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In our final article on the impact of the Autumn Budget, we look at what actions private equity firms, their portfolio companies and lenders can take to protect value as the operating environment gets tougher
The Autumn Budget elicited decidedly mixed reactions from financial institutions. On the one hand, there was relief among investors that capital gains tax (CGT) did not rise by as much as expected, although the CGT on carried interest will ramp up in the coming years. On the other hand, there is concern that trading conditions will get a lot tougher for businesses and this might impair the quality of loan portfolios held by banks and other creditors and dent the value of companies owned by private equity (PE) investors.
The scale of the changes to the business outlook will have lenders and PE firms hitting the pause button until they understand the impact of the Budget on their portfolios. Companies can help by proactively reaching out to explain how they expect the Budget to impact their forecasts, free cash flow, debt servicing and investment. Sharing this information early on will place businesses on the front foot if they need to ask for a capital injection or to renegotiate credit terms in the months ahead.
One way to do so is to run a Common Platform Information process, where independently assessed information is made available to all financial stakeholders. This approach can save time, cost, minimise disruption, and build confidence to deliver consensual outcomes for all parties.
Beware debt traps
Many businesses in the UK still carry a lot of the debt taken on to tide them over the pandemic. Recently, a drop in inflation and the prospect of interest-rate cuts had given indebted firms a measure of relief, as evidenced by a fall in the rate of insolvencies for England and Wales. However, the Budget’s provision for a sharp increase in government debt is likely to keep corporate borrowing costs higher for longer. Heavier employer taxes and minimum wage increases will also squeeze the free cash flow available for investing in growth and debt service.
The challenge now is for lenders and owners to understand which companies might be at risk of funding shortfalls, breaching loan covenants or otherwise struggle to meet performance targets. We are already hearing that lending terms are being significantly tightened for businesses most affected by the Budget, such as retailers and the hospitality sector, providing opportunity for alternative capital providers to fill the void, albeit at higher rates of interest. Frank conversations now between creditors and owners, and their clients or portfolio companies, are critical, before impacted businesses run out of time and see their financing options narrow significantly.
No respite for private equity
For operating teams in private equity firms, the higher cost structures introduced by the Budget come as a blow after the painstaking work of shepherding portfolio companies through the pandemic, the energy price shock resulting from Russia’s invasion of Ukraine, and the resulting spike in inflation.
Higher operational costs, in the context of a tightening credit market, are likely to affect leverage, valuation expectations and the ability to exit investments. However, there may be some upside for PE investors, depending on the investment strategy pursued by each firm.
Growth investors, who identify promising new markets, products and companies with growth potential, will clearly be impacted by the tougher business environment, at least initially. But in the medium to longer term the growth outlook could brighten, particularly for government contractors, once the Chancellor’s planned spending increases on housing, infrastructure and social services begin to feed through.
Value investors, who look for undervalued or poorer performing companies with upside potential, are likely to find good investment opportunities in the larger pool of operationally challenged businesses post-Budget. Distressed PE funds will also be on the lookout for over-leveraged businesses that run into difficulties with their loan covenants or repayment schedules.
Don’t run out of options
To protect their interests, lenders and PE investors need a proactive engagement strategy to anticipate pain points and plan ahead. PE firms stress tested their portfolio companies under different scenarios during COVID-19 and this practice should be revived to understand what the Chancellor’s measures mean for trading projections, cash flow and investment plans.
For stressed or distressed companies, this may require discussions in respect of equity injections or forbearance around covenants or interest payments. The earlier stakeholders can engage, the sooner companies can be put on a sustainable path to recovery.
In more distressed situations, the benefits of strategically using restructuring tools such Restructuring Plans or Schemes of Arrangements should be explored, to provide relief from near term pressures and allow the business to go forward with a more sustainable capital structure. Alternatively, liability management approaches provide a platform to optimise a company’s debt profile.
Even for companies that are not experiencing financial pressures, now is a good time to improve operational efficiencies and optimise costs. Not only will this help to neutralise the impact of the Chancellor’s measures, but it might also uncover new value-creating opportunities for either organic growth or through mergers and acquisitions.
Read our Budget reflections for the Retail, Hospitality and Leisure sectors:
