Q&A: COVID-19 – challenges in distressed debt and liability management
October 2020 | SPECIAL REPORT: BANKRUPTCY & RESTRUCTURING
Financier Worldwide Magazine
October 2020 Issue
FW discusses the challenges COVID-19 poses for distressed debt and liability management with Robert Novak at BDO, Gifford S. West at The Debt Exchange, Inc., Thomas J. Salerno at Stinson LLP and Richard H. Golubow at Winthrop Golubow Hollander, LLP.
FW: In what ways has the COVID-19 pandemic affected distressed debt markets in recent months? How would you gauge current levels of activity?
Novak: The initial reaction to a highly ambiguous situation rightly drove pricing down to reflect risk. However, as the economic impact of the pandemic has stabilised, debt levels have moderated as well. Dry powder is still propping levels and a quest for yield is very real, but in this market, we have seen everything from aggressive to defensive lenders and investors. The benefit of a diverse array of thinking is that there are both opportunities to take over positions in distressed debt and, from a company perspective, to reset the capital structure through a refinancing to meet current liquidity needs.
Golubow: The coronavirus (COVID-19) pandemic has vastly increased the distressed debt market, based upon both the number of funds looking to raise capital and the heightened amount of capital targeted. The industries most affected by COVID-19 and contributing to the increase in the distressed debt market include entertainment, sports and hospitality. The exceptional growth of distressed debt markets is only expected to increase as the impact of COVID-19 continues to reveal itself over the coming months and possibly years. With such an increase in the market, there has also been an increase in large firms raising funds. For example, within one month of the US quarantine, Oaktree Capital Group sought over $15bn in distressed debt funding – the largest in its history. Thus, the full impact is yet to be determined, but we have already seen that an increase in requests has led to an increase in large firm funding.
Salerno: The pandemic has left an indelible mark on debt markets in recent months. Debt markets initially froze as the markets assessed the nature and expected breadth of the pandemic. Would it be one month in duration? One year? In the traditional debt market space in the US, the federal government stepped into the breach with a multi-trillion dollar economic stimulus package which included outright emergency grants, ‘loans’ that could be forgiven under certain circumstances, and other such measures. Six months in, the government stimulus packages are slowing down, and the debt markets are adjusting and once again becoming active, albeit cautious, with loan underwriting standards conservative to reflect the as yet unknown length of the pandemic, as well as the longer term economic effects on such industries as travel and entertainment, commercial real estate, brick and mortar retail, energy, although for non-COVID-19 reasons, and similar industries.
West: In the US, demand for distressed debt secured by real estate has grown significantly, particularly in the past few months. We are seeing a higher number of bids for distressed debt and a higher number of marketplace registrants looking to buy distressed debt. Banks that are actively managing their balance sheets have been selling loans that were in trouble prior to COVID-19 and now are unlikely to survive the repercussions of the pandemic. Banks that have adequate reserves are also seeking to get ahead of the expected non-performing loans (NPLs) crush in sectors like retail and hospitality. In the US, the lesson from the last crisis is very relevant in this one: banks that clear their balance sheets first will emerge stronger. Balance sheet health determines whether a bank will be acquired or an acquirer. In general, European banks have been slower to set aside reserves compared to their US counterparts. This partially explains the level of deal flow. Southern European markets are still seeing a good flow of potential deals secured by real estate, but there is scepticism about how many of the deals will actually close. Northern European banks have been directing resources to their thinly staffed workout teams to manage troubled loans. Given market liquidity programmes, banks are having a hard time gaining transparency on the credits that are unlikely to survive.
“It is imperative that debtors understand their contracts and agreements with creditors and actively work with them to mitigate all potential damages – often through renegotiation.”
FW: Given the financial distress which certain sectors are facing, what should be the key considerations for debtors? How important is it to reassess capital structure and engage with creditors, including bondholders?
Golubow: The key for any debtor is to be proactive in preserving value and preventing any additional harm. This is easier said than done, but there are two key considerations. First, creating a plan based on how sweeping restrictions on both goods and people impact your business. This includes addressing continued workforce and supply chain disruptions. And second, creating a plan for all financial obstacles that have occurred and will likely continue to occur. This includes understanding how financial relationships will change from the costs of maintaining employee health to missed targets with business partners, creditors and vendors, among others. Intimately related to all this, is the importance of reassessing one’s capital structure and actively engaging with creditors. Now is not the time to be passive. It is imperative that debtors understand their contracts and agreements with creditors and actively work with them to mitigate all potential damages – often through renegotiation.
