Guest comment by David Conrod
Two years into the covid-19 pandemic, central banks are acting behind the curve. With headline inflation in the US reaching 7 percent and global consumer price inflation rising 5.2 percent year-on-year in December, the highest 12-month increase since 1982, inflation has proven not to be transitory.
Historically high inflation, combined with a 5.7 percent jump in average hourly earnings last year, has put the Federal Reserve in the position of playing catch-up. Central banks are starting to come to terms with the loose monetary and fiscal policies that were passed to combat inflation and other unintended near-term impacts of lockdowns and widespread disruption. Across the globe, inflation rates are at their highest levels in decades and negative GDP growth is also appearing.
Against this background, some of the recent reactions by policymakers have been surprisingly tone deaf. The governor of the Bank of England even suggested extreme measures such as telling workers not to ask for higher wages to prevent inflation from becoming entrenched. The Fed has indicated it will not only begin raising rates and tapering asset purchases in mid-March, but also pursue a balance sheet reduction. In total, rates are expected to increase seven times this year.
The prolonged impact of the global covid-19 pandemic, coupled with supply-chain shocks, inflationary pressures and tapering of Fed policies, has increased the opportunity set for agile distressed investors who are willing to come in as a “white knight” and provide stability to companies in these uncertain times.
Companies that were already too highly levered pre-covid were encouraged to take on additional debt to cover losses and benefit from free government stimulus. These companies benefitted greatly from payment deferrals and covenant waivers that saved them from default scenarios.
These factors drove total 2021 leveraged debt issuance to a record high with the annual tally topping $1 trillion for the first time ever. These actions effectively kicked the can down the road, and it is becoming evident that the burden of servicing these higher debt levels under increasing capital costs and margin pressures will force companies to renegotiate waivers or be forced into restructurings. These workouts provide distressed managers unique entry points.
The addressable market for distressed opportunities was $7.1 trillion across the US and Europe as of the end of 2021, almost 3.7x 2007 levels. The concentration of loans rated B- and below (the riskiest section of the credit rating spectrum) as a portion of US leveraged loans increased from 22.1 percent at the end of 2008 to 30.6 percent (1.4x) in Q3 2021. Within the same timeline, global debt in advanced economies increased from 70 percent of GDP in 2007, to 124 percent of GDP in 2020. With the increased debt load, any economic shock would render many governments semi-insolvent and unable to bail out lenders, corporations, and households. Governments around the world have already terminated most support programmes.
More defaults coming
The earnings destruction and heightened economic uncertainty precipitated by the covid-19 pandemic and subsequent accommodating economic policies by central governments is likely to trigger defaults and restructurings in sectors where high debt and operational challenges exist. Their financial position prevents them from being able to effectively manage price increases, diversify their supply-chain networks, and adapt their business models to changes in consumer behaviour post-covid.
The management teams of companies in these challenging situations cannot alone handle the operational and financial challenges that are diminishing their strategic viability. In these circumstances, experienced value-add distressed debt investors that are prepared to act as a “white knight” and partner with these companies to provide creative, well-structured financing solutions, offer balance sheet stability, and support operational and technology transformations are expected to generate extraordinary returns.
Challenging conditions are already starting to take hold in certain sectors as they confront these inflationary pressures and rising interest rates. For example, fintech companies that are under pressure from investors to keep growing are lowering underwriting standards, leading to deterioration of overall credit quality in favour of increasing the size of their loan portfolios. As inflation and rising rates begin to affect the borrowers’ ability to repay, defaults and write-offs can be expected to become more frequent, squeezing the financial margins for fintech lenders from both ends.
Companies within the consumer discretionary industry that didn’t mitigate their supply-chain disruption have found themselves in a position of dealing with surging commodity, logistics and labour costs along with the most severe inventory shortages in 25 years. Ralph Lauren said it expects cost inflation in the “mid- to high-single-digit percentage” range. Similarly, cotton prices are up another 12 percent year to date, and are at the highest levels since 2011. These forces are expected to keep consumer businesses in the top three most-distressed sectors in 2022 for the 12th year in a row. Similarly, industrials and manufacturing companies aren’t equipped to deal with increased input prices such as steel and plastic resins costs, higher factory wages and the semiconductor chip shortage.
The stress placed upon the healthcare industry by the recurring waves of covid-19 variants has brought it to its breaking point worldwide. Elective surgeries were delayed as healthcare systems were forced to attribute every available bed to treatment of covid cases, deeply cutting into providers’ revenue streams. Burnout for healthcare workers is forcing hospitals to bring on more frontline workers and incur additional staff replacement costs. These staff shortages also lead to cutbacks on beds that can be serviced, thus further straining the system.
Defaults in the current environment are starting to show in certain sectors but can domino into a broader distressed cycle as inflation, increases in interest rates and supply-chain disruptions take effect. The historically high relative size of the addressable market enables a multitude of opportunities for an agile distressed investor to partner with management and provide expertise to create value for stakeholders.
Such investors are differentiated in their approach, as they position themselves to initiate operational, technological and ESG transformation within the business, reinvigorate growth, and competitively position the company for a post-covid market.
David Conrod is co-founder and chief executive officer of FocusPoint, a capital raising and advisory firm, and LandC Investment, a diversified financial services platform