Formal insolvencies in Australia were down by approximately 45% in 2020 due to the various stimulus measures put in place by the Federal Government. The big question, once the stimulus measures unwind at the end of this month, is whether there will be a 'catch up' with those businesses that ordinarily would have failed and required that capital be reinvested through a new enterprise or restructured via the existing enterprise.
One would think there has to be. However, we will likely see the gradual increase in insolvencies rather than the 'cliff' because of the underlying strength in the economy, which grew at the higher than expected rate of 3.1% in the December quarter.
In a near zero interest rate environment, it is expected that all three levels of government will continue spending big on infrastructure, which should help to stimulate the building and construction and associated industries.
Pre-COVID under-performing business will still need to address the challenges that the COVID stimulus supplements helped them avoid. This will more immediately affect with SMEs where 90% of job keeper payments have been deployed. Loan covenant breaches, particularly Loan to Value Ratio and Material Adverse Change events will come to the fore.
In addition to these challenges, certain sectors will also face structural issues. The rise of environmental, social and governance (ESG) concerns for coal mining, coal fired power and related infrastructure may make it difficult for some businesses in these sectors to refinance on the looming maturity of their debt facilities.
There is no doubt that the crisis generated by COVID-19, and its impact on the way people travel, holiday and work, will have lasting effects on previously profitable industries. Many may not survive, and many will need to significantly invest to change the business model to meet the new demand.
How this investment is funded, through debt or equity or a combination of both will be critical. The equitable capital markets have already been extremely busy.
The large number of amended and extended loan variations from the major financial institutions, which embodied the 'Team Australia' approach to last year's economic crisis will start to run out in the coming months, which will heighten the need to address business underperformance.
There is no doubt that there is a huge amount of liquidity available from alternative financiers seeking high single and low double digit returns, in particular, to do this.
Interestingly, we are seeing a rise in the number of convertible debt instruments put in place. Perhaps this reflects an investing environment where the need to earn above market yields can only be met by taking some equity upside when many businesses are still facing significant cash flow and current liability challenges. Convertible notes can bridge the yield gap.
We expect distressed M&A to be the dominant form of restructuring this year – where the revenues of two stressed businesses are combined. Organic revenue growth will be challenging in many sectors once the COVID-19 stimulus is unwound.
The blending of two revenue streams with the associated cost synergies, should allow the core operations of entities with compelling business plans to continue in some form or another. However, that is not really what we have seen to date.
Industries that will take some time to return to normalcy as Australia and the rest of the world slowly emerge from the pandemic include mass tourism and education and student accommodation, airports and media and entertainment. Other industries such as early learning and child care, aged care and will face regulatory, as well as economic, head winds.
Directors owe continuing duties to assess the solvency of the company, as well as to act with the same degree of care and diligence as a reasonable person would in the director's shoes. Forecasting business performance at the best of times can be difficult, let alone at a time of significant social uncertainty and the withdrawal of substantial fiscal stimulus.
It is important for directors to not be unduly concerned. The clear policy direction from the Federal Government for last 10 years or so evidenced by the raft of amendments to Australia's insolvency regimes, including the introduction of the insolvent trading safe harbour and temporary moratorium, has been to allow directors sufficient breathing space and not prematurely appoint voluntary administrators. Nevertheless, directors will need to be vigilant and take appropriate steps to properly preserve enterprise value.
So while Australian business overall may be able to avoid an insolvency cliff as government emergency stimulus funding is rolled back, the fall-out of COVID-19 may last many years and impact the structure of the Australian economy into the future.
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