Salerno: Debtors in this volatile environment face a number of immediate considerations, and then longer term issues. It is important to keep in mind that the true impact of the financial crisis repercussions have not yet hit, and likely will not until fourth quarter of 2020 or first quarter of 2021. On the immediate considerations, key debtor considerations include cash preservation and access to governmental resources for short term, bridge financing needs. As the governmental sources become depleted – taxpayer funds for commercial use have a limit, even in an election year – debtors must proactively be addressing capital structures with key constituents in those capital structures. Even assuming, however unlikely, that the global economy rebounds relatively quickly from the nearly unprecedented impacts of this pandemic, there will be transition periods as businesses and markets adjust, all of which will put strains on cash flows and credit availability. ‘Negotiation and ‘renegotiation’ will be the order of the day.
West: Debtors should recognise that in both the US and Europe we are in a period of ‘phoney war’. A crisis has begun, but its true magnitude is far from being fully understood. It is critical for banks to assess the strength of their balance sheet and the underlying credits. Without a very granular understanding of their credit strengths and weaknesses, they are essentially flying blind. Banks have nearly universally been generous with extensions, payment holidays, covenant waivers and other acts of flexibility in light of the pandemic due to borrowers’ inability to service their debt from operating results. In some cases, this has been in response to government incentives. In others, it is due to the recognition that most borrowers have little idea when their business will return to normal. Larger enterprises have been able to stockpile cash in anticipation of when banks become less flexible. Smaller debtors have been more dependent on government programmes. Debtors are preparing for when this will end. It may be prudent for debtors to start exploring non-bank sources of finance now toward the day when traditional bank lenders will be looking to exit the credit either through foreclosure or sale to a distressed debt buyer.
Novak: First, determine whether the impact is short term or long term. What does the business look like under several fluid assumptions? Then work to refine those assumptions as the situation reveals itself. Finally, determine what capital structure can be supported in the wide range of realistic scenarios. Once a different capital structure is realistically determined, communication is key. Do not assume that creditors understand everything about your business. Start from the beginning and distil the exercise into concise points, while showing your work. Include any operational restructuring that has already taken place or is planned. Expect to share the pain and show the lenders that the company has done all it can to mitigate the impact of the situation before asking for help.
FW: What steps can debtors take to reduce the risk of breaching loan or bond conditions and avoid cross-defaults throughout the debt structure? What liability management techniques might be deployed?
Salerno: When the commercial markets are hit with a sudden, unexpected and certainly for this generation unprecedented event or series of events, avoiding breaches of loan terms, including covenant defaults, is difficult at best. Borrowers, like lenders, are in reactive mode, and loan terms and covenants set before the pandemic hit can be materially out of sync with actual circumstances post-pandemic. While lawmakers attempted to delay the inevitable with emergency legislation that created legal delays in creditor enforcement activities, such as moratoria on enforcement of lease default remedies, eventually these will expire as the markets must be able to correct themselves. That said, debtors can attempt to reduce the risk of debt or bond defaults and the domino effect of cross defaults with other debt instruments by vigorous and proactive communications with lenders. While lenders will no doubt extract what they can from any concessions they make, in truth both lenders and borrowers alike are anxious to see as best as possible the new economic reality before taking irreversible actions. Again, the full brunt of the economic repercussions are not likely to be felt until fourth quarter of 2020 at the earliest.
Novak: Once a company knows it is reasonably likely to default, working to amend in advance can avoid the problem in the first place. Especially in the COVID-19 environment, lenders have shown significant flexibility to allow companies to navigate the situation, but that flexibility needs to include consideration in the form of pay-in-kind fees and, significantly, contributions from equity. In the US, the government has made massive amounts of money available. The Paycheck Protection Program has expired, but it buoyed companies through a very difficult period. Now the Main Street Lending Program remains and can be a very good option to supplement liquidity or refinance expensive debt for companies that were profitable in 2019.
Golubow: The first step for debtors is familiarising themselves with the terms and conditions of all agreements. This is best accomplished via in-house counsel or retaining experienced corporate restructuring counsel. The assessor of agreements must identify the following. First, covenants, conditions, representations and warranties that have or may come under stress. Second, future breaches that could lead to events of default. Third, upcoming debt maturities. Fourth, access to alternative or revolving lines of credit. Fifth, options for increasing earnings before interest, taxes, depreciation and amortisation (EBITDA) for losses and expenses related to COVID-19. Finally, all other terms, conditions and options related to the particular debtor. Several liability management techniques are available to debtors, including open market debt purchases or tender offers, exchange offers, public or private, consent solicitations and exit consents, bankruptcy and in-court options and tools to increase transaction options and, where applicable, to protect the debtor, and other transactions appropriate for the particular parties.
