Bankruptcy Industry Update
Restructuring Outlook Survey Takeaways: Fed Stimulus Spoils Party for Distressed Players; Potential Increase in Involuntary Filings Due to ‘Creditor-on-Creditor Violence’; Overvalued Markets Vulnerable to Inflation
Thu 01/21/2021 08:00 AM
2020 saw the greatest ever plunge in quarterly GDP and a level of bankruptcy activity not seen since the 2008 financial crisis, brought forth by the Covid-19 pandemic. The resulting public health crisis and fears of a prolonged economic downturn prompted the Federal Reserve to launch yet another round of quantitative easing and slash interest rates to near zero, fueling rallies in debt and equity markets. With the markets flushed with liquidity, investors plowed into riskier assets, forcing a revaluation of what constitutes distressed, according to a survey of 138 Reorg subscribers comprising investment banks, law firms and the buy side, conducted from Dec. 11, 2020, through Jan. 8, 2021.
‘90 Is the New 80’
Investor sources interviewed by Reorg noted challenges in finding attractive opportunities after the rally in sub-investment-grade asset prices that began in late March and gathered pace with Pfizer’s vaccine launch. For many distressed debt investors, the fleeting period of adjustments in debt prices in the spring proved too short. “It’s like you are planning for a party, and right before the guests arrive, the caterer calls and says ‘I can’t bring any food or any booze, and the party is off,’” according to Colin Adams, a senior managing director at M-III Partners.
The threshold for what qualifies as “stressed” has moved ever higher price-wise, with many respondents to the Reorg survey suggesting that a price of 90 cents on the dollar or below now qualifies. The Fed-backed liquidity-driven surge has destroyed price discovery, meaning relative value has become increasingly important, the sources noted. One portfolio manager said he has never seen leverage so high and investors so unconcerned, adding that he unloaded a lot of lower-quality credits during the rebound. A correction of 30% to 40% from current levels would not be unsurprising, sources said.
Burden Sharing
When the Covid-19 outbreak erupted in late February, many companies thought that, even with no revenue, their 30 to 60 days of liquidity would be good enough to get them to the other side of Covid, according to George Davis, global chair of the restructuring group at Latham & Watkins.
But as the outbreak morphed into a pandemic that dragged on and businesses spiraled downward, stakeholders in distressed credits became increasingly competitive with each other and less collaborative compared with the beginning of the pandemic, according to William "Tuck" Hardie, a managing director in Houlihan Lokey’s financial restructuring group. “Now we are in round two, and everybody is convinced we are going to get through this pandemic, so now the question becomes, who is going to pay the price to get the company through 2021? And how is that burden negotiated and shared?” Hardie said.
While the Fed’s monetary measures have helped many companies extend their liquidity runways, sources say that financial assets are incredibly overvalued and therefore extremely vulnerable to any changes in inflation or interest rate expectations. In addition, middle market companies already struggling with limited access to capital markets remain vulnerable should demand fail to return.
This makes it very likely that restructuring activity will pick up again starting midyear, as debt relief tails off, short-term bridge financing matures and liquidity dries up, M-III Partners’ Adams said.
Brick-and-mortar retailers, restaurants, leisure, commercial real estate, hospitality, industrials and oil and gas will see the most restructurings. In the long run, permanent changes of behavior may hit a number of industries including travel, leisure and real estate, according to Jeff Bjork, global vice chair of the restructuring group at Latham & Watkins.
More non-pro-rata priming transactions are also expected until a court rules against them, according to Bruce Bennett, global leader of the restructuring group at Jones Day, who sees the possibility of more involuntary chapter 11 filings as a defensive measure due to so-called creditor-on-creditor violence.
In the meantime, cooperation agreements have become the norm because of the proliferation of investors in distressed deal negotiations, according to Andrew Rosenberg, co-chair of the restructuring group at Paul Weiss. “Organizing early and putting it in writing is probably the way to protect yourself,” he said.
From the issuer’s point of view, however, access to liquidity remains paramount, and if certain lenders have the ability to provide that capital on a non-pro-rata basis, and if that is how they would like to proceed, the company has to get that liquidity, according to Josh Sussberg, a restructuring partner at Kirkland & Ellis.
