The world has come a long way since the collapse of the financial markets last October. Since the crisis lows, the equity markets have roared back, making impressive gains of 30%+. The new issue market and public debt markets have thawed, although broad-based IPOs remain sparse. Government intervention aimed at effecting interbank and general lending has taken hold and lower LIBOR and TED Spreads have put lending institutions back in business.
With the summer upon us and the financial markets moving in the right direction, it is easy to get caught in the euphoria of an ugly time passed. The M&A markets have picked up and are expected to continue to gather steam as cash-rich companies look for bargains that are the result of depressed valuations, carve outs or distressed companies unable to stretch through the downturn.
Certainly, the next several years will be as interesting as the past one. Fundamental systemic changes to entire industries coupled with the long-term hangover expected from astounding global government intervention on fiscal and monetary policy and the private sector will continue to play out. The phrase “business as usual” will have an entire transformation as the marketplace realizes the full implications of what has occurred.
The dramatic slowdown and level of uncertainty going forward is no doubt a cause of great concern for the average business owner or management team. But within all the turmoil lies tremendous opportunity for those armed with the knowledge, appetite for risk and financial wherewithal, willing to come out of the trenches. That being said, effecting change in today’s environment requires a heightened level of awareness and exhaustive planning for the potential risk ensuing from the uncertainty and for what lies ahead.
Recognizing the risks
The single largest risk is the misconception that with the road to recovery in sight, the need for proactive planning is no longer a top priority. Though we may very well be on our way, the road needs to be carefully navigated. Assessing the options from varying perspectives which include operational, strategic and governance will minimize the potential for issues along the way.
Certain industries including automotive, forestry and paper, construction and building products, retail and consumer and real estate continue to be most negatively affected by the declining economy. In addition to significant exposure to declining U.S. demand and volatile exchange rates, companies in high-risk industries are more susceptible to customer and supplier failures resulting from fundamental industry issues. Particular attention should be paid to customer/supplier concentration and to critical suppliers; a defined program for managing an interruption should be in place. At the end of this downturn, there will be systemic changes to most of the industries listed above; the key question that should be asked is – where do you want to fit in the vastly changed landscape?
Lack of planning or sensitivity forecasting
Strong economic growth over the past several years negated the perceived need for sensitivity forecasting. Yes, companies planned and budgeted for growth; however, the large majority had not planned for a significant downturn, leaving many with a considerable gap in performance. A flexible sensitivity model enables a company to adjust all of its inputs in line with expected changes in demand and profitability. It enables management to assess a worst-case scenario and plan for it well in advance of it becoming a reality. Worst case scenario planning should be taken a few steps beyond what management believes could happen to ensure all possibilities are accounted for.
Liquidity and access to capital
Maintaining a healthy balance sheet should always be a top priority for a business. There is no doubt that many have eaten into their cash reserves and drawn down on operating lines to weather the downturn. With the public and private debt markets seeing some relief, it is an ideal time to reassess short- to medium-term liquidity needs. Areas that should be addressed in assessing how much cash is enough include: working capital, maturing debt, capital expenditure requirements, off balance sheet exposures, pension funding obligations and counterparty risk. It would also be prudent to segregate some cash for opportunistic activities.
Restructuring with limited refinancing options
Restructuring a business in today’s environment has become complex and challenging. In the past, it was not difficult to find an alternative lender willing to step into someone else’s shoes. Today, restructuring presents difficulties with respect to finding participants to provide debtor-in-possession (DIP) financing as well as exit financing. As such, restructuring has evolved into a complex manipulation of the balance sheet by way of debt to equity conversions often with sweeteners such as warrants. Although this may provide some relief for debt holders, such reengineering has significant ramifications for equity holders. A growing alternative to debt restructuring is financing provided by distressed buyout funds. The relative risk for this type of investment is clear in the pricing demanded by the specialist providers.
Lenders have gone back to basics. Over the past few months, there has been a noticeable pick up in the lending market. Operating loans, term debt and acquisition lines are being secured by new customers on a limited basis. Lenders are cautious, willing to lend to new clients that exhibit a strong balance sheet, a solid business plan and significant security. Due diligence on new accounts is extensive, escalating the need for sound and timely financial information. Loans for distressed situations remain largely available to existing customers only. Pricing, although down from crisis highs, remains above pre-crisis levels with risk clearly reflected in it. Covenants have tightened restricting sr. debt to EBTIDA ratios to three times and total debt to EBITDA ratios to four times. Though the lending market has clearly thawed, it is important to remember that as re-intermediation of the financial industry progresses, the available pool of funds will be restricted.