“It is important to keep in mind that the true impact of the financial crisis repercussions have not yet hit, and likely will not until fourth quarter of 2020 or first quarter of 2021.”
FW: When focusing on liability management, what legal considerations, such as loan terms, do debtors need to consider?
Novak: Anything contained in a standard term sheet should be reviewed carefully and incorporated into a financial forecast and illustration. That illustration should endeavour to lay out reasonable worst-case scenarios as well. Brainstorming with management during the planning phase of any project is a good way to come up with risks. One effective way of doing that is to have the managers imagine themselves in the future standing in front of a failed project or, in this case, a defaulted loan, and explain what went wrong. Different management perspectives will often reveal various risks that can be addressed up front in loan documents or mitigated by strategy and operations. On the flip side, companies should review prepayment options and any associated penalties as cheaper money may become available and the company should preserve its option to modify its capital structure when it is advantageous to do so.
Golubow: A review of existing contracts and loan agreements by insolvency counsel experienced in bankruptcy and bankruptcy alternatives is critical, with a particular focus on financial covenant compliance and cash-flow-related default provisions. Lenders and other counterparties to agreements will expect management to have engaged competent legal and financial advisers to help navigate the complex landscape of non-bankruptcy restructuring alternatives. This includes analysing current contracts with a focus on force majeure clauses, reviewing insurance contracts to identify claims for business interruption coverage, notification requirements and default provisions and pursuit of forbearance agreements, as well as waivers of certain financial and nonfinancial covenants, and other amendments to existing agreements. The goal for management is to implement strategies that maintain value moving forward, and to do so without the need to seek formal bankruptcy court intervention.
West: For some debtors, their operating income no longer covers their operating cost, and there is no certainty when this will end. They are effectively transitioning to caretakers of their banks’ assets. As a result, it is critical to strategically identify the assets where this is less likely to happen and focus resources as early as possible. Similarly, communicating to their lenders early may be an effective strategy.
Salerno: While not welcome news for beleaguered businesses, the best liability management for debtors will be to incur yet another expense – specifically, obtaining competent professional assistance in navigating the complexities of various, and often competing, debt instruments. Just the review of the myriad complex documentation can seem Herculean, and seasoned professionals will be most helpful in that essential exercise. This is particularly true where there might be personal exposure for certain principals, such as guarantees. Usually outside professional expertise is critical to ensuring the full universe of debt instruments and the interplay between and among them are considered in any approach. It is important that any strategy undertaken does not invoke the law of unintended consequences – an approach that solves one issue with one lender but creates myriad issues with another. This can be particularly problematic in certain bond debt where there are intercreditor and subordination dynamics, further muddying the waters.
“The footsteps of the coming NPL crisis in the US and Europe are loud. We can hear it coming. Banks will not be able to staff up with experienced workout personnel fast enough; these departments will be overworked.”
FW: How important is it for debtors and their boards to familiarise themselves with securities laws as part of any liability management strategy they put in place?
Golubow: Any liability management strategy will likely call for the need for experts versed in the relevant securities laws implicated by the strategy or that may be implicated by the strategy. A securities violation, a claim of market abuse, or claim of insider trading could have drastic civil and possibly criminal implications on any transaction, the debtor and board members. Thus, it is absolutely essential that debtors and their boards familiarise themselves with securities laws as part of any liability management strategy. That does not mean that the actual chief executive of the debtor or the actual board members must be experts in securities laws – there are experienced professionals that debtors and their boards should rely upon to attain such expertise. Therefore, either in-house counsel or experienced corporate restructuring and securities law counsel should be retained as part of any liability management strategy.
Novak: It is extremely important to know what you do not know. Familiarising oneself with securities laws goes hand in hand with management and board fiduciary duties to company stakeholders. Securities laws are in place to protect those same stakeholders. In a fiduciary role, ignorance is never a defence, and not knowing the basics of the laws and regulations presents risk. Knowing the basics should alert management to ask further questions of its advisory and compliance team and avoid unnecessarily running afoul of those laws.
Salerno: Emergencies require consideration of numerous matters, all competing for priority. The economic emergency that COVID-19 has produced is no exception. When one considers the experience of the US securities markets – both debt and equity – over the last few months, there appears to be a material disconnect between the equity markets and the economic realities of the issuers. In any event, securities laws are reactive in nature – they create liabilities after the fact. While understandable in the cases of fraud, in circumstances such as these where businesses are themselves reacting to a volatile dynamic, tripping securities law requirements can be very problematic, issues such as timely reporting, the new disclosures necessitated by the uncertainties of the pandemic, and the like. An understanding of the securities law is an important part of the proactive strategy for moving forward, and given the specialised nature of those laws, again the services of a knowledgeable professional are often required.
