Bankruptcy activity is expected to be steady as the pandemic and recession persist.
As we assess our outlook for turnaround and restructuring activity in 2021, it’s difficult to overstate the level of disruption companies faced in 2020. Healthy, well-capitalized companies faced acute liquidity crises, and even the most prudent management teams lacked critical tools and capabilities to manage through the uncertainty. Liquidity planning, annual budgets and covenant forecasts were rendered obsolete overnight, and companies had to scramble to raise capital to weather a storm of unknown size and length.
Now businesses face a crucial question: Have we closed the door on the fallout from COVID-19 and begun a new phase of recovery and growth, or are we in the calm before a storm of operational uncertainty, mandated shutdowns and increasing leverage? Expectations for earnings projections, liquidity forecasts and covenant analyses were set without the benefit of historical precedent or hard data on which to build assumptions. If those expectations aren’t met, another round of support and flexibility may not be available from capital providers in 2021.
The second round of federal stimulus approved in December 2020 will provide much-needed support to companies through the first half of 2021, but we think there’s more financial distress ahead of us than we’ve seen in the past year. Companies that bolstered liquidity through capital raises now must manage higher debt service and more levered balance sheets in the face of continued operational uncertainty and a challenging earnings and cash flow environment. These underlying challenges haven’t yet had time to trickle through the economy and manifest in financial restructurings.
The number of Chapter 11 filings with greater than $10m of liabilities grew by 16.5% in 2020 — a relatively modest increase compared to the disruption companies faced during the year. While that volume was the highest level since 2012, it’s well below the levels during and after the Great Recession of 2007 to 2009. In fact, among smaller companies that represent the largest market segment, Chapter 11 filings decreased 0.7% during 2020. Over the past 10 years, lower middle-market Chapter 11 filings have accounted for 77% of bankruptcy filings, so changes in this segment have an outsized impact when compared to the larger company categories.
How were companies able to navigate the unprecedented financial uncertainty in 2020 and avoid restructuring? The muted impact is due, at least in part, to the swift government monetary and fiscal response in March 2020. The Federal Reserve Board’s consecutive interest rate cuts stimulated credit markets and provided near-term relief to companies, as did direct support through passage of the Coronavirus Aid, Relief and Economic Security (CARES) Act and direct purchase of corporate bonds and loans through the FOMC's newly-established primary market and secondary market corporate credit facilities. Capital providers were keen to put money to work in a flurry of new debt issuances to shore up liquidity reserves. Lenders were also willing to underwrite debt modifications, waivers and amendments to help companies avoid financial distress and defaults, while equity markets posted new highs.
The largest Chapter 11 filings accounted for $95.5 billion of liabilities, which is in line with the levels we’ve seen in recent years. These generally didn’t surprise stakeholders: Nine of the ten largest companies to seek Chapter 11 protection were on distressed watchlists at the start of 2020, before the market had carefully considered the effects of COVID-19. Therefore, the virus was a contributing factor to financial restructuring, but not a primary cause.
The fact that many of the larger bankruptcies in 2020 already were distressed before the pandemic supports the notion that the elevated activity was more likely an acceleration of bankruptcies that were inevitable. The full impacts of the virus haven’t yet worked their way through the economy and driven broad-based financial distress and restructuring activity.
Our outlook for the first half of 2021 is largely more of the same, as fresh stimulus should allow companies to continue to tread water through the vaccine rollout and hopefully bridge to a reopening of the economy. However, in the second half of 2021 and in 2022, it will become clearer whether companies are tracking toward the performance projected in their V-shaped recovery scenarios — enabling balance sheet deleveraging from operations — or whether those projections were overly optimistic, and debt service and balance sheets must be addressed through debt restructurings.
We think that the additional financial and operational leverage companies have had to take on to navigate the operational burdens of COVID-19 in 2020-2021 likely won’t be sustainable for some businesses. Companies that act now to recover will have more options available to achieve sustainable solutions, avoid friction costs and minimize process disruption.
This year, we’re closely monitoring several sectors in which we think these themes may drive increased restructuring activity.
US Business Recovery Services Leader, Principal, PwC US
Director, PwC US