“We would want to see everybody treated pro rata when possible, and we are always pushing for resolution and settlement,” Sussberg said. “As long as the company has access to capital, we never like to see extended litigation.”
In the long run, an evolution in approval thresholds in debt documents is expected to address this issue, because so many investors have suffered losses from it, Houlihan’s Hardie said. Lenders to Premier Brands, PSAV and Hornblower have used the opportunity of either a potential default or the issuer’s liquidity need to negotiate tighter credit agreements to prevent non-pro-rata transactions.
‘Greater and Greater Flexibility’
In the meantime, however, in the primary market, “from a fifty thousand foot perspective, flexibility keeps getting greater and greater,” according to Eli Vonnegut, a partner in Davis Polk’s restructuring group. “Where I see more lender-protective provisions are in the one-off club deals. When you have a top-tier sponsor doing a broadly syndicated financing, they typically get a lot of flexibility. It is an auction dynamic, so until there is less competition to finance deals, sponsors have the leverage.”
On average, as a percentage of LTM adjusted EBITDA, high-yield bonds issued in 2020 provided U.S. issuers with the most flexibility to incur secured debt and the least flexibility to pay dividends; they also had more flexibility to transfer assets to unrestricted subsidiaries than to incur structurally senior debt, according to Americas Covenants by Reorg.
While sponsored issuers had significantly more flexibility to incur secured debt and structurally senior debt than non-sponsored issuers, non-sponsored issuers had more flexibility to pay dividends than sponsored issuers; both groups had virtually identical flexibility to transfer assets to unrestricted subsidiaries.
High-yield bond issuance surged in 2020 as the Fed pumped more and more money into the system. A record $438 billion issued last year, with companies from Carnival Cruises and AMC Entertainment taking advantage of investor need for yield to increase their liquidity buffers. Coupons on high-yield debt fell to the lowest on record, according to Refinitiv data, as corporations seized the opportunity to borrow for longer terms at lower rates.
Restructuring Triggers
Catalysts for another wave of restructurings include an increase in Covid-19 infections despite the global vaccine rollout and ongoing increases in unemployment that crimp consumer spending, according to respondents to the Reorg survey. The number of jobs flushed from the economy is enormous, and while many are in service industries such as restaurants and retail, many white-collar workers have also lost their jobs, the sources noted. Many sources highlighted the risk of inflation, given the amount of liquidity pumped into the economy by Federal Reserve and government programs, and with additional multi-trillion-dollar stimulus packages from the Biden administration. A worst-case scenario, sources said, would be an increase in job losses, additional consumer weakness and a Fed forced to raise rates in order to tamp down inflation.
While sources interviewed by Reorg said they do not expect a surge in inflation or an increase in interest rates over the near term, the eventual rate increase will be a significant catalyst for an uptick in restructuring activity. Many leveraged borrowers refinanced with floating-rate debt, and a surge in LIBOR could effectively double the interest rates paid on such facilities. Even so, sources noted that on Thursday, Jan. 14, Fed Chairman Powell said that the central bank would not raise rates merely in order to ward off a “theoretical” inflation threat, and Fed Vice Chairman Clarida on said on Wednesday, Jan. 13, that the Fed would not hike rates until inflation grows at 2% for a year.
All the sources concurred that the fallout from the pandemic was far from over. Consumer spending drives the U.S. economy, and there is likely to be a surge in unemployment once the effects of stimulus wear off, resulting in diminished demand, the sources noted. The worst pain, sources said, will be felt among smaller, “mom and pop” and middle market businesses. Despite the abundance of liquidity in the primary high-yield and leveraged loan markets, the middle market corporate issuers, with less than $500 million of tradable debt and $120 million of annual EBITDA, have missed out on tapping the capital markets, and many are experiencing a liquidity shortfall, M-III Partners’ Adams said.
Most sources said that airlines should be able to weather the storm, given their ability to access capital markets; the industry, along with cruise ships, may benefit from pent-up demand for leisure travel as vaccinations take hold. Other sources cautioned that business travel, a significant driver of revenue for the industry, is unlikely to ever return to pre-pandemic levels.