FW: What essential advice would you offer to debtors with liquidity issues that may lead to distressed debt? How should they go about developing a liability management strategy that can help them prepare for and cope with the unprecedented challenges posed by COVID-19?
West: The footsteps of the coming NPL crisis in the US and Europe are loud. We can hear it coming. Banks will not be able to staff up with experienced workout personnel fast enough; these departments will be overworked. Debt in which the bank cannot see a path forward are likely to be moved more quickly either through foreclosure or a sale to a private equity (PE) fund. In some cases, sale to a PE fund can be a lifeline. PE funds will have capital to invest in projects that need to be completed and may keep the sponsor involved.
Salerno: There is of course no one size fits all plan of attack for distressed businesses. That said, there are common elements to essential advice for the distressed business facing, or in the midst of, debt issues. First, a candid assessment of cash flow challenges to ensure that management is being realistic about the scope and depth of the economic issues. Second, preservation of all- important cash in the business. Third, the creation of prospective business plans that are best case, mid case and worst case to candidly assess options. Fourth, discussion of potential concessions that the business will need from various lenders and those in the capital structure, such as landlords, to develop a ‘wish list’. This is key because oftentimes it is difficult to go back to seek additional concessions after the business has approached a lender, bondholder or landlord. Careful planning for the wish list minimises this, although there will always be additional items as discussions progress among constituencies. Fifth, emphasising the need to remain flexible throughout the process. A borrower will never get everything it wants or requests, but flexibility is necessary to maximise the chances of success to save at least material portions of a distressed business enterprise. Finally, engagement with key creditor constituencies is important – albeit engagement once at least the semblance of a prospective business plan has been formulated. Opening discussions without an exit strategy from a business or economic plan, however preliminary, will be counterproductive.
Novak: Get in the habit now, whether the debtor is distressed or not, of running a weekly cash flow forecast. Those take time to develop and refine, and are imperative in times of distress. Orient the company’s thinking toward cash. A weekly cash flow will force you to think through and highlight the liquidity impact of any actions. Then address the situation proactively, and do not assume that your lenders will be willing to defer principal and interest any longer. If it is a liquidity issue rather than insolvency, and there is a clear, near-term path to cash flow generation, then there should be options. Lenders have dry powder and we have seen an appetite for new debt and equity investments.
Golubow: The worst thing that a debtor with liquidity issues can do is wait and hope for a turnaround in the economy or its business. Especially during COVID-19, the chances of a manageable turnaround based on improved economic conditions are extremely dire and debtors must seek to proactively take measures before it is too late. Liability management strategies are quite complex matters riddled with extensive legal, financial and operational issues and considerations. As such, debtors should reach out to their in-house counsel or to experienced corporate restructuring counsel that are expert in distressed financial situations to begin discussing their options. While experienced financial restructuring counsel will guide debtors through myriad legal issues, equally important is to engage financial advisers to assist with the following. First, updating financial projections to evaluate cash flow in worst, likely and best-case scenarios, with an emphasis on hoarding cash. Second, creating alternative business plans based upon the updated financial projections. Third, assessing cash availability from current streams of revenue, existing loans and lines of credit. Fourth, assessing unencumbered assets that could be used as collateral to borrow additional funds. Fifth, summarising employee wage and benefit requirements and available assistance programmes. Finally, implementing cost reduction plans to achieve or maintain positive cash flow.
“It is extremely important to know what you do not know. Familiarising oneself with securities laws goes hand in hand with management and board fiduciary duties to company stakeholders.”
FW: With global markets facing a challenge unlike any other, what are your predictions for distressed debt in the coming months? How would you describe the extent of the task facing debtors seeking to mitigate the risks and liabilities stemming from a default or possible insolvency?
Salerno: My predictions are four-fold. First, we can expect to see distressed funds, already formed and forming, waiting for the market to bottom out before actively and aggressively buying debt at discounts. These funds – sometimes called ‘vulture funds’ – will then seek to actively parlay the debt into either economic returns or use the debt as currency to acquire assets of businesses. This is part of the dynamic of every down cycle, and this cycle, although caused by something unusual in the pandemic, should be no different. Second, as government stimulus starts to recede, debt markets will have to focus on collection, and will do so aggressively. Not surprisingly, this will result in a substantially greater number of restructurings. Third, I believe it is an impossible task for debtors to try to avoid ‘insolvency’, as from a liquidity standpoint, insolvency is not looming, it is already present. Finally, the ripple effect of the economic tsunami that this pandemic has wrought will cause lenders to experience their own distress. Such lenders are likely already facing regulatory and liquidity issues of their own as collateral values get reassessed in light of new and realistic cash flow projections.
