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Analysis / Research - Fall 2009

The Next Wave - continued

Patching Up the Wounded

Despite the daunting parade of upcoming corporate-debt maturities, there are no outward signs of panic just yet. Scheduled maturities for 2010 are relatively light (Chart B) and most likely to be manageable under current market conditions. However, the refinancing burden will intensify in 2011 and beyond. Concerned senior executives of underperforming businesses may be working hard to create a meaningful earnings recovery by then, but few are banking on it to save the day, judging by their actions of late.

Compelling evidence of highly cautious attitudes about the corporate credit environment can be found by examining the flurry of amends and extends (A&Es) carried out in 2009, often pre-emptive and usually on very costly terms, for debt maturities that were one or two years away. A&Es are essentially short-term deals that allow a company to extend loan maturities.

For borrowers, A&Es can push out maturities that cannot be refinanced outright, or they can grant financial covenant relief or added headroom until operating results improve. Lenders typically get to re-price these loans closer to market spreads, insert tougher loan covenants and extract lucrative fees as well. A&Es account for much of the recent leveraged lending activity, with S&P reporting over 200 rated borrower requests for loan amendments in the first half of 2009.

The problem with the A&E solution, known as ‘forward-start agreements’ in Europe, is that often it just delays the inevitable day of reckoning. It is a leap of faith by borrowers and lenders that the lending environment and operating conditions will be substantially better in the not-too-distant future. It does nothing to remedy the fundamental problem: too much debt. And given the mountains of debt due for refinancing before 2014, there is no assurance that credit markets won’t be just as tight or selective as these revised maturity dates approach.

Similarly, on the bond side, debt-exchange offers – whereby companies offer bondholders the opportunity to exchange maturing bonds for new bonds with a later maturity date and/or equity positions – have figured prominently in restructuring activity this year. Through August, S&P tabulated 74 distressed debt exchanges of rated securities in 2009 – easily more than twice as many as in the whole of 2008. Like A&Es, these transactions are often viewed as short-term fixes that allow distressed borrowers to buy some time to repair their businesses while achieving some degree of near-term financial relief.

This option is only possible because junior creditors often recognize that they are unlikely to see any meaningful recovery under a bankruptcy scenario, given the present economic environment and marketplace conditions. Ironically, it is the distressed borrower that often has the upper hand in these colorful, if not contentious, negotiations with bondholders, by using the prospect of a Chapter 11 filing as a cudgel to get creditors on board with an exchange proposal. Despite these fervent efforts to stave off payment defaults and bankruptcy, history tells us that many companies orchestrating distressed debt exchanges today will eventually file for Chapter 11 relief.

Both A&Es and distressed debt exchanges are practical responses to the scarcity of fresh capital for perceived high-risk borrowers in today’s new lending regime. But what other options are available, and what should companies facing significant maturities in 2011 and 2012 be doing now to prepare for the refinancing that’s just ahead?

The Potential Fallout

For the legions of companies that financed their growth with piles of cheap debt, the double-whammy of a recession and a stringent credit environment is likely to hasten a showdown with lenders or creditors. While A&Es and distressed debt exchanges might paper over the cracks in the short term, by allowing struggling companies to limp along in an uncompetitive fashion, the pain is merely prolonged, and recoveries for creditors may ultimately worsen.

This backdrop is likely to mean heightened levels of bankruptcies well beyond the end of this recession. Once upon a time, a failing business might still have had new money thrown at it. Nowadays investors or lenders are more likely to be throwing in the towel, or at least be looking at other ways to extract value and maximize recoveries – without necessarily saving the enterprise. Turnaround professionals and interim managers will be utilized more extensively as key players lose patience with incumbent executives in floundering organizations.

While deal-making continues to be difficult, there has been a huge upturn in distressed M&A activity. The Deal recently reported that Section 363 sales – the equivalent of auctioning off a failed entity’s business or assets – have almost doubled in 2009. These days especially, it may take a while to get to a Chapter 11 filing, but once there, the timetable really accelerates for some debtors.

Vulnerable sectors going forward will include a raft of consumer-dependent businesses that are asset-intensive, and burdened with debt or other onerous financial obligations. This extends well beyond the retail sector itself and includes airlines, travel and lodging, gaming, consumer finance, media and entertainment and consumer product makers, among others. In the healthcare sector, retirement homes and assisted-living communities are also looking vulnerable as the falling value of residential real estate and retirement accounts is frustrating the ability of potential new customers to take on units in these communities.