Movie theaters will continue facing considerable challenges, with some suggesting that audiences will never return to pre-pandemic levels. A structural shift had already been underway in the theater industry, given the rise of streaming services in content creation and distribution; the pandemic merely hastened the final act. Other consumer-facing industries such as restaurants and retail are also likely to continue to suffer.
--Harvard Zhang, James Holloway
‘90 Is the New 80’
Investor sources interviewed by Reorg noted challenges in finding attractive opportunities after the rally in sub-investment-grade asset prices that began in late March and gathered pace with Pfizer’s vaccine launch. For many distressed debt investors, the fleeting period of adjustments in debt prices in the spring proved too short. “It’s like you are planning for a party, and right before the guests arrive, the caterer calls and says ‘I can’t bring any food or any booze, and the party is off,’” according to Colin Adams, a senior managing director at M-III Partners.
The threshold for what qualifies as “stressed” has moved ever higher price-wise, with many respondents to the Reorg survey suggesting that a price of 90 cents on the dollar or below now qualifies. The Fed-backed liquidity-driven surge has destroyed price discovery, meaning relative value has become increasingly important, the sources noted. One portfolio manager said he has never seen leverage so high and investors so unconcerned, adding that he unloaded a lot of lower-quality credits during the rebound. A correction of 30% to 40% from current levels would not be unsurprising, sources said.
Burden Sharing
When the Covid-19 outbreak erupted in late February, many companies thought that, even with no revenue, their 30 to 60 days of liquidity would be good enough to get them to the other side of Covid, according to George Davis, global chair of the restructuring group at Latham & Watkins.
But as the outbreak morphed into a pandemic that dragged on and businesses spiraled downward, stakeholders in distressed credits became increasingly competitive with each other and less collaborative compared with the beginning of the pandemic, according to William "Tuck" Hardie, a managing director in Houlihan Lokey’s financial restructuring group. “Now we are in round two, and everybody is convinced we are going to get through this pandemic, so now the question becomes, who is going to pay the price to get the company through 2021? And how is that burden negotiated and shared?” Hardie said.
While the Fed’s monetary measures have helped many companies extend their liquidity runways, sources say that financial assets are incredibly overvalued and therefore extremely vulnerable to any changes in inflation or interest rate expectations. In addition, middle market companies already struggling with limited access to capital markets remain vulnerable should demand fail to return.
This makes it very likely that restructuring activity will pick up again starting midyear, as debt relief tails off, short-term bridge financing matures and liquidity dries up, M-III Partners’ Adams said.
Brick-and-mortar retailers, restaurants, leisure, commercial real estate, hospitality, industrials and oil and gas will see the most restructurings. In the long run, permanent changes of behavior may hit a number of industries including travel, leisure and real estate, according to Jeff Bjork, global vice chair of the restructuring group at Latham & Watkins.
More non-pro-rata priming transactions are also expected until a court rules against them, according to Bruce Bennett, global leader of the restructuring group at Jones Day, who sees the possibility of more involuntary chapter 11 filings as a defensive measure due to so-called creditor-on-creditor violence.
In the meantime, cooperation agreements have become the norm because of the proliferation of investors in distressed deal negotiations, according to Andrew Rosenberg, co-chair of the restructuring group at Paul Weiss. “Organizing early and putting it in writing is probably the way to protect yourself,” he said.
From the issuer’s point of view, however, access to liquidity remains paramount, and if certain lenders have the ability to provide that capital on a non-pro-rata basis, and if that is how they would like to proceed, the company has to get that liquidity, according to Josh Sussberg, a restructuring partner at Kirkland & Ellis.
“We would want to see everybody treated pro rata when possible, and we are always pushing for resolution and settlement,” Sussberg said. “As long as the company has access to capital, we never like to see extended litigation.”
In the long run, an evolution in approval thresholds in debt documents is expected to address this issue, because so many investors have suffered losses from it, Houlihan’s Hardie said. Lenders to Premier Brands, PSAV and Hornblower have used the opportunity of either a potential default or the issuer’s liquidity need to negotiate tighter credit agreements to prevent non-pro-rata transactions.