Difficult business and personal conditions have increased the likelihood for, and intensified the incidence of fraud. The stresses of declining profitability, large-scale layoffs, salary caps/reductions and scrupulous review of management compensation will increasingly result in a sense of desperation with more people feeling the pressure to “cross the line”. Rationalization of departments, merging of job functions and rapid change can all leave gaps in control systems previously used to detect anomalies.
Idling facilities, scaled back production or R&D spending
There are several reasons a company may choose to idle a facility or scale back production or R&D spending. In addition to understanding the key rationale for the action, it is important that a comprehensive plan address the timing, costs, impact on future earnings and competitive market position. Consideration should also be given to whether the assets related to the scale back can be translated into cash.
Despite there being a heightened level of risk, the hardships for some are resulting in tremendous prospects for others. The economic shakeout has presented what some are considering the opportunity of a lifetime. The market is ripe to proactively gain market share, enter new geographies, acquire or develop new technology or products, strengthen supply chain relationships and upgrade assets. Assessing needs, being aware of the various options and where to find them, and understanding the nuances of transacting in the current environment are important in developing a successful growth strategy.
Tough business conditions have backed many good companies into a corner. Cash-generating options available to corporations in a liquidity crisis include: partial sale of the business; carve out of non-core assets or products; joint venture/partnership arrangements and sale-lease back of real estate. Having a strong understanding of your respective strengths and weaknesses can enable proactive targeting with the goal to broaden products or services, add technology and customers, diversify geographically and acquire intellectual property as a defensive strategy against competitors.
With decreased competition from private equity players who in the past have used leverage to outbid strategic acquirers, companies with strong balance sheets can take advantage of depressed valuations or share prices to initiate takeover actions.
Distressed M&A has its own unique set of considerations. When a company enters into a court-governed creditor protection process, the uncertainty surrounding the outcome often negatively affects customer and supplier contracts. Identifying distressed opportunities prior to a formal filing can avoid the potential damage to the ongoing business. Distressed deals are often completed on a proprietary basis, reinforcing the need to stay on top of sector activity and competitor plans.
To reduce risk and maintain required capital ratios, lenders are increasingly selling debt positions into the secondary market. Paper trading in the secondary market usually does so at a discount with lower pricing being indicative of higher risk. Assuming the credit agreement allows for it, the paper can be acquired by the borrower or by a third party. For the borrower, buying back their debt at a discount can be a cheaper way to decrease leverage to reduce interest costs or to avoid a covenant breach. If the company is heading for default, buying debt enables the purchaser to step into the creditor’s position and regain control of the company. Purchase by a third party would likely be motivated by the potential opportunity to gain control of the borrower with the intent of turning debt into equity at some point in the future.
Debt buy backs are technical transactions with little opportunity for due-diligence, which could take time to realize value and have tax implications. While the benefits may be substantial, entering into such a transaction should be carefully considered.
Joint ventures and collaboration
Globalization and relocation of manufacturing to low cost countries has redefined global industries. Companies that have stayed their course in the mature North American market will find it increasingly difficult to compete with those that have adapted. JVs enable companies to focus on their core offering while protecting their market position by “controlling” the competitive landscape, access new growth markets, IP and products and move manufacturing to more desirable geographies.
Alternative sources of capital
For companies having difficulty addressing liquidity needs, there are several alternatives to Schedule A Bank debt that could be considered. Both BDC and EDC have publicly announced programs to assist Canadian companies weather the storm. These include direct lending or acting s guarantor for other lenders. Beyond senior debt, sub-debt, asset-based lenders and private equity are other available sources of capital, albeit at a higher prices.
With the economic recovery in visual sight, this is the time to address key risks and opportunities to position your company to reap the benefits of the upturn. It is important not to lose sight of today’s unique set of needs and circumstances; but it is equally important not to lose sight of the future. The global shakeout across all industries will eliminate the dead wood leaving a transformed, vibrant future for the survivors.