According to the UK’s Insolvency Service, there were a total of 2,974 company insolvencies in Q2 2020, which was 23 percent lower than Q1 2020 and 33 percent lower than Q2 2019. Of those insolvencies, in the past quarter, 386 were administrations and 47 were company voluntary arrangements, respectively down 10 percent and 49 percent in comparison with the same period in 2019.
This is, in part at least, evidence of the strength of the government’s financial response to the covid-19 pandemic. The various financing support schemes have provided liquidity to many businesses. Tax payments have been deferred. Measures have been taken to reassure directors who are concerned about liability for ‘wrongful trading’ under the Insolvency Act, to help avoid precipitative action. Landlords have been prevented from taking action against their tenants in respect of unpaid rent. The Coronavirus Job Retention Scheme has helped to preserve jobs.
However, the Office for National Statistics has confirmed that GDP fell by more than 20 percent in Q2 2020. Further, the window for loans under the government’s Coronavirus Business Interruption Loan Scheme, for example, is due to close at the end of September and the chancellor has taken steps to wind-down the ‘furlough’ scheme in the coming months. Critically, protection against landlord action is also due to come to an end at the end of September, with no solution to the issue that many businesses, particularly those in the retail and leisure sectors, will have generated comparatively little income for more than a quarter, while rental liabilities have generally continued to accrue at the same rate as before.
A solution that plugs the gap
Many businesses have to face that gap between income and costs somehow and, notwithstanding the statistics, one route being seen more frequently in the market of late is the CVA. The processes recently undergone by Travelodge, The Restaurant Group, All Saints, Poundstretcher and Buzz Bingo, and those reportedly planned for New Look and Pizza Express, would all indicate that this remains an important tool in the restructuring kit.
They also show the flexibility of the CVA, by allowing some to keep all their sites open but compromise that ‘income gap’ caused by lockdown, while allowing others to close their worst-performing sites, so that the remainder of their portfolio has a better prospect of success. Recent CVAs have also given many the benefit of a switch to a more ‘turnover’ based approach to rent, to help guard against a second wave, although care has to be taken to ensure that they don’t offend ‘fairness’ requirements under the Insolvency Act. In one case, the CVA was even used to compromise obligations owed under leases of sites outside the UK. No doubt, as we see more transactions in the market, the envelope of what can be done with a CVA will continue to be pushed further.
From the perspective of a secured lender, CVAs are relatively straightforward on the basis that they cannot bind a secured creditor without their consent. Given this, for voting purposes, it is the unsecured creditors whose views on the CVA will cause it to be approved or fail. Although there are comments in the market around the possibility of a secured creditor revaluing their debt and voting the ‘unsecured’ (ie out of the money) portion in a CVA, that remains an aggressive move, which is untested in the courts as to its effect on the secured balance of the debt. Lenders have also tended to be wary of this approach for reputational reasons.
Despite the anecdotal evidence of CVAs being used more frequently, there do remain questions as to whether a CVA works in every situation. The criticism that has often been made is that the concessions required to cause creditors to approve a CVA mean it doesn’t achieve the required level of cost-cutting in order to help a business thrive beyond a few years. The more successful transactions have tended to be those where a CVA is combined with other restructuring measures, such as the provision of additional equity capital and a debt-for-equity swap.
In any event, a CVA is an expensive and time-consuming process and, as has been seen recently in the cases of the Casual Dining Group and Azzuri Group, where there isn’t sufficient time and resources, then the only alternative is often administration. A sale out of administration is detrimental to value, for obvious reasons, and no less complex than a CVA due to the level of stakeholder involvement that is often required.
Secured lenders are often asked to “roll-over” their debt into a newco structure by a purchaser, which is more straightforward for a fund lender but which can risk falling foul of the policies of bank lenders against “phoenix” arrangements if not managed carefully. Landlords will usually also be required to give their consent to the assignment of their leases to a buyer vehicle, so a lender agreeing to roll will as a minimum want to understand the likely shape of a business once the lease re-negotiation between landlord and tenant as part of the assignment process has been concluded.
Financial pressures increasing
Looking beyond the end of September, as the various government support measures are currently projected to come to an end, the financial pressures on businesses will become more acute. Not only will the reduction in outgoings via furlough and non-payment of rent be less available, those businesses which are re-opening now will have spent a portion of their remaining financial resources in doing so.
They will by then also have a more realistic understanding of their likely income going forward. Those that haven’t taken measures to deal with accrued liabilities will need to face up to those challenges in the very near future. Those whose income in the current climate isn’t sufficient to meet expenses, potentially including interest payments to lenders, will have even more fundamental balance sheet issues to deal with. Many may have to deal with both and lenders will of course be looking very closely at their loan books for signs of trouble, particularly in the sectors that have been hardest hit.
However, lenders should not only be concerned about operating businesses in sectors such as retail and leisure. Every CVA and administration of a tenant has an effect on the landlord. The cumulative effect of tenant insolvencies has already been felt by intu, for example. The expectation is that many more landlords will suffer financial hardship in a second wave of distress within the economy and real estate lenders will therefore need to be wary too.
The timing for all these issues coming to a head will obviously vary significantly from one borrower to the next. It seems likely, however, that we will see many more CVAs and other restructuring processes in Q4 2020 and the first half of next year, unless government initiatives are extended. To finish on a quote from Mark Twain: “The lack of money is the root of all evil.”
Jatinder Bains is a partner in the London office of law firm Macfarlanes