Covid-19 had an immediate impact on all business sectors around the world. Some have thrived, but the majority have been adversely affected. What have been the most pressing challenges for capital markets?
While the damage caused by the pandemic isn't confined to select pockets of businesses, it's clear that some have suffered the most and continue to suffer – with aviation, retail, hospitality, financial services, real estate and automotive some of the hardest hit.
On the other hand, some sectors like technology, healthcare and pharmaceuticals have flourished. Amazon, for instance, posted the biggest profit in its 26-year history as online sales and its lucrative business supporting third-party merchants surged during the pandemic.
It's difficult to quantify precisely how much global capital markets will be affected by the pandemic. What we have seen, however, is that structured finance and capital markets encompass a variety of asset types that have been directly affected by the outbreak.
In Europe, we saw the lowest-ever issuance of securitised products in the first half of 2020, with only €79.4bn being issued. This is 8% lower than in the first half of 2013, previously the lowest half-year issuance on record, and 15% lower than in the first half of 2019.
Securitisation secondary markets have suffered disproportionate reductions in liquidity due to central bank support. And uncertainty around the macro effects of the pandemic is likely to continue to add to market volatility for securitised products, especially on liquidity and pricing.
If we look at the lessons learned from the financial crisis of 2008 and the Eurozone sovereign debt crisis, we can see that well-designed asset-backed-securities (ABS) are resilient under stressed circumstances. However, while government forbearance may be a necessary stopgap measure, the resulting frictions on cash flow with respect to underlying assets may make financing these assets more challenging and, as a result, may have longer-term repercussions on funding in the real economy.
Early in the pandemic, were businesses finding it difficult to restructure existing debt or look for new debt funding?
It's pretty clear that the world's largest banks were preparing for a dramatic rise in defaults and bad loans after Covid-19 hit. Although global banks are in far better shape now than 2008-09, the impact of defaults and payment delays is unknown and could damage even the healthiest balance sheets. As a result, many banks and financial institutions took a conservative stance and adopted a wait-and-see approach, which made it difficult to raise new debt. That said, there was a measure of forbearance from an existing debt perspective.
A number of heavily indebted businesses went to the wall quickly – did Covid simply expose the weaknesses that already existed in companies such as this?
The pandemic caught everyone by surprise. But yes, the imposed shuttering has exposed the balance-sheet frailties caused by poor fiscal choices made by business executives over the past decade. The debt had been readily available for real estate companies, for instance, so many found themselves in high debt, which has been accentuated by cash flows drying up during the pandemic. As a result, some had to resort to bankruptcy.
We saw how some highly indebted companies found it difficult to service interest payments on loans, and it was only down to governments offering moratoria on interest payments that helped them survive. Indeed, many had no option but to go hat in hand to the government, seeking assistance.
With fragile balance sheets, shuttered businesses are now facing an existential threat. Most of the companies in line to get taxpayer money don't have any rainy-day fiscal buffers to absorb economic shocks from unpredictable events.
What's more, the debt of global economies was already at an all-time high, and Covid has exacerbated that. We are living in a debt world. To solve the problem of debt, we are doling out more debt – it's counterintuitive, but that's the reality of the world today.
Aside from government support, what other actions should distressed businesses be taking?
The ways in which companies can manage right now are to:
- conserve cash; give out early disclosures on any specific
impact on operations due to Covid-19 as also prescribed by ESMA;
work with investors toward the restructuring of payments;
- work with rating agencies on proper disclosures;
- work with corporate service providers and trustees on restructuring and resolution plans.
There is also an urgent need for constant monitoring and early warning signals, which will help all parties to ABS transactions. With better information given to investors, businesses will be in a better position to negotiate.
When businesses are faced with a direct cash flow issue and are staring at a default, it needs to be dealt with directly. We always strongly advocate that companies facing cashflow issues assess the situation and take steps such as reaching out to creditors and starting discussions.
Ultimately, however, companies with substantial debt will need to understand whether they have sufficient resources to support their debt service obligations. There is no shame if you are a well-run business, and your market has suddenly contracted.
Businesses might also consider selling assets to allow them to meet their scheduled obligations. If a company has enough unencumbered assets, then it could just sell them to generate cash to support its debt service needs.