Novak: Distress will likely be prevalent in the global market for more than two years. The unprecedented cost of fighting COVID-19 will have left consumers and businesses with limited appetite for further debt, and limited ability to incur further debt. In addition, while global supply chains are reworked to mitigate risks revealed by the outbreak, companies may not have the means or willingness to make further capital investments to drive growth. Mitigation requires restructuring operations to suit the new normal and, in many cases, liabilities to match what the reorganised entity can support. The task of mitigation will be all-encompassing for many organisations in the near term.
Golubow: Currently, distressed debt markets are at one of their highest peaks ever. Both the number of funds looking to raise capital and the total amount of capital being sought are extremely high and appear to be growing. Many believe this is just the tip of the iceberg and as businesses begin to run out of reserve funds, government support and other means of support that both the number of funds seeking capital and the total amount of capital sought will vastly increase for several months, if not years to come. Such opportunities have led to significant funding requests by large firms that will likely also continue to grow as such opportunities provide for potential large profits for such firms. Now more than ever it is imperative that debtors take action immediately to understand their agreements and confront potential defaults before they actually occur.
West: A large part of the NPLs in the 2008 crisis were overleveraged businesses that could cover their operating costs, but not their debt costs. In many business sectors, such as retail shopping, restaurants and hotels, 2021 will be about businesses and properties that can no longer generate operating revenue to cover their historic operating model. Government liquidity programmes are currently masking the worst situations from banks, but when these programmes end, their plight will become apparent. The worst strategy for banks and borrowers will be the inventorying of ‘zombie’ loans in the workout department. A borrower’s flexibility will be hamstrung by the inability to restructure its loans and raise new capital. Similarly, banks’ ability to manoeuvre will be hampered by the size of workout both in terms of staff and balance sheet. In the 2021 NPL crisis, lenders that cannot negotiate an exit from their borrowers can expect to find themselves in one of three places. First, the bank’s balance sheet, either as NPLs or as equity. Second, a government created ‘bad bank’ or asset management company. Third, a distressed debt fund. The first and second option are purgatory – neither able to move up or down. Banks that transition these loans through sales to PE funds will be helping both themselves and their borrowers.
Robert Novak, based in Chicago, is a managing director with BDO’s business restructuring and turnaround services practice. He has substantial experience in crisis management, operations improvement and debt refinancing and restructuring, and held multiple C-level and director positions. He has worked across a range of industries including mining and metals, energy, healthcare, manufacturing and retail. He has led in and out-of-court restructurings with a focus on harnessing the opportunity to prompt change and maximise value. He can be contacted on +1 (312) 863 2333 or by email: rnovak@bdo-ba.com.
Gifford S. West is managing director at the Debt Exchange, Inc. Mr West is responsible for international business activities and is engaged by banks and governments across Europe to structure and execute successful loan sales. Prior experience includes assignments within the strategy, risk and capital market consulting groups of Booz, Allen & Hamilton and Oliver, Wyman & Co. in London, Frankfurt, Hong Kong and New York. He began his career at Credit Suisse First Boston. He can be contacted on +1 (617) 531 3436 or by email: gwest@debtx.com.
Thomas J. Salerno brings global experience and out-of-the-box solutions to his work with complex commercial corporate restructurings, helping distressed, often high-profile companies find new paths forward. He has advised lenders, distressed companies, committees and asset acquirers restructurings and recapitalisations in bankruptcies and out-of-court settlements. He also works with a global roster of clients from an array of industries, including casinos, hotels, real estate, sports, tech, power generation, agribusiness, construction, healthcare, manufacturing, airlines and franchising. He can be contacted on +1 (602) 370 7025 or by email: thomas.salerno@stinson.com.
Richard H. Golubow is a founding member and managing partner of Winthrop Golubow Hollander, LLP. Mr Golubow devotes his practice to and has extensive experience in the areas of financial restructuring, insolvency law, complex bankruptcy and business reorganisations, liquidations and litigation, out-of-court workouts, distressed asset sales, Uniform Commercial Code foreclosure sales, assignments for the benefit of creditors and receiverships. He has also been retained and designated as a bankruptcy law expert on several occasions. He can be contacted on +1 (949) 720 4135 or by email: rgolubow@wghlawyers.com.
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