Fri 01/07/2022 11:21 AM
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Restructuring experts are waiting for companies that eluded the inevitable since the Covid-19 pandemic began to finally meet their fate.

Issuers that took on expensive debt to extend liquidity runway, capitalized interest payments, and went on a covenant holiday hoping to outrun the pandemic may have to restructure their debt if profitability is not materializing, according to Steve Zelin, partner and global head of PJT Partners’ restructuring and special situations group. Easy money won’t be available forever, Covid-19 refuses to go away, and labor and raw material costs are rising. A lot of companies have now exhausted the tools and flexibility allowed in their credit agreements to raise capital, so now it is purely fundamental credit analysis. Travel, commercial real estate, consumer and entertainment, midstream oil and gas, healthcare, and power industries may all experience stress.

“It’s not just about getting back to the level of profitability in 2019, but also getting back to the growth profile of that,” Zelin said. “Companies will struggle to grow into their pre-pandemic capital structures if they are growing slower now than pre Covid, before considering the incremental debt they took on to extend the runway.”

Long Covid-19

Absent continuous support from the U.S. government, domestic airlines may need to restructure their debt through chapter 11 to make the structural changes necessary to adjust to a new reality of significantly diminished business travel, according to Evan Fleck, partner in Milbank’s financial restructuring group. The only two domestic airlines that don’t rely on business travel right now are Spirit Airlines and Southwest Airlines.

“Domestic airlines and cruise operators took on a tremendous amount of debt during Covid, and if the projections for a return to normalcy or demand just aren't met, we’d expect a significant amount of pressure on them,” Fleck said.

Similarly, the hospitality industry is directly tied to what happens with the continued reopening of the world and a changing business travel model, and there may be more stress there as the expectation of recovering to 2019 occupancy levels has been pushed back to 2023 and beyond, according to Sean Gumbs, senior managing director in FTI Consulting’s corporate finance and restructuring group.

The commercial real estate sector, at the center of changing workplace behaviors, may finally see more restructurings as a result of prolonged decreased demand pressuring liquidity, according to David Hillman, co-head of Proskauer’s private credit restructuring group.

“Landlords can only kick the can for so long and, while that sector appears to have withstood the temporary dislocation caused by the pandemic, it will be increasingly more challenging for landlords, especially those with significant debt, to withstand a more permanent shift in workplace behaviors,” Hillman said.

Inflation, Supply Chain

High labor, transportation and raw material costs are accelerating the need to restructure for companies focused on energy infrastructure, according to John T. Young Jr., senior managing director at Riveron.

“It will be years, even with $80 oil, before production supports demand for capex in the midstream space,” Young noted. “There’s a significant increase in restructuring activity related to infrastructure and midstream construction services. Additionally, lack of support from the current administration has further crippled the outlook for midstream development.”

​Additionally, job preservation, traditionally an important objective for professionals in restructurings, has been stripped from the equation, Young said. In today’s labor market, employees simply walk across the street to be employed by a more creditworthy employer, he said. Retaining labor has become more difficult than ever, and particularly challenging for financially stressed companies, Young added.

Other industries such as meat packing, which rely upon low-skilled workers, are having difficulties filling their workforces, sources said. Other sectors including hydrocarbons and chemicals will also be hit by supply-chain challenges and higher transportation and input costs. While some may be able to pass costs along to consumers, it could take as much as six months for some increases to be pushed through, which could have a significant impact on liquidity, the sources said. Ultimately, companies will need to be much more diligent in cash flow management, they said.

Game Changer

The transformation of business will lead to more restructurings for auto companies because of the shift from cars using combustion engines to electric vehicles, as well as for the less environmentally desirable sectors including coal mining and oil refining, according to Gregg Galardi, head of Ropes & Gray’s global business restructuring practice.

Merchant generators, especially those with coal-weighted portfolios, are likely to face ongoing challenges related to the growth of capacity in renewables and mediocre capacity prices, especially in the PJM Interconnection, the nation’s largest energy market, sources said.

A decline in reimbursement rate, disruptions including the No Surprise Act, long-term effects of Covid-19, high labor costs, and pricing pressure may push more hospitals, healthcare services, nursing homes, and pharmas into distressed territory, sources said. Notable credits that Reorg has been covering include Envision Healthcare, TeamHealth, Air Methods, MultiPlan, Endo and SmileDirectClub.

