We are experiencing a quiet restructuring market and relatively high corporate survival rates at a time when historical trends would suggest a period of increasing insolvency activity. Historically there has been an uptick in the number of corporate insolvencies when exiting recession (largely driven by growth funding needs, over-trading and high interest rates) whereas we are currently seeing a less pronounced impact (figure 1) – principally by virtue of interest rates being kept at historical lows (since March 2009) and a push by the UK government for banks to lend to SMEs in order to stimulate growth.
Figure 1: UK insolvencies, GDP and interest rates
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This is perhaps an appropriate time to take stock - I consider below a number of the key market characteristics that we have seen in recent years, combined with current trends in the broader economy and financial markets and, importantly, what this may mean for the shape of the restructuring market in the coming years.
RESTRUCTURING OF THE FINANCIAL SERVICES SECTOR ITSELF
Issues within the financial sector sat clearly at the heart of the global financial crisis which has led many commentators to badge it a ‘different kind of recession’ to those seen before. The most recent recession, driven by optimistic lending combined with intertwined investment structures and derivative instruments traded across financial institutions, has fundamentally changed the face of the banking sector as we know it. The level of systemic risk in existence at the time of the global financial crisis is now considered unpalatable for the regulators and this is likely to impact on the shape of financial markets and, as a result, the restructuring industry, going forward.
We have seen: the failure of two large US investment banks; a bail out of the world’s largest insurer; the government rescue of two UK clearing banks; the deployment of quantitative easing; and a wholesale bank deleveraging programme across the UK of unprecedented proportions. The Asset Quality Review (‘AQR’) process across Europe is now fully underway and will undoubtedly drive increased activity in the financial sector. Whether we will see the failure of further financial institutions remains to be seen and will largely be driven by the extent to which local governments are minded to take a harder line as advocated by the European Central Bank as opposed to potentially opting for softer landings by way of ‘bad bank’ structures or consolidation. At the very least, we are likely to see portfolio sales to deleverage, fundraising to help shore up stressed balance sheets and some large single ticket restructuring work. The UK should be largely insulated from any pan-European fallout by virtue of the fact that we sit outside the Euro and have already taken steps to strengthen the UK banking sector, albeit we will watch with interest at developments on the continent.
AN EVOLVING CLIENT BASE
Prior to the global financial crisis the UK restructuring market was dominated by the main clearing banks as the lenders to most mainstream UK corporates. This is changing by virtue of three important factors:
- The deleveraging exercise referred to above (ultimately driven by increased bank regulation);
- The emergence of the alternative capital providers (both distressed players and alternative par lenders seeking to fill a funding gap for British corporates). Ultimately, there is an increasing level of liquidity in the market which has facilitated ease of exit for a traditional clearing bank in the event that they sense a distressed borrower – the market to trade out of a position is now a lot more advanced than it was previously and the decision as to whether to sell out or back a turnaround is coming at a much earlier stage; and
- The ability of the borrower to refinance through less traditional channels is increasing all the time (the high yield bond market on bigger ticket deals, the re-emergence of CLO activity in the upper mid-market down to smaller mid-market debt funds and even peer to peer lending in the SME space).
The clearing banks are increasingly conscious of their PR and (rightfully) wish to treat customers fairly and avoid precipitive insolvency action where possible. This plays to a trend of considering an early exit through a debt sale where possible – it is ultimately a brave credit sanctioner who supports the backing of a difficult five year turnaround as opposed to pursuing an exit of their position at a reasonable level (to a credible purchaser with good intentions and capital to invest in the business) which is increasingly possible in the current market given existing levels of liquidity and demand for assets – the relatively high cost of capital for banks in respect of distressed assets will also be a consideration here. The sell/hold decision is now featuring much earlier in a lender’s options analysis – often on entry to their work-out team (and a sale is potentially more likely in situations whereby a particular lender is unable to influence the ultimate outcome).
