Turnaround and restructuring 2021 outlook
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.
Bankruptcy activity in 2020
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.
Outlook and sectors to watch in 2021
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.
Access to capital markets will likely remain constrained for most oil and natural gas producers in the near term, and borrowing base redeterminations in the spring will determine the size of the next wave of bankruptcies. Any price softening from rollbacks in OPEC+ production cuts or additional economic shutdowns could trigger borrowing base shortfalls and additional bankruptcy filings.
This will trickle down to the oilfield services sector, which is expected to remain under pressure for the foreseeable future. Operators have cut costs substantially and hope to ride out the storm, but interest costs of highly leveraged players will continue to challenge liquidity. Consolidation in the sector is needed to remove capacity, cut overhead costs and improve pricing power.
Midstream and downstream companies have largely been spared from the bankruptcy wave, but they’re starting to face their own headwinds. Overcapacity due to reduced volumes — along with recent court decisions allowing the rejection of gathering and transportation agreements, previously thought to be safe — have reduced midstream pricing power and resulting cash flows. This also gives upstream customers more leverage to renegotiate above market rates or minimum delivery commitments.
Political and macroeconomic trends add another layer of headwinds across the sector, as a renewed focus on the transition from fossil fuels to renewables is expected from the Biden administration.
The pandemic has dramatically accelerated ongoing retail industry trends, including growth in digital commerce platforms and a dramatic shift in consumer habits away from apparel and toward essentials and the home. Mandated lockdowns and prolonged store closures have further pushed liquidity-constrained retailers to consider large-scale permanent store closures, financial restructurings and even outright liquidation. There were more than 8,000 permanent brick-and-mortar store closures in 2020, and when taking into account temporary store closures, total estimated store closures could eventually approach 25,000.
The restaurant subsector has arguably been forever changed, with impacts felt hardest by those that continue to rely heavily on indoor dining. While mobile ordering and grab-and-go business models have fared better, the restaurant sector continues to be a matter of survival of the fittest in the face of continued pandemic fallout.
Looking ahead, we expect consumer spending and dining habits to hinge on the pace of new COVID-19 cases, the continued rollout of the vaccine and additional government assistance programs. The ability of troubled retailers to continue to lean on landlords for various forms of rent waivers or abatement will likely reach its tipping point by mid-2021 as exhausted landlords increasingly deal with their own financial challenges. While the winners and losers of the 2020 holiday season have yet to be declared, we expect most retailers to face a rocky road ahead, especially during the first half of 2021.
The US travel industry faced its worst year in decades, as the concurrent health and economic crises caused by COVID-19 pressured hotel owners, lenders, brands and operators. The collapse in demand for leisure and business travel is expected to cause a 44% drop in US hotel occupancy and a 21% drop in average daily room rates for 2020. While the fallout has impacted the entire sector, destinations that rely on business, group and international demand have suffered the most.
The CARES Act and Paycheck Protection Program, combined with loan modifications and forbearance agreements, have provided hotel owners much needed breathing room. If vaccine distribution proceeds as planned, the industry may see a much-needed surge from pent-up leisure demand in the second half of 2021, but it could be years before business travel returns to 2019 levels, if at all.
So far, investor commitment to the sector has remained strong, and lenders have hesitated to pursue foreclosures and take ownership of these assets outright. But that trend is contingent on achieving sustainable control of the virus. If the vaccine rollout stumbles or demand doesn’t materialize in the second half of 2021 as hoped, the industry could face a liquidity crisis and a surge in foreclosures, especially among noninstitutional hotel owners.
The global health crisis stemming from COVID-19 has disproportionately challenged healthcare providers. The cancellation of profitable elective procedures at hospitals has pressured margins and cash flows, particularly at smaller rural systems where patient volumes were already declining. Providers benefited from substantial government support in the CARES Act, including the acceleration of Medicare and Medicaid reimbursements, but that will end beginning in Q1 2021. Once that happens, we expect more hospitals to face liquidity challenges that will drive restructuring activity.
Senior living operators are also at risk given the impact COVID-19 has had on demand from new residents in a sector that was already dealing with excess capacity. While the longer-term demographics are favorable for the sector, near-term supply-and-demand imbalances may drive increases in restructuring activity in 2021.
