McDermott Will & Emery partners Aymen Mahmoud and Mark Fennessy in London, Felicia Perlman in Chicago and Jon Levine in New York examine how struggling companies fared in 2022 with reduced access to liquidity, and predict an increase in distressed M&A activity and out-of-court transactions as debtors look to deal with those liquidity issues in the year ahead.
It is not unreasonable to think that what became of 2022 was predictable based on prior markers: the roots for the economic slowdown in the second half of the year can be seen clearly as we look back to the pandemic. But those roots alone did not appear able to bring about the slowdown; they needed some help.
Covid-19 led to stimulus and other palliative measures that were often predicted to drive ination or the types of increased taxes that might negatively impact the economy. At the same time, the world cruised through an extended period of easing across various economies. While those features did not alone pull us into a recession, they may have exacerbated the global economic impact of the war in Ukraine which has in turn impacted raw material costs and driven increased energy costs, leading to increased inationary pressure. The geopolitical instability was arguably a stronger contributor to the slowdown, as was the continuing change to UK politics andscal policy.
What then was the role of the M&A markets? Were they fatigued? Did the splintering pace of activity in 2021 taken its toll on the market?
These ingredients are part of the usual recipe for stress and distress and permeate the kinds of nancial markets where 'special situations' are prevalent. In those markets, even performing credits are stress-tested by increased costs of materials, labour and energy, having greater difculty in tapping markets for liquidity and, ultimately, having to seek more expensive debt.
Add to that some volatility in foreign exchange markets on one side of the Atlantic, and the directional shift is worsened. We have moved quite quickly from a long period of very cheap liquidity to a period where access to liquidity is more limited, and where any available liquidity is also more expensive.
Does that lead to the potential for overstatement in the bearish approach? It could very well do so. What the last ve years have shown us is that traditional economic theory may not present in actuality and, even when it does, it may do so in short bursts and a quick rebound to the previous status quo. What would the more orthodox economic views suggest?
First, that consumer discretionary spending will be hard-hit as consumers tighten their belts, leading to a reduced level of activity and a greater amount of stress in less defensive industries. That prediction does not yet appear to have taken hold - for example, technology and Software-as-a-Service (SaaS) businesses continue to drive market activity alongside a range of sectors. Exits and recapitalisations are predictably slow while market participants try to best understand where pricing should be and try to reduce risk, which may well represent more of a transactional reluctance rather than a deeply illiquid market. After all, the liquidity is still here, it is just not being deployed quite as freely as perhaps it once was.
For the most part, economic indicators that lead to stress or distress do not always drive restructuring activity. For that to happen, a business itself needs to be in a position of stress or distress and a trigger is needed to drive forward some type of process.
That trigger either comes from the company side via directors who need to take an action or respond to a need for accountability, or equity holders in the place of those directors; or it comes from a different stakeholder with some power to act or compel, typically a creditor. For example, for companies that have benetted from widely permissive debt documentation, the nancial covenant, which was typically seen as the 'canary in the coal mine', letting creditors know when things are bad may not always be of particular use.
Over the last few years, an increased number of transactions have been underwritten without a maintenance nancial covenant, as is often seen in the capital markets. However, even those with proper maintenancenancial covenants may have been crafted with very wide headroom and allow for EBITDA adjustments that mean that a covenant breach is simply extremely hard to occasion. In those more extreme circumstances, when the covenant is breached, the early warning sign is of little use and the company is in very real distress. At that point, a lender may be left with very little room for manoeuvre.
Combining the covenant impact described above with what is, in all practical terms, a less liquid market for companies to borrow, can easily give rise to a more formal process. However, we are commonly seeing more temporary measures, such as covenant resets, waivers, forbearances and amend and extends (A&E). The terms of these "A&Es" vary considerably but, in the most typical examples, a 12-18-month extension to maturity is sought in exchange for an economic uptick of c.100 basis points. Interestingly, this dynamic encapsulates two other eventualities.
The rst is that many capital structures are nanced by direct lending or other non-bank sophisticated capital that is able to apply greater levels ofexibility to stressed situations, whether in covenant reset or maturity extension terms or even documentaryexibility. Such lending aligns with the oft-cited "patient capital" marketing approach from direct lenders over the last decade and assumes that there is a performance normalisation in the medium term. The second linked point is that borrowers (and often their lenders) seemingly believe that the period of stress or distress is short, and that rather than entering into a more formal, convoluted or expensive process, the going concern value of the business is better maintained outside of the process. Such thinking is certainly in line with what was seen during the globalnancial crisis - many businesses were fundamentally good businesses that would come through the other side if given the time and space to do so.
