Making hay while the sun shines

How to make the most of resilient capital markets and an extended runway 

Overall, the U.S. economy has performed stronger than many expected in 2023, and the Fed may be close to pulling off its elusive “soft landing,” bringing inflation under control while avoiding a recession. 

The strong economy and capital markets have been a boon to both consumers and corporates. Credit markets, even for lower-rated companies, have been resilient over the past few months and sponsors continue to get deals done. Refinancing activity, distressed exchanges, and liability management exercises have pushed out many of the normal liquidity and debt wall triggers that lower-rated credits would otherwise face. Double-dips, drop-downs, and other creative financing tools are being used with increasing frequency, buying both time and optionality.

As borrowers look to access these markets while the window is still open, they must understand the consequences of increased capital costs and take advantage of the newfound runway to implement operational changes. 

Markets are resilient…but at a cost

Although Chairman Powell’s recent comments signaled a freeze to additional rate hikes in the near term, he demonstrated the Fed’s determination to keep rates higher for longer. The strong Q3 GDP print adds further uncertainty to future rate moves and markets will continue to watch closely for signs indicating that the Fed may truly pause or instead continue increases. As the markets continue to digest the higher for longer mantra, interest rates continue to set decade-long highs with the 10-year yield crossing the 5% threshold for the first time in 16 years and lower rated credit yields reaching peaks not seen since the 2008 financial crisis. 

High Yield bond yields have sustained levels at the highest level since the 2008 financial crisis. 

Given this environment, perhaps it’s no surprise that bankruptcies are also on the rise. Through October, U.S. bankruptcies are at their highest levels since the pandemic (Figure 2) and may end the year at levels not seen since 2010. 

However, much of the increase is a result of smaller companies and those in the real estate sector, in particular, feeling the squeeze.

Larger corporates, with access to creative financing options, have tapped the markets more readily, buying themselves time and optionality outside of court.  

Bankruptcies have been increasing, but mainly for smaller companies and single asset real-estate.

Lower rated companies who are evaluating refinancing options need to be aware of the potential cost. Currently, speculative grade credits who have sizable maturities in 2024 and 2025 have an average coupon rate of 5.6%, however, the average yield for those same borrowers now averages 8.7% as markets factor in individual credit concerns and account for the recent shift in the wider interest rate environment[1]. Additionally, the average coupon on refinanced loans for similarly situated, speculative grade credits, has averaged 8.4% over the past 6 months[2].

Borrowers must be acutely aware of the fact that their actual cash interest payment may increase by 3%, or more, when considering their options, especially crucial for companies facing business and operational challenges. 

Evaluating your options; liability management will no doubt be discussed

For companies evaluating their options to tackle near term maturities, many will have discussions about various liability management transactions available based on the specific structure of their credit documents and overall creditor makeup. These transactions often provide solutions to near-term maturity walls and increase optionality given an extended liquidity runway. 

To best evaluate and execute on these options, it’s important to map out the path to operationalize the transaction and understand the long-term implications to the operations and cash flows of the business. For example, double-dips and drop-downs require an understanding of the cash flows between parents and subsidiaries and any effect on operations or shared services between them. Uptiers require a collateral analysis and a review of the borrowers ability to service new debt. Chewy releases and asset sales call for effective execution of spin-offs and carveouts, as well as an analysis of the impact on go-forward operations and the ability to service new debt.

Utilizing the options made available in borrower friendly credit documents and an open window in the credit markets to tap these transactions can buy a company time and runway. Effectively executing the transaction and planning for the post-transaction operational improvements will be key to taking advantage of this runway.

So, you’ve bought some time 

Taking additional liquidity and buying additional time are all overall positives in the short term. 

Taking full advantage of this opportunity requires concentrating on two critical realities:

1. Financial maneuvers cannot fix operational challenges. Recent examples abound of companies falling back into distress or even filing for bankruptcy after undertaking a refinancing (particularly expensive ones) or liability management exercises over the past few years.
2. Interest coverage is the name of the game. The face of leverage has changed in this new high-rate world. Previous leverage metrics are not nearly as telling as a review of interest coverage. The current cost of credit, and a company’s ability to truly service their ongoing debt costs will need to be accounted for when undertaking new financial moves. 

What should you do next?

As we outlined in our 18^th annual Turnaround and Transformation Survey, the number one challenge restructuring experts see in the year ahead is the cost and availability of capital. That reality is not going away anytime soon.

First, map out a business plan with both the financial and operational overlays, with a true liquidity and working capital forecast. One place where many fall short is being realistic about operational realities. Lay out different scenarios and understand how revenues and cash flows will be impacted. 

Doing so will give you a better sense of the future and avoid unexpected surprises. Staying informed and being adaptable and open to new opportunities can help you pivot when necessary.

Second, understand how bottom lines will be affected by increased capital costs. Game plan for operational maneuvers to minimize these impacts. A decade of cheap credit may have lulled many management teams to ignore the significant cost of covering their debt and resulting decrease of cash to invest elsewhere.

Remember that building a financial buffer takes time and discipline. Even if your growth expectations don't meet your initial targets, having a financial buffer in place will provide you with a safety net and financial security. More tactically, identify non-productive assets to shed,  analyze and determine your highest (and lowest) ROI investment opportunities, and prepare a zero-based budget to pinpoint the key areas requiring management and employee focus. Identifying these areas, sticking to your investment strategy, executing the company's strategy, and effective communication with employees and investors will help  companies prepare themselves for life in a higher rate world. 

Gaining additional time is just the first step in fixing a company that is struggling. Take advantage of this opportunity: Mapping out a realistic go-forward business plan and applying operational effectiveness to financial maneuvers is the only way to ensure long-term success. 

[1] Source – Bloomberg - US speculative grade credits rated CC- to BB+ with loans greater than $250mm maturing in 2024 and 2025

[2] Source – Bloomberg - US speculative grade credits rated CC- to BB+ with loans greater than $250mm who have refinanced since April 2023