Global Economic Disruption—Impact on International Secured Lending
By Eileen Wubbe
SFNet’s recent Virtual International Lending Conference offered insight on the effects of the COVID-19 crisis from geopolitical risk consultant, David Chmiel, co-founder/managing director, Global Torchlight; Marc Finer, director, Debt Advisory Group, KMPG LLP; Scott Fuller, director, Valuations, Gordon Brothers; Richard Hawkins, CEO, AtlanticRMS and Robert Horak, managing director, Lincoln International. David Morse, partner, Otterbourg P.C. and Richard Kohn, principal, Goldberg Kohn Ltd. served as conference moderators.
The conference kicked off with geopolitical risk consultant David Chmiel of Global Torchlight who explained what the post-pandemic world may look like. He offered his review of the impact of the crisis on international business and the world economy.
Chmiel said COVID-19 had, in some ways, amplified and solidified ongoing debates about trade and economic policy, such as whether uninhibited globalization was a good thing or not.
“Many countries have faced significant shortages of critical medical equipment and pharmaceuticals and they have become more protectionist as a result,” Chmiel began. “Some supply chains have ground to a halt because manufacturing around the world was affected very early on. There are also concerns that, with weakened currencies and depressed asset values, opportunistic investors may seek to acquire critical assets at less than their full value. As a result, governments around the world are subjecting inbound investment to greater scrutiny. The definition of what they consider ‘critical’ is also expanding significantly. We’re seeing the ‘securitization’ of economies as governments categorize a number of industries as critical to national security.”
This momentum against trade will translate into policy risks for business and for the lenders who finance them, Chmiel noted.
“I think it is safe to say we are going to see considerable demand for self-sufficiency in the production of goods that have been critical in the fight against COVID-19. Many countries are actively seeking to develop the capacity to produce protective equipment and similar goods internally, so they are not as reliant on global supply chains as they have been previously.
“I think we may also see a more extensive debate around principles of patent protection. If and when scientists develop a vaccine or any sort of revolutionary drug treatment regimen, there will likely be considerable political pressure on whomever makes those developments to share them with the world at minimal cost.”
Chmiel added that the current situation will also contribute to perennial debates in many countries about public vs. private involvement in healthcare provision. COVID-19 has generated considerable focus on areas peripheral to primary care, such as long-term care facilities. We are already seeing calls for significant reforms in extended healthcare provision to correct perceived failings, including even bringing such facilities into public ownership.”
The pandemic is also contributing to ongoing debates in the U.S., the UK and elsewhere about issues of economic inequality and corporate finance strategies.
“Many companies are taking on more debt to finance themselves through the economic crisis,” Chmiel said. “Even a few months ago, pre-crisis, politicians were raising concerns about overleveraged companies and whether that was putting jobs and livelihoods at risk. If we start to see these highly leveraged companies keel over, especially if investors continued to extract large volumes of cash from those businesses, you have the potential for even greater political scrutiny and regulation. The UK government, for example, is already requiring certain companies taking government-financed loans to agree to pay no dividends or cash bonuses to senior managers. When you combine that with the politicization and securitization of certain M&A activity, you see significant headwinds starting to form.”
How Lenders and Their Borrowers Across Markets Are Adapting to the Challenging Circumstances of the Current Economic Crisis
After Chmiel set the stage, the Conference’s assembled group of debt advisors, appraisers and workout consultants, with experience in the U.S., UK and Europe, discussed what they are seeing and how lenders and their borrowers across markets are adapting to the challenging circumstances of the current economic crisis.
Robert Horak, managing director, Lincoln International, kicked off the panel representing the debt advisor world and explained some highlights categorizing the U.S. markets.
“U.S. lenders were hit with unprecedented revolver draws in late March,” Horak said. “The balance of power has shifted back to lenders. After years of dealing with aggressive structures and terms driven by private equity firms, lenders are pushing back and are looking for tighter documents, stricter covenants, fewer baskets, and less willingness to accept addbacks and adjustments. In the U.S., gone are the days of DDTLs, incrementals and adjusted pro-forma run-rate EBITDA. In today’s environment, lenders are more focused on actual EBITDA.”
Right now, lenders have set a higher bar for what companies they will lend to and are generally not willing to take syndication risks, meaning the sponsor or borrower has to take on the work of creating a club in order to get a deal done.
“Similar to how the U.S. economy is opening up in stages, I think traditional lenders are only receptive to a fraction of the market, those businesses where revenue and EBITDA have been resilient and are expected to remain so,” he added.
U.S. commercial banks are generally faring well in terms of having capital. However, the U.S. banks are also the administrators of the CARES Act programs and have had to spend significant time and resources to support the special lending programs that have been enacted in the U.S.
“All of the applications for funds being provided by the government have been run through the banks. Some of these banks are also expecting significant transfers of accounts coming from their commercial banking divisions to their ABL groups and we’ve noted that ABL pricing has gone up significantly,” Horak said.
Mezzanine funds, on the other hand, have been relatively unimpacted by the crisis since they don’t use leverage as part of their fund structures and are better positioned to weather the COVID-19 storm.
