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COVID-19 and the distressed investor

Understanding the environment is key to the right deals

RFP
Young male trader at office work concept sitting looking at screen thoughtful The impact of the COVID-19 crisis on the economy means that many investors are seeking to acquire distressed or bankrupt businesses or assets. But what do they need to understand how to operate in that environment? As part of its Middle Market Week, co-sponsored in part by Grant Thornton, The Deal hosted Ryan Maupin, a principal in Grant Thornton’s restructuring and turnaround practice, and Vin Batra, a managing director at Configure Partners, to discuss distressed investments in today’s environment.

It starts with the distressed environment itself. In March and April, most consumer-facing businesses got hammered. Unless a business was deemed an essential service and allowed to remain open, it faced some very difficult choices. Unless it was able to pivot almost instantly to an online or other no-contact model, most had to mothball the business and try to preserve liquidity. At differing rates in different states and in fits and starts, businesses are slowly reopening, but are still at nowhere near pre-COVID capacity.

A cloudy crystal ball “We’re going to see distressed activity continue to heat up through the third and fourth quarters,” says Maupin. “Beyond that, it really depends on when people can start moving again. So many industries, from airlines to hotels to rental cars, depend on people being able to travel. And social distancing rules affect many others. The longer that travel is limited, and people are restricted from or are afraid to get together, the worse the situation will get.”

Lenders have been offering forbearance to a large degree, and the Paycheck Protection Program (PPP) and other stimulus efforts helped buy time for many businesses. However, most of the stimulus programs have run out, and regular unemployment benefits for laid off workers will start to expire soon. “What is the holiday season going to look like in these conditions?” asks Maupin.

On the plus side, Batra does not see any current systemic threats to the financial system such as the ones the economy faced in 2007 and 2008 at the start of the Great Recession. “There is plenty of liquidity and reserves are healthy,” says Batra, “so I don’t see any systemic risk, but there are going to be a lot of distressed companies over the next two to four years.”

But not all distressed companies are created equal. “There are two buckets of distressed companies,” says Maupin. “In the first bucket, you have companies that already had issues before COVID hit. In the second are companies with issues primarily resulting from the pandemic. Lenders and investors aren’t going to look at them the same way. Lenders will be far more willing to work with companies in bucket number two.”

Corporate debt’s role in the crisis One reason many companies are in the first bucket? Too much debt — and especially too much covenant-light debt. “Something like 80% of corporate debt when the pandemic hit was covenant-light,” says Maupin. Loan covenants provide early warning tripwires based on EBITDA, leverage ratios or other metrics, which help lenders spot troubled loans early and increase the chances that issues can be resolved. Companies that were over-leveraged, but flying under the radar because of covenant-light loans when COVID hit, face a much harder road to recovery—and may be more likely to end up in the cross hairs of investors seeking distressed targets.

While lenders have generally been flexible until now, that won’t continue indefinitely. They are looking at three key issues as they evaluate their borrowers:

  • What’s the real EBITDA? EBITDA is obviously a key financial metric, but many companies have been making EBITDA adjustments, some of them vague. There is always a business perspective and a lender perspective, but companies can expect lenders to be taking a closer look at any adjustments.
  • What’s the liquidity situation? More is obviously better. But distressed companies should not wait for a crisis to start talking to their lenders and other parties of interest. “We have companies come to us when they can’t make payroll next week, and that’s too late,” says Maupin. “Address things when they are an income statement problem. Don’t wait until they are a balance sheet problem.”
  • What’s the leverage versus the value? This is where the huge run-up in corporate debt over the 11-year economic expansion is going to come home to haunt some companies. A downturn is no time to be over-leveraged.

The huge run-up in corporate debt, especially in covenant-light debt, isn’t the only after-effect of the record 11-year economic expansion that is complicating the distressed company environment. “The lack of volume of distressed companies over the past decade or more means there is a lack of experience in dealing with distressed companies,” says Maupin. “There’s distressed experience at the very top at some organizations, but very little on the teams that actually have to manage the deals. The volume we’re looking at now will stress resources for lenders and investors alike. It’s one of the reasons that the right advisors are going to be critical.”

Cooperation is best Whether you are a distressed company, a lender, an investor or another party-in-interest, it’s best to stay out of court in many cases. “Traditionally, the majority of deals end up in court, but bankruptcy is expensive - especially for middle market or smaller companies. It erodes value for everyone,” says Batra. Think carefully about bankruptcy. What benefits does it offer? What are your outstanding claims? What is your unsecured position? “I think we’ll see far more deals settled out of court this cycle,” says Batra. Even in cases where liquidation is the best option, a negotiated assignment for the benefit of creditors may be a better option than a Chapter 7 filing.

In any case, start early and involve everyone. “It’s a dance,” says Maupin. “It takes creativity and it involves everyone. The company, the lenders, the other creditors, any sponsors, any potential investors — everyone needs to be at the table and working in good faith. The earlier you start, the better you do.”

A fresh plan Whatever their route forward, distressed companies need a fresh business plan. You can’t show up with the plan that got you there in the first place. “Forecasts are tough right now,” says Maupin. “You need a fresh plan based on your new normal. Suppose you’re a restaurant chain and you realize that 20% or 30% of your locations were underperforming even before COVID hit. PPP has given you some breathing room. You’ve furloughed staff and stopped lease payments to buy time. Work out a new plan that reorganizes your capital structure and moves forward with only your high-performing locations.”

Like lenders, private equity funds will also need to pick winners and losers. Portfolio companies with the right business plans and sufficient liquidity may be worth the additional equity. “Most funds have a fair amount of dry powder,” says Maupin. “And funds raised to invest in distressed assets are going to have a wealth of targets.” But where funds need to shut down portfolio companies, how that is done matters. Most funds want to do it quickly, but they also need to do it properly. “Companies can be closed down responsibly or irresponsibly,” says Maupin. “But how it’s done will impact the fund’s reputation with lenders, investors, potential targets, everybody.”

The number of companies in distress will continue to grow for at least the next few quarters. The better that investors understand the environment and the better the advice they get, the better their results will be.