From an origination perspective, whilst we are seeing an increased issuance of high yield bonds in the bigger ticket space, the traditional lenders are likely to continue to hold prominence in the more traditional mid-market given their existing origination channels (albeit this is a clear area of emerging focus for private debt funds).
An interesting dynamic on the Big Ticket side will come when any of the recent European High Yield Bond deals start to falter. The structural issues around those are noteworthy and widely commented upon (generally governed by US documents but with their own local jurisdictional restructuring and insolvency regimes at times of distress i.e. potentially conflicting legal jurisdictions). Failure in this space in relation to recent high yield bond transactions is, as yet, largely untested but the complexities involved could lead to substantial restructuring work.
The impact of all of this on the restructuring market is that it has widened our potential client base previously dominated by the traditional clearing banks and corporates to include increasing numbers of alternative investors. The traditional clearing banks will continue to be important providers of capital and transactional capabilities and, as such, restructuring opportunities. However, work flow will be less concentrated than it has been historically, which is likely to be encouraged by the regulators who will be keen to keep some higher risk lending away from the providers of day-to-day clearing facilities (thus seeking to mitigate the systemic risk we saw at the height of the global financial crisis).
THE RETURN OF THE INSOLVENCY PRACTITIONER
If you cast your mind back six years to the pre-crisis period where liquidity was abundant and it was considered that stressed/distressed situations would simply be refinanced as opposed to restructured, the prospect of large scale insolvencies was scarce and, as a result, the role of the Insolvency Practitioner somewhat unfashionable.
Then came Lehman, which is clearly a key broader reference point in the Global Financial Crisis, but also, through the crisis we have had the insolvencies of MF Global, The Structured Investment Vehicles, hmv, Nortel, Woolworths and Blockbuster to name but a few.
Nowadays, insolvency is slightly more ‘in vogue’ than pre crisis and a particular driver of this is the approach of the alternative and distressed investor community who:
- Perhaps place greater emphasis on the input of an Insolvency Practitioner when considering exit strategies prior to entering a deal (be it a portfolio or single ticket transaction) – ultimately to understand fall back value to assist in their pricing decisions;
- Will be less concerned at sub-par recoveries driven by insolvency sales given the discounted values at which they will have bought in; and
- Are likely to be less averse to taking enforcement action to maximise value for their own stakeholders than traditional lenders, to whom PR is of increasing importance.
It is increasingly acknowledged that, in the modern market, Insolvency Practitioners can add significant value in structuring innovative solutions using insolvency as a delivery mechanism for a transaction where a fully consensual deal is, for whatever reason, not possible/desirable from their client’s perspective – additionally, modelling likely insolvency outcomes is fundamental to understanding the fall back positions of various stakeholders which will always be a key consideration in restructuring negotiations.
Other jurisdictions across Europe are developing their restructuring and insolvency rules to try and facilitate more of a rescue culture, however, the UK remains the ‘jurisdiction of choice’ for implementing complex restructurings given the relative certainty afforded by our regime.
Given the shift in the nature of those creditors sitting at the value break in a deal and the difference in mind-set between a traditional par lender and alternative capital providers (generally more driven by a desire to maximise short term return), combined with an inevitable interest rate rise (now looking increasingly likely for late 2014), the potential for an increase in insolvency activity is clear.
It used to be taken as a given that a bank’s security would be of a relatively standard nature and all worked correctly – in recent times this has been subject to greater and greater challenge and in instances where things have not worked as they should, this has fundamentally changed the restructuring dynamic. The last few years has seen a growing number of cases brought to court challenging financial structures and their related documentation prepared in the heat of the pre-financial global crisis era. This has resulted in various clarifications on insolvency law - the terms agreed between competing secured creditors, the rights of high street landlords under the insolvency priority waterfall, the determination of when a company is ‘insolvent’ and the validity of the appointment of the insolvency practitioner. Weaknesses in documentation and structures provide leverage.