It is also the natural order for some types of companies to fail, including those in the consumer discretionary sector where spend has reduced, and some of the early-stage companies that have borrowed aggressively to drive growth and which now stutter owing to the wider economic climate. Even those business types most impacted by ination, such as manufacturing or accommodation fall into this category. For those early-stage businesses, reduced liquidity may be particularly impactful - to the extent a business considered that it would later have easy access to the debt markets to take it through the next stage of its development, the absence of that liquidity and the concomitant difculty of accessing the equity markets would meaningfully stunt the type of growth required for those companies to achieve performance metrics, and in a pre-EBITDA business that impact quickly leads to distress.
Might this lead to 2023 being peppered with the type of consolidation in which smaller or less-developed businesses are subsumed by larger businesses, or even turn to merger-like structures to ensure their going concern veracity? Following the theme of difculties in the equity markets, we can expect to see a continuation of failed SPACs, as well as defunct asset managers. We have already seen examples of asset managers having multiple portfolio issues, often rendering their continued management of those assets unsustainable. Much like the merger or acquisition dynamic that might apply to early-stage companies, these failed SPAC and asset manager failures may spark a signicant amount of M&A, particularly add-on M&As as opportunistic investors try to buy on the cheap.
As we move into 2023, the impact of economic slowdown and the actions taken to stave off the resulting distress will yield opportunities for some and concern for others. As many market participants still have signicant liquidity, there is likely to be an increase in distressed M&A activity. Those with capital, or access to capital, will be able to take advantage of situations in which companies took temporary measures - betting incorrectly that the period of distress or stress would be shorter than it was, and who nownd themselves unable to access the capital markets or sustain the leverage offered by those markets.
Some businesses continue to be impacted by the increase in costs of goods and labour. Other businesses were over-levered as a result of incurring additional debt to try to get past the market challenges of the last several years or by excessively seeking to maximise returns through high, non-amortising leverage. These businesses are now unable to service their debt, having been hit by increased costs of capital due to the uptick in interest rates. Many of these businesses are good businesses but need a longer runway than available to return tonancial health. Many start-ups will continue to be challenged by the decrease in the availability of capital as their timeline to get to protability is signicantly reduced.
Without the liquidity to extend the timeline, such businesses may become fodder for those with access to capital. It is likely that this will result in market consolidation in newer markets where too many entities looked to enter the market, and investors will be able to either pick the strongest to sustain, roll up several market entrants or utilise their own strengths to put their smaller competitors out of business. The market instability will provide companies with liquidity, and the ability to benet from market misperceptions (or the market reacting based on short-term factors) that result in their debt trading below par. These companies can take advantage of wrongly depressed debt prices to buy back their own debt, often at a substantial discount.
In the year ahead, it may become more commonplace for companies with liquidity issues to utilise, with the support of all or a subset of their lenders, out of court solutions such as up-tier transactions or drop-down transactions. Although both such transactions have been challenged in the courts over the past few years, companies continue to access capital through them, especially in light of theexiblenancing agreements seen throughout the industry. For those capital structures that go beyond those buy-backs, up-tier exchanges or consensual processes, there is likely to be a continued increase in the number of cross- border transactions looking to utilise a larger variety of regimes than in previous years.
In the past, most cross-border restructurings have taken place through a US Chapter 11 proceeding with foreign recognition proceedings elsewhere. The UK and many European jurisdictions have now enacted modernised restructuring regimes that are more similar to the US Chapter 11 process and allow cross-border restructurings to proceed with more certainty and more impact. In addition, while the US still has the benet of a clear history and process for these transactions, with the enactment of new restructuring regimes, parties may look to take advantage of non-US jurisdictions going forward.
We can see that our backward-looking observations show that even the most astute students of economics would have struggled to identify the magnitude of factors affecting global economies. Our forward-looking predictions must then be had with a similar level of careful regard to that which cannot be seen. In that, investors (and therefore markets) will continue to move carefully. A strong feature of private capital is that sophisticated investors do not want to have to go back to their investors to explain mishaps. Equally, private capital is only economically efcient if it is deployed; sophisticated investors do not like to go back to their investors to say they haven't done anything at all.
With the difculties that managers of collaterised loan obligations (CLOs) have in reinvesting repaid capital, private credit looks to be the key source of debtnancing in the medium term. Therefore, we can expect a number of priming instruments to be made up of private debt at a high economic threshold, much as was the case following the globalnancial crisis. Sales processes will likely be less competitive for a period, while corporate carve-outs are expected to form a more signicant proportion of M&A transactions in 2023. Hung bridge facilities will likely continue to exist and be syndicated to private capital at deep discounts. And, of course, those businesses for which things have gone too far will have no option but to consider a formal process to restructure.
Originally published by Global Restructuring Review.
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