Triple negative – making sense of the current wave of corporate restructurings

May 2016 | SPOTLIGHT | BANKRUPTCY & RESTRUCTURING

Financier Worldwide Magazine

Corporate restructuring is cyclical, defaults rising and falling with the general level of economic activity. It is often argued that little changes from cycle to cycle. Business failures have common causes. Remedies fit standard moulds. Cyclical magnitude and duration are predetermined. Plus ça change, plus c’est la même chose.

That said, in contrast to the rapidity of the recovery from the housing recession, there is a dawning awareness that the current wave of defaults reflects a seismic shift. Given the fundamental changes propelling this shift, the global economy may be on the crest of a much broader and longer correction than generally appreciated. In any case, it should be clear at this stage that corporate failures extend well beyond oil & gas exploration, the nexus of defaulting junk bonds in 2015.

Three secular changes can be recognised today in business. Each has the potential to destabilise corporate enterprise. In combination, their impact threatens to upend and overturn a much wider range of credits than in past restructuring cycles. Immediately obvious and reflected in the global decline in commodity prices is the decrease in purchases as China curtails its unsustainable growth and broadens from a manufacturing-driven economy. A second damper is the finale of a three decade long bond rally central bankers have capped by experimenting with negative interest rates. Third, and likely to be the biggest game changer, is the increased transparency and corresponding decline in pricing of a huge range of products and services enabled by evolving information technology.

Imbalanced supply and demand

The reversal in commodity prices extends well beyond the impact of newly recoverable supplies of US oil & gas from fracking. Energy is only one set of commodities in a tailspin. The world’s largest economy (measured by population), China’s rebalancing from manufacturing and capital investment to service and consumption has precipitated a broad decline in commodities. Given the size of its imports, China’s shifting priorities have caused a dramatic reversal in prices ranging from primary metals, fuels, metallurgical coal, to precious metals. The duration of these declines is difficult to predict and will vary by market. But the immediate increase in restructuring activity is clear. Price declines once thought to benefit consumers and inflate retail sales appear to be wreaking havoc on local economies and financial institutions as well as overall confidence.

Limits of central banking

In 1999, Peter Warburton published ‘Debt and Delusion, Central Bank Follies that Threaten Economic Disaster’, a provocative critique of central bank interventions – eventually dubbed ‘quantitative easing’. Warburton analyses the consequences and risks of overriding capital markets through increasingly proactive monetary policy. Subsequently, the Federal Reserve bulked up its balance sheet to $4.5 trillion in an unprecedented exercise to break the economy’s fall from 2008. The global economy continues to underperform. As anticipated by Warburton, markets now confront bankers with a day of reckoning. Manipulating markets through the accumulation of a burgeoning portfolio of public and private debt risks greater misallocation of capital from artificially depressed rates. Negative interest rates evidence that bankers have hit the limit on intervention. Interest rates can only rise with an inevitable dampening effect on a broad range of valuations, including stocks and bonds, commodities and real estate, as well the Fed’s own balance sheet. Of tremendous significance to the junk market will be the refinancing risks for the billions of dollars in bond maturities looming on the horizon.

To be amazoned

“You’ve been amazoned” – yet to be recognised as a proper verb, this is used to describe an increasingly common dynamic of losing a sale, contract or business when a prospective customer, lender or investor checks the web to determine there are cheaper, better or quicker solutions available. Not only retailers, but distributors and manufacturers are now experiencing the effects of price transparency and efficiencies afforded by technology as revenues and profit evaporate. The drivers for business are increasingly found in the advancing utility of the cloud and handheld microcomputers, aggressively applied by innovators such as Amazon. Legacy risks of overstored retailing, shifting sourcing patterns, and anaemic spending pale in comparison to the increasingly evident carnage from being ‘amazoned’.

The difference

The sheer scale of this set of ‘triple negatives’ holds the potential for corporate restructuring of a new magnitude. Slumping global demand for commodities, a bear bond market, and the impact of price transparency across industries suggests that the current wave of corporate defaults is just the first. Each of these secular changes is different, but together, potentially reinforcing. This year’s estimated corporate default rate of 2.1 percent is likely to prove the tip of a very sizeable iceberg. Not only will commodity-related defaults continue, but extend to service providers, utilities, lenders and municipalities. This can be expected to be amplified by dislocations accompanying rising interest rates, and the destruction wrought by Amazon and other technology leaders on long-established retail, distribution and manufacturing businesses.

This time is different. In prior restructuring cycles, triggering events have been concentrated and effects limited. The oil price reversal of the 1980s hit the energy sector, the S&L crisis of the early 90s struck banking and junk bonds, the tech bubble in 2000 was isolated to telecom and the then fledgling internet, housing was the centre of the great recession of 2008. Reflecting a confluence of secular changes, 2016 is likely to prove the beginning of a broad and extended period of restructuring, arguably overdue since 2008, and certainly more challenging. Given the inherent inefficiency in the market for distressed securities, corresponding opportunities should abound.

Anders J. Maxwell is the managing director of Peter J Solomon Company. He can be contacted on +1 (212) 508 1683 or by email: amaxwell@pjsc.com.

Anders J. Maxwell

Peter J Solomon Company