These recent cases have shown that stakeholders in the market today have been willing to challenge the traditional senior creditor friendly protections that the UK insolvency laws provide. So whilst it is difficult to see where legal innovation in the restructuring space will go next, it would not be surprising to see a further push on the introduction of a more chapter 11 type restructuring process across Europe. This is already seen in the more prevalent use of schemes of arrangement across Europe and the push to widen the use of CVAs.
In any event, the increasing involvement of alternative capital providers in the restructuring market is likely to continue to encourage the use of innovative legal structuring to drive value.
We are experiencing a period of change in the world economy and the financial sector. Whilst it is difficult to be specific on how this will drive the restructuring market over the next couple of years, I set out below a few predictions on what we may see:
- A significant focus on Europe driven by the AQR. This is inevitable given the current stress testing work. To fully capture this opportunity, it will be key that practitioners have experienced teams focussed on portfolio and single asset positions with broad cross firm expertise on a pan-European basis.
- A continued shift in the structure of funding for mainstream UK businesses. In the UK, traditional clearing banks still provide much of the finance in the market, whereas the US has seen a shift since the last banking crisis such that clearing banks now provide only c.20% of finance (the balancing 80% being private debt providers – Figure 2) – many commentators feel that we will move closer to such a model and we are already starting to see evidence of the increasing involvement of the Alternative Lender community across Europe (Figure 3). Increased regulatory pressure driving up banks’ cost of capital and low interest rates will be the key drivers and with the market currently awash with alternative liquidity, borrowers are pushing harder on leverage and other traditional lender controls making the more flexible private debt fund alternatives more appealing to them (albeit private debt funds have no track record of supporting businesses through the cycle, which will be an understandable concern for some borrowers).
- Teaming of traditional clearing banks and private debt funds. The traditional clearers will remain a key source of capital, however, as noted, ongoing regulatory pressure is likely to broaden the playing field. Whilst traditional banks and alternative lenders are competitors in one sense, given the clearing banks’ origination channels and transactional/clearing capabilities, they are likely to be key allies for the alternative lender community and some form of teaming/alliance relationships as the market develops is a clear possibility.
Figure 2: Evolution of the US leveraged debt market
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Figure 3: Alternative lenders - deals completed
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- An increase in insolvency and restructuring activity in the mid-term. With interest rates now clearly signalled to rise by the end of the year from an historic low of 0.5% (since March 2009), an increase in restructuring and insolvency work over the mid-term would be logical. Additionally, we cannot forget that whilst the economy is growing, consumers have been buying more on credit and have had an enormous windfall from mis-selling claims (£14.7 billion has been paid to consumers in PPI compensation since January 2011, which is enough to finance half of the increase in consumer spending over that period). As such, there is an obvious question as to whether we are seeking ‘real’ growth in the economy or simply opportunistic purchases on the back of unrealistically low interest rates and indirect bank funding in the form of PPI compensation – that being said, we are seeing a fall in unemployment, decreasing inflation and real growth in wage rates, which are all positive signs. Ultimately the extent to which a rate rises translate to restructuring or insolvency work will be driven by available liquidity in the market, however the increasingly borrower-friendly nature of funding packages we are seeing (covenant lite, leverage multiples increasing, equity contributions decreasing etc) indicates that this round of refinancing may again be storing problems up for the future– albeit this time around shared between a broader set of stakeholders – more institutional investors and less bank concentrated.
- The increase of a company led restructuring and insolvency model. Whether or not we adopt a wholesale shift to more of a chapter 11 approach or not remains to be seen, however, I envisage more company control on the driving of any insolvency action going forward. At the smaller end this will be driven by the PR concerns of traditional lenders and in the bigger ticket space the structural considerations around the current high yield bond issuances (mainly the absence of traditional early warning covenant structures that may hinder a lender’s ability to undertake effective contingency planning) means that the major creditors may not know that of a distress position until the point of payment default, which will either result in a missed opportunity to appropriately restructure a business pre insolvency or provide the corporate with clear leverage in restructuring discussions.
Whether all of these observations represent permanent winds of change or just temporary gusts in alternative directions is difficult to say, but it is clear that we are at a time of change in the restructuring market.