Following the global financial crisis, Mohamed El-Erian coined the phrase “the new normal,” in reference to an uneven journey toward a new destination.
Fast forward 10-plus years, and the most apt description for what awaits our economy following the covid-19 disruption is “the new abnormal” to characterize the challenges of discerning what the next three months will look like, never mind the next three years. It’s appropriate, too, that the phrase can be attributed to the album of a post-punk revival band attempting a comeback after a 10-year hiatus, a similar situation facing seasoned restructuring professionals today.
If investors can be certain about anything, it’s the likelihood that the next few years will be as trying as anytime in recent history. Fitch Ratings reported in July that the trailing 12-month leveraged loan default rate topped 4 percent for the first time in a decade and projects the two-year cumulative default rate to reach 15 percent in a base-case scenario.
For the few restructuring professionals who have been here before, most know the clock is ticking. While the combination of government stimulus and decisive action have allowed at-risk companies to survive the initial covid-19 shock, life will become far more difficult as lenders, landlords, and other stakeholders grow impatient amid stalled re-openings. Most already know speed will be critical, but based on early restructuring work in this new era of distress, the importance of clean, well-organized, transparent and accessible accounting records – or data hygiene – can’t be overstated to increase the odds of survival.
Distinct glimmers of hope exist for financial sponsors with assets directly impacted by the pandemic. Recent private equity investments have enjoyed less leverage than those consummated ahead of previous downturns. According to Pitchbook, leveraged loan multiples stood at 5.9x EBITDA in 2019, a full turn below 2007 levels. Moreover, the lender universe today – in which private debt investors have largely replaced commercial banks – is proving to be more amenable to finding alternative solutions to avoid bankruptcy. For instance, much has been made about the proportion of covenant-lite debt in the capital markets. However, given the shock and urgency of the outbreak, sponsors and lenders have been proactive and collaborative in dealing with problematic credits.
What also can’t be overlooked are the lessons learned from the recent past. As one investor remarked, “What happened with the GFC was essentially a dress rehearsal for covid-19.” This experience is reflected in how quickly sponsors reacted, as early as February in some cases, to shore up balance sheets, collect receivables, and pull-down revolvers. Sponsors were also quick to initiate negotiations with lenders and landlords to secure payment holidays, draft delay clauses, arrange payment-in-kind extensions and buy time to get to the other side. So while PE-backed companies may have been unable to access government stimulus, firms demonstrated their value by prompting portfolio-company management to act swiftly, before the rolling shelter-in-place restrictions drained revenue streams overnight.
Five months after PE firms first initiated these bulwarking efforts – characterized initially by awareness and then “first response” efforts and triage – financial sponsors are now entering a crucial third phase, as clarity brings about difficult decisions. That large swaths of the US remain mired in the interim phases of the CDC’s re-opening only adds further pressure as affected portfolio companies scramble to figure out how they will enter the fourth and final phase, the “new abnormal.”
Even without knowing what the future holds, or when it can begin, portfolio companies can take steps now to improve their odds even if the worst-case scenarios play out.
Clarity through data
In the past, there had been a tendency to wait until the 11th hour to bring in restructuring professionals, only to discover little could be done outside of a Chapter 11 filing or liquidation. So far, sponsors have been more proactive compared to past downturns. This may be attributable to several factors. Many are aware that seasoned restructuring professionals often get pulled into the largest bankruptcy proceedings first, creating unforeseen talent shortages. But the unprecedented nature of the pandemic left many with little choice but to bring in specialists immediately to gain a clear picture of past and present financial performance and future business potential.
Another wrinkle is that most companies have yet to be stress-tested under the watch of their current owners. Some may have traded hands three times since the GFC or pursued ambitious rollups with minimal integration. Before sponsors can begin modifying processes, they need clarity around which levers are available to pull and conviction around the expected results. Data hygiene is critical.
Post-covid, restructuring teams are discovering serious deficiencies in core accounting data. In many cases, data is nearly unusable to conduct P&L and balance sheet forecasting inclusive of new, unforeseen variables. Assumptions, pre-covid, were often built into and on top of years of earlier assumptions, all presuming base-case scenarios. This optimism was evident in the propensity for add-backs in financing arrangements in recent years. As assumptions have crumbled, accounting systems are failing to capture basic inputs, even on a wholesale basis, and companies reliant on multiple books of record – not uncommon for rollups – demand significant manual interventions. This creates disruptions to accounting and financial planning and analysis workflows, increases the risk of error, and absorbs considerable resources.
As it relates to restructuring, this means the initial work revolves around reconstructing financial models from the ground up – department by department, customer by customer. The data has to be scrubbed and reworked to facilitate immediate interpretation and action. But good data hygiene isn’t just to accommodate the needs of CFOs and company executives: in a distressed situation, as investors consider any and all alternatives, clean data allows for optionality.
The data work is akin to the preparation that precedes a dual-track process, in which healthy companies test the market for either a sale or public offering. The data has to be dynamic to extrapolate it into a future that considers a wide range of scenarios. Against the backdrop of covid-19, decision makers need clarity around where and to what extent they can reduce spend. They also need to identify any potential bottlenecks that will restrict growth when the faucets turn on.
Data also must be versatile to support different constituencies and stakeholders that would participate in a workout. This includes existing lenders or other sources of liquidity for rescue financing, turnaround investors, consolidating competitors, or other acquisition candidates to outbid stalking horse offers premised on liquidation value. In these scenarios, when peers are facing the same threats and pursuing the same suitors, data hygiene can make the difference of who survives.
Having gone through several cycles, we believe the third phase is the most critical. Reliable data translates into conviction; conviction translates into speed; and speed provides optionality as alternatives winnow. Nobody can claim to know how the “new abnormal” will play out; getting to this phase requires clarity that can be elusive following a decade in which economic growth has only moved one way.
Landen Williams and Jonathan Marston are partners at accounting advisory and management consulting firm WilliamsMarston LLC in Boston.