The covid-19 crisis thrust an extraordinary number of companies and industries into survival mode in 2020 before an equally unexpected level of government intervention entered the global economy.
The resulting market volatility led debt funds and distressed debt investors to adopt a ‘wait-and-see’ approach in the face of the unknown impact of the pandemic and in the absence of accurate financial reporting. The window for secondaries investment was no sooner open than it was closed as true opportunity waned. Government support resulted in inflated prices, with hedge funds not engaging as usual in the special-situations market to contrast the longer positions taken by central banks.
As vaccine distribution continues, government stimulus begins to wind down and the world enters a new normal, we may see a return to special-situations financing throughout 2021 to address the lingering effects of the pandemic.
Debt funds and distressed debt investors finished 2020 with substantial dry powder in a market that favours the flexibility, transparency and ease of execution of private credit. Yet whether 2021 proves to be a year of opportunity for distressed investors remains to be seen.
2021: a year of opportunity?
Certain themes look set to endure. Covid-19 led private equity sponsors and portfolio companies to apply various approaches to address the uncertainty on reported financial results, such as focusing on future earnings as opposed to actual reported results.
Private equity firms are likely to continue this trend in the near term while the precise nature of the recovery remains unclear. Future earnings, however, are also uncertain, which means there will be continued uncertainty about what the new normal will look like.
While the traditional banks grapple with regulatory oversight, distressed debt investors are looking to take advantage of undervalued and opportunistic positions.
“While the traditional banks grapple with regulatory oversight, distressed debt investors are looking to take advantage of undervalued and opportunistic positions”
As national and supranational government support is withdrawn, a corresponding increase in the number of bankruptcy or insolvency proceedings can be expected. This is especially likely in the mid-market space, where companies have fewer resources available to endure long-term economic difficulty and reduced access to financing from traditional lenders.
Businesses that have been severely affected by covid – such as those in the retail, automotive, entertainment and real estate sectors, whether directly or through their supply chains – will struggle to access liquidity and may have to compromise on higher pricing.
US commercial real estate and hospitals are likely to be hot markets in the coming year for distressed investors. As forbearances expire and traditional lenders run out of patience or are no longer able to continue extending credit, well-positioned distressed investors may find numerous opportunities to fill the financing gap, particularly given the ‘back-end leverage’ available to those funds to further increase investment size.
This may be one of many areas in which technology disrupts more traditional operating methods and significant growth is predicted.
Fundraising for US and European players was reduced in 2020. This year began with significant optimism, with expected growth in fundraising efforts to take advantage of opportunities to acquire companies that are still struggling from the effects of the pandemic. In turn, distressed investors may have an increased role as deals are sought with creditors willing to fund these acquisitions. Interests are aligned across a greater number of stakeholders, as funds seek additional investment and investors seek yield.
In the post-pandemic world, equity and debt holders need to understand their risks and returns and obtain reliable estimates to fulfil their regulatory responsibilities. Valuations will receive increased attention but, for illiquid
assets, they will be affected by the volatility in global equities and government debt yields.
Investors and intermediaries are still navigating valuation issues. What is certain is that these will require more subjective judgment than in the recent past and the use of historical data may no longer accurately predict future earnings.
Will special-situations financing increase in 2021? If traditional lenders continue to tighten their requirements for extending credit, particularly with working capital requests, stressed and distressed companies will need to explore new sources of financing, including balance sheet restructurings, debt-to-equity conversions, non-core asset divestitures and additional equity raises.
Where cashflows are hit and valuations are challenging, as is the case today, distressed debt and special-situations investors are well positioned to provide immediate support and liquidity. They can do so at a yield reflecting a risk level that traditional banks may not be willing to take, even with the potential for equity upside, by buying distressed debt of companies that need additional financing as a way to get into the market based on existing documents and leading to a debt-for-equity swap in a restructuring proceeding.
Moreover, in the private debt markets, investors may be able to purchase the debt at a discount if the existing lender group is not interested in providing the additional financing or in holding a distressed asset on its books due to regulatory constraints, or in holding too many non-performing or stressed assets.
The level of competition in this space demands fast action. Speed of execution is therefore key, notwithstanding the informational asymmetry, along with a willingness to adopt cross-border structures to reduce the time needed to implement and execute an investment strategy.
Well-standing reputations and legal systems, particularly for bankruptcy and insolvency proceedings, make the US and UK ideal jurisdictions for debt fund and special-situations investors.
The US statutory and common law framework includes a court-based approach that provides certainty for debtors and creditors through the automatic stay, rules for asset sales (including plan confirmation requirements) and easy access to cross-border restructuring regimes through chapter 15 of the US Bankruptcy Code (where available).
The English statutory framework has recently been bolstered, particularly through the introduction of a new restructuring tool brought in under the Corporate Insolvency and Governance Act 2020, known as the Restructuring Plan, which includes provisions derived from the US plan of reorganisation under chapter 11 of the US Bankruptcy Code.
The desire of international courts to protect the ‘going concern’ value of companies has been highly facilitative to international special-situations investing.
We have therefore seen, and expect to continue to see, significant cross-border restructurings increasingly including the use of special-situations investing or aspects of it. As advisors, it has become progressively clear that cross-border integration is required to mirror the business structures of stakeholders.
Over the coming year, and in the years that follow, a heightened level of these types of transactions is likely to remain.
Aymen Mahmoud and Felicia Gerber Perlman are partners, based in London and Chicago respectively, at law firm McDermott Will & Emery. Giulia Venanzoni, Max Brady, Riley Orloff and Alexander Andronikou also contributed to this article