The delayed distress cycle

Macroeconomic developments seem to have taken a more positive slant, but the need to refinance will expose weaker credits in the end.

With gas prices beginning to fall towards the end of last year and what seemed a certain recession now open to doubt in the early months of 2023, distressed investors might have a feeling of déjà vu. It wouldn’t be the first time that a severe downturn has come into view only to remain tantalisingly out of reach. The covid pandemic would be history’s most recent example of a near miss for the distressed market.

But while the macroeconomic picture has taken something of a turn for the better, market sources tell us that patient distressed investors will eventually get their reward. While many companies are able to continue growing and not see any significant hit to their bottom lines, no one can fail to notice that inflation and rising interest rates are proving to be “sticky” – a ‘higher for longer’ environment is what we appear to be heading into.

There are some businesses with the ability to power through a high-inflation/higher base-rate environment with strong sales growth, while others are taking the opportunity to “amend and extend” – what cynics might see as a can-kicking exercise. But for the remainder, with an uncomfortable mix of low ratings and high leverage, let’s just say the future looks interesting. As an example, if you levered yourself to the maximum on interest rates between zero and 1 percent with the intention of refinancing around 2025 – but with the terminal base rate now close to 4 percent in Europe and 5 percent in the US – don’t necessarily expect healthy cashflows.

As a result of this stress in the system, the view of many observers is that the distressed cycle is delayed but not cancelled. The likely nature of it has also changed, given that the original expectation was of a cycle driven by recession and lower earnings. It is now shaped around the challenge of refinancing and the expectation that not all sponsors will gladly stump up more cash to keep firms afloat.

While putting a timeframe on the so-called “refinancing wall” is not straightforward in the private markets, where there’s less visibility, some are saying 2025/26 is crunch time for the liquid markets. So, while the next year or two may be more benign than many thought possible, don’t assume the distressed cycle has once more been dodged.

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