‘Greater and Greater Flexibility’
In the meantime, however, in the primary market, “from a fifty thousand foot perspective, flexibility keeps getting greater and greater,” according to Eli Vonnegut, a partner in Davis Polk’s restructuring group. “Where I see more lender-protective provisions are in the one-off club deals. When you have a top-tier sponsor doing a broadly syndicated financing, they typically get a lot of flexibility. It is an auction dynamic, so until there is less competition to finance deals, sponsors have the leverage.”
On average, as a percentage of LTM adjusted EBITDA, high-yield bonds issued in 2020 provided U.S. issuers with the most flexibility to incur secured debt and the least flexibility to pay dividends; they also had more flexibility to transfer assets to unrestricted subsidiaries than to incur structurally senior debt, according to Americas Covenants by Reorg.
While sponsored issuers had significantly more flexibility to incur secured debt and structurally senior debt than non-sponsored issuers, non-sponsored issuers had more flexibility to pay dividends than sponsored issuers; both groups had virtually identical flexibility to transfer assets to unrestricted subsidiaries.
High-yield bond issuance surged in 2020 as the Fed pumped more and more money into the system. A record $438 billion issued last year, with companies from Carnival Cruises and AMC Entertainment taking advantage of investor need for yield to increase their liquidity buffers. Coupons on high-yield debt fell to the lowest on record, according to Refinitiv data, as corporations seized the opportunity to borrow for longer terms at lower rates.
Restructuring Triggers
Catalysts for another wave of restructurings include an increase in Covid-19 infections despite the global vaccine rollout and ongoing increases in unemployment that crimp consumer spending, according to respondents to the Reorg survey. The number of jobs flushed from the economy is enormous, and while many are in service industries such as restaurants and retail, many white-collar workers have also lost their jobs, the sources noted. Many sources highlighted the risk of inflation, given the amount of liquidity pumped into the economy by Federal Reserve and government programs, and with additional multi-trillion-dollar stimulus packages from the Biden administration. A worst-case scenario, sources said, would be an increase in job losses, additional consumer weakness and a Fed forced to raise rates in order to tamp down inflation.
While sources interviewed by Reorg said they do not expect a surge in inflation or an increase in interest rates over the near term, the eventual rate increase will be a significant catalyst for an uptick in restructuring activity. Many leveraged borrowers refinanced with floating-rate debt, and a surge in LIBOR could effectively double the interest rates paid on such facilities. Even so, sources noted that on Thursday, Jan. 14, Fed Chairman Powell said that the central bank would not raise rates merely in order to ward off a “theoretical” inflation threat, and Fed Vice Chairman Clarida on said on Wednesday, Jan. 13, that the Fed would not hike rates until inflation grows at 2% for a year.
All the sources concurred that the fallout from the pandemic was far from over. Consumer spending drives the U.S. economy, and there is likely to be a surge in unemployment once the effects of stimulus wear off, resulting in diminished demand, the sources noted. The worst pain, sources said, will be felt among smaller, “mom and pop” and middle market businesses. Despite the abundance of liquidity in the primary high-yield and leveraged loan markets, the middle market corporate issuers, with less than $500 million of tradable debt and $120 million of annual EBITDA, have missed out on tapping the capital markets, and many are experiencing a liquidity shortfall, M-III Partners’ Adams said.
Most sources said that airlines should be able to weather the storm, given their ability to access capital markets; the industry, along with cruise ships, may benefit from pent-up demand for leisure travel as vaccinations take hold. Other sources cautioned that business travel, a significant driver of revenue for the industry, is unlikely to ever return to pre-pandemic levels.
Movie theaters will continue facing considerable challenges, with some suggesting that audiences will never return to pre-pandemic levels. A structural shift had already been underway in the theater industry, given the rise of streaming services in content creation and distribution; the pandemic merely hastened the final act. Other consumer-facing industries such as restaurants and retail are also likely to continue to suffer.
--Harvard Zhang, James Holloway
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