“There is always a new business to come that will be a changer, and there will be regulations and ESG,” Galardi said. “Businesses affected by those factors will have to restructure or die a long death. It’s not like restructuring will never be, even though we may see a fairly light restructuring market in the next four to six months. Right now, Reorg is not Reorg, it’s ‘Who’s Getting Financing Today.’”

Year of Free Money

Companies across the ratings spectrum capitalized on the flood of cheap capital in 2021 to extend maturities by as much as eight to ten years with coupons around 200 bps lower than the debt refinanced, sources said. Interest rates are likely to remain low, even as the Federal Reserve tapers its asset purchase programs and signals its intent to boost interest rates by as many as three times this year. This means that even highly leveraged borrowers with 2023 and 2024 maturities may be able to extend at very attractive rates, the sources said. In addition, the trend of cov-lite issuance and weak investor protection in bond indentures is likely to continue, they added.

A record 677 deals priced for $450.5 billion in the high-yield primary market last year, eclipsing the previous record of $401.3 billion that priced during 2020. Deals supporting M&A led volumes, according to S&P Global, while many companies took advantage of record-low interest rates to pre-fund maturities due over the remainder of the decade. Yields on new issue high yield bonds fell to a record low in 2021, dipping to 4.83% in June from 6.39% in 2019, prior to the Federal Reserve’s launch of stimulus measures to counter the impact of Covid-19-driven economic lockdowns. S&P also noted that institutional term loan issuance through November 2021 totaled $576 billion, shattering the prior $503 billion record set in 2017.

Nevertheless, investors are likely to be more selective this year, sources said. While there is a great deal of capital that needs to be deployed, a few borrowers were forced to pull their deals toward the end of the year - Monitronics, Ahern Rentals, LifeScan, CM Group and American Physician Partners - and a handful of loans that priced wider than initial talk shows that investors will still likely be less forgiving of companies that do not deliver solid results.

“Companies that had previously used the pandemic as an excuse for underperformance will have less leeway going forward and will need to meet or exceed their projections,” Ajay Bijoor, managing director at DC Advisory, said. Nevertheless, Bijoor added, “the market has an abundance of capital for opportunistic companies to refinance or address capital requirements.”

Clouds on the Horizon

However, distressed debt and secondary market activity may pick up later in the year, sources said. Fixed income markets may have yet to fully discount the impact of monetary policy tightening. Minutes from the Fed’s December meeting, released on Wednesday, Jan. 5, stated that given policymakers’ outlook for the economy, labor markets and inflation, “it may become warranted to increase the federal funds rate sooner or at a faster pace than participants had earlier anticipated."

Ten-year Treasury yields broke through 1.7% after the release of the minutes. The yield increased further to 1.76% on Friday after the release of payrolls data, which showed the unemployment rate falling to 3.9% and hourly earnings increasing by a higher than expected 0.6%, which together indicated to market participants that the central bank could raise interest rates as early as March.

Privately held middle-market companies can be expected to have a fair amount of financial stress because their leverage profile is less forgiving, PJT’s Zelin said. The types of restructuring the market may see would be prepack chapter 11 filings or consensual out-of-court transactions, because of the cost of a prolonged in-court process, and the willingness of sponsors to turn over the keys to lenders if there’s no recovery, Ropes & Gray’s Galardi said.

Despite a record low default rate, sources noted that aggressive valuations and record debt issuance, the ingredients for balance sheet problems down the road.

“Credit cycles are not extinct,” Proskauer’s Hillman said. “There will be another boom and bust cycle, just like there was before.”

A Changing Landscape

Restructuring professionals highlighted a number of bankruptcy issues and trends to watch out for, including non-pro-rata debt transactions, which are expected to continue until courts define the limit, releases of claims against non-debtor third parties in chapter 11, payment of interest on unsecured claims against solvent debtors, and bankruptcy venue.

Sources also noted an increase in post-confirmation litigation. ​“Historically, there’s been a rush to plan confirmation to contain the administrative costs of in-court restructurings. More than I’ve seen before, creditors are now focused on fighting for every last penny, especially with a slower filing pace,” Riveron’s Young said. “In addition, more availability of litigation financing is driving a significant ramp-up in post confirmation litigation.”

--Harvard Zhang, James Holloway
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