Clearly, the nuclear option is the default, although this is probably the least likely initially. A company may give notice to its investors that it may not be able to meet its forthcoming contractual obligations, but its first step will be to engage with professional advisers and use any relevant laws to temporarily protect themselves, such as US Chapter 11. Communication with lenders and bondholders will be important at this time.
And what of non-dilutive short-term liquidity, CLOs and the like – are any trends emerging?
There has been an increase in trading activity in the loan markets as investment managers proactively look to take advantage of the current market volatility. This will be beneficial for trading activity tariffs in loans administration.
Prices of CLOs and other debt products are well below market value right now, and this is where big hedge funds will take advantage, and we should see huge returns. CLO managers will push for the ability to either provide companies with rescue financing or increased flexibility to receive equity in a workout situation in order to be able to participate in future reorganisations.
The dynamic with non-CLO lenders could also be that they would pick up distressed loans and drive the restructuring and the economics of the restructured debt.
From where we're sitting, while the pandemic has been a hugely active period, EMEA CLOs seem to have held up reasonably well. That said, while issuance has continued, it's definitely off compared to where it was last year. The most significant change has been the timelines involved in getting deals done. Whereas before, you could go from picking up a first draft document through to pricing in six weeks or longer, now we're looking at a fortnight, maybe even less.
Is this only the tip of the iceberg right now – can we expect to see a tidal wave of distress coming down the line?
It's difficult to predict when or how this pandemic will end and what shape the world will be in when it does. However, looking at the data, the 2020 global corporate default tally reached 152 in early August 2020. At the same time, defaults in Europe reached a historic year-to-date tally of 20, surpassing the 2009 high of 15. If businesses don't return to pre-Covid levels of cash flow, especially if they are carrying high levels of debt, then we will likely see more distress.
What's more, we do see banks preparing for non-performing loans (NPLs), with over 30% growth anticipated in key markets in H2 2020. This suggests we are heading into an autumn and winter of defaults.
On the flipside, are we going to see an increase in capital raising in order to acquire distressed businesses?
The phrase about not letting a good crisis go to waste has been cited time and again during the pandemic, and for some, this is the right time to buy assets at the right price. There is no surprise that private equity will be on the lookout for opportunities – and vulture funds and stressed asset funds are waiting in the wings. As the economic cycle turns, private equity attention is likely to refocus on the NPL markets, and opportunities to purchase portfolios from both bank and non-bank lenders.
With bankruptcies and the number of distressed companies likely to rise, especially as government support programmes expire, a lot of managers are setting up new vehicles to take advantage of the dislocation. Many fixed income funds would be in the offing too, to take advantage of the current bond market volatility.
Funds that had undrawn commitments have expedited capital calls from their LPs. Some are also seeking new capital raising to acquire assets or companies at cheaper valuations in coming months, specifically in fintech, healthcare and consumption-linked business.
Clearly, any investment decisions will be made after they've looked at a company, studied the balance sheet and figured out the relevant value of the company versus its stock market value now and its future opportunity value.
How long do you think the pandemic will continue to impact capital markets? Are the ripples likely to be felt for many years to come?
I may be looking at things with a glass half full, but none of us are comparing issuance levels now with the financial crisis in 2008, we're comparing them with 2013 when the market had recovered. So as long as we don't hit levels below that, things should be OK, and the data coming in supports that.
That said, there is clearly an increase in global debt and this will have outcomes. Going forward, we can expect massive restructuring, loans and securitisation, an increase in 'Covid loans', new kind of CLOs in the market, and certainly more consolidation and higher monitoring requirements. The reality is that we are in the midst of a seismic shift that will continue to roll out for some time.
To end on a positive note, this situation also gives the world a unique opportunity to carefully plan its recovery and adds further impetus to the environmental, social and governance (ESG) agenda which had already been gaining momentum.
The pandemic has helped fast track the trust stakeholders have in ESG. Whether it's governments, investors, employees, vendors, contractors, suppliers or the community at large, they will hold corporations more responsible on ESG parameters going forward. The pandemic has given society a pause to reflect on what really matters.
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