“They’ve become more relevant in transactions that would have gone to a unitranche or an all-senior structure prior to COVID-19,” Horak added.
Marc Finer, director, Debt Advisory Group, KMPG LLP, discussed the advice debt advisors are providing to their borrower clients in the UK when liquidity is so critical.
“There were immediate reactions from borrowers needing cash. The advice that my colleagues and I have been giving is for borrowers to recognize that, although the drivers for the need for liquidity have changed in this market—it is not M&A and growth and capex—the approach to engaging with lenders shouldn’t be that different to how you might engage with your lenders in a business as usual, normal environment. You have to tell the story of what’s going on with your business before you can expect a lender to part with their cash,” Finer said.
Finer stressed needing to have a clear story on the impact of COVID-19 on your business: what will the longer impact be, what is the strategy, and what is being done to stabilize the business and minimize reliance on additional financing.
“Put yourself in the shoes of your lenders,” Finer added. “They’ve also experienced a massive amount of disruption inside their organization and personal lives – there’s a lot of borrowers can do to help lenders help them.”
From an ABL perspective, an interesting element, noted Finer, particularly from the larger clearing banks in the UK, is seeing some cash flow-lending elements of the bank trying to encourage borrowers to move into invoice financing or asset-based lending structures.
“Of course, it’s not always that straightforward,” he said. “We always talk about the merits of ABL as a product and how it can work so well when market conditions are not great. But I think this particular crisis is really highlighting the greatest risk around ABL, which is sometimes cash flows dry up to the extent that exactly when you need the liquidity you don’t actually have the volume of trade coming through your business. The debtor book is not big enough; your stocks are not there. It’s not a failure of ABL, it is just the dynamics of the market.”
What is happening to asset values and how do you determine values given the market disruptions?
Scott Fuller, director, Valuations, Gordon Brothers, discussed asset values during the COVID-19 crisis.
“We’re getting a real mix of responses from different organizations and types of lenders,” Fuller said. “Many lenders already have their own assumptions on the impact of what the coronavirus will be and what actions they want to take over asset values. Some are driven by regulations. They’ve got less flexibility on the timing of appraisals and the period that that the asset must be valued over. They’re also under government pressure to continue lending.”
Alternative lenders may take a more pragmatic view, Fuller said. They have more flexibility in structures and can take a longer-term view on what asset value may be.
“We are also seeing the impact on clearing banks, where they are worried about reduction of EBDITDA multiples and are looking at asset values to provide downside protection. They are looking at converting distressed revolving credit facilities onto a more structured ABL facility. In many cases, lender motivation depends on what they are looking to achieve, and how they see the financial strength of the underlying company, and what implications there may be if a company is unable to trade for a period during the crisis. There is no one-size-fits-all in the current environment.” It is important for lenders to balance the need to take proactive measures to preserve and maximize value, with a measured approach to taking enforcement actions in the short term, which may not be in the lender’s best interest.
If it’s a re-appraisal, lenders are asking to take a second valuation to be consistent with pre-COVID conditions and be consistent with their underwriting. If it’s downside protection or insolvency, you’d want a more immediate exit, Fuller added.
With social distancing here to stay for a while, valuations will continue to be conducted remotely.
“Asset values haven’t really dropped. People are in a holding pattern. We are finding the costs are increasing because you have to hold that inventory for a longer period of time. What was a three-month exit is now a six month exit as people are holding on to assets for longer, waiting for the market to reopen or return to some form of business as usual. The coronavirus pandemic spreads and peaks throughout the world at different times and in different ways. When things open up businesses will need to market themselves more aggressively than before so that everyone knows you have re-opened again. People are looking at brands and the good brands and businesses will develop and survive during this.”
What strategies are there to maximize recoveries for lenders in an environment with so much uncertainty?
Richard Hawkins concluded the Conference sharing his perspectives on restructuring and insolvency.
“Zombification seems to be becoming more prevalent now,” Hawkins began. “Some of the reasons behind that is government support provided in a number of countries to help businesses survive during this time. There’s been extensive use of credit, levels of accounts receivable are down significantly. Cash is being hoarded by a lot of corporates right now. With lender forgiveness the attitude is passive now. No one wants to be aggressive towards their clients. Businesses that would have failed have also been giving a second life in some cases.”
Hawkins expects to see a change in the dynamic of collateral. While no one is changing their approach to inventory finance levels, they will not be able to avoid the increased level of receivables aging. Over the next several months extended aging reserves will be done on a case-by-case basis.
“I would stress that we are very much at the beginning of this process,” Hawkins added. “The more support that has been provided, the longer the process will take in terms of where we really are. There’s been a liberal application of lender finance programs out there. These businesses are taking extraordinary risks from merchant services to spot invoice financing, asset purchase finance, and credit lines to sub-prime lenders in relation to auto, equipment and so forth. I think that is something that is beginning to become more significant and there will be interesting headlines around that.”
SFNet would like to thank its International Lending Conference sponsors, AtlanticRMS and Gordon Brothers.
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