Lastly, consider the state of the banking sector. While some Wall Street banks were considered too big to fail, smaller regional banks will end up being too small to rescue. The irony is that many regional banks were conventional lenders that mostly avoided material exposure to toxic paper, risky financial derivatives and other structured investments that embroiled Wall Street. However, sliding values for commercial real estate, a business mainstay of regional banks, will inevitably impair their collateral and erode capital levels. Many believe the knock-on effect on balance sheets could prompt smaller regionals to fall by the wayside. No doubt the best assets of these failed institutions will be snapped up at bargain prices by national money centers and large investment banks – some of which qualified for previous bailout assistance. 

In all of this, antitrust authorities will likely seek to play a more active role, but their voices may ultimately favor measures that restore corporate profitability and the preservation of jobs. It follows that strong companies should have a good opportunity to pursue in-market acquisitions successfully over the next year or two, particularly if the target would otherwise struggle financially, or go bankrupt.

There Are No Magic Bullets

So what can be done? Most important is for companies to address the appropriateness of their capital structure and debt layering long in advance of refinancing dates, bearing in mind both the new tolerances and valuation parameters of capital markets and the expected persistence of weaker operating earnings in light of the recession.

As previously mentioned, a distressed debt exchange, especially one involving a substantial debt-for-equity swap, is a means by which a troubled borrower can reconfigure an unsustainable balance sheet in the absence of new money, and possibly without the need for filing for bankruptcy. But it requires Herculean negotiating efforts with recalcitrant creditor groups which may end up on the courthouse stairs in any event.

Secondly, companies must focus ruthlessly on driving business efficiency. Many have done so admirably during this downturn, with the retail sector coming to mind first. Large U.S. retailers generally surpassed Wall Street’s low earnings expectations in the second quarter, despite slumping sales and gross margin compression. Such results can be achieved through a combination of cost-cutting, vendor and landlord negotiations, reduced capital investment and better inventory management. Senior executives should keep an eagle eye on subtle changes in critical trends that impact their business, and should understand how key performance indicators can be utilized.

Companies with marketable assets might consider selling some of the family silver to pay down debt. While M&A markets are slow, the deal environment is gradually improving. Sometimes such measures are painful, but necessary. Struggling retailer The Talbots sold the J Jill Group – a business segment it could no longer support, given the distress at its namesake chain – in June to a private equity shop for $75 million. Talbot’s purchased the J Jill chain some three years earlier for $500 million in cash. Even if a sale is not possible straight away, companies can start positioning some dispensable businesses or assets for sale as soon as markets improve.

Which Way Now?

We know that refinancing the dozens of billions of high-risk debt slated to mature over the next few years will be a challenge for most, and impossible for many. While there is a good chance that economic conditions may be showing signs of improvement as we move into a new decade, the consensus points to a slow, below average recovery. It is likely to take several years for corporate earnings to return to 2007 levels, for job prospects and personal wealth to recover enough to kick-start consumer spending and for lenders to shake themselves free of the noxious overhang of bad assets and bad practices that they acquired during the halcyon days of the credit boom.
However, some just can’t hold out that long; others will be unable to earn their way out of their financial predicaments. The term ‘jobless recovery’ is already being bandied around with a casualness that belies the grim reality of the expression for many millions of Americans. To make matters worse, federal budget deficits and borrowing needs will remain exorbitant. It’s not exactly a recipe for optimism.

2010 is certain to be a pivotal year for the U.S. and global economies – a ‘show me’ year in the minds of both equity and credit investors who now fully expect to see fresh, indisputable evidence of positive economic growth and solid earnings recovery, and who have already priced such expectations into capital markets. Many economists, though, are less sanguine about any rosy growth scenario as long as stricken consumers stay planted on the sidelines. The interplay between corporate operating performance and credit market conditions will likely be reinforcing: better than expected earnings may further embolden credit investors and ease access to capital, which will in turn bolster corporate results. But it could work the other way too, with vast pockets of economic weakness that persist into 2010 finally causing financial markets to doubt the adequacy or sustainability of a recovery. How the economy unfolds in 2010 may very well determine whether the debt maturity challenge eventually rises to the level of a crisis. We’ll be watching closely.

Dominic DiNapoli is Executive Vice President and Chief Operating Officer of FTI Consulting, responsible for the day-to-day operations of the company’s five business segments.

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