By Jeff Zilka, Josh Hochberg and Arielle Patrick
As the United States tumbles into a coronavirus-induced recession, its restructuring ecosystem faces unprecedented challenges.
After only five weeks of sheltering-in-place, more than 26 million workers have sought jobless benefits, and unemployment could exceed 20% by month’s end. Fearing a deep recession, companies have massively drawn down their bank credit lines and bulked up their cash balances to weather the storm.
The damage is industry-agnostic, touching the energy, lodging, gaming, and retail sectors. With benchmark West Texas crude futures trading in negative territory and social distancing mandated in most of the country, energy companies Whiting Petroleum and Hornbeck Offshore Services and retailers Pier1 and Modell’s Sporting Goods have already sought federal bankruptcy protection, and many more companies are likely to follow suit.
As companies and their legal and financial advisors prepare for stormy times, Edelman sees these key restructuring trends and communications considerations:
- Banks’ Balance Sheets Are in Better Shape. Following the Great Recession, a raft of “amends and extends” enabled many companies to avoid fundamentally restructuring their troubled credits. Many bank lenders, themselves thinly capitalized, sought to avoid recognizing nonperforming loans and instead took loan renegotiation fees and higher interest rates at a time when they made few new loans because of the depressed economy.
Today’s environment differs. While the depth of this recession is more severe, many bank lenders are better able to withstand the pain of NPLs. Bank balance sheets are stronger, with the six largest U.S. banks alone adding nearly $25 billion to their reserves during the first quarter in anticipation of a wave of bankruptcies.
- New Sources of Capital are Available. Private equity – with over $1.5 trillion in cash ready to deploy – is actively seeking deals in the struggling travel, entertainment, and energy industries. While PE sponsors must make key portfolio company decisions and their need to shed undeforming assets may accelerate, they are already deploying capital. Oaktree, General Atlantic and Fortress are reportedly forming new distressed funds totaling more than $20 billion; and the increase in private investments in public companies (PIPEs) through April 13 exceeded $4.3 billion, the most for the start of a year since 2008.
Moreover the federal government again is acting as a direct lender, notably with $25 billion in grants to the airline industry. Thirty percent of the grants must be repaid and also include stock warrants worth 10% of loan amounts exceeding $100 million.
- Companies Possess More Levers at Their Disposal. Many companies drew down credit lines in February and early March, increasing cash as the depth of the looming COVID-19 recession emerged. With the prevalence of covenant- and document- lite loans, ratings agencies warn that companies have unprecedented flexibility in how they behave in paying back their loans.
Moreover, some lenders, counting on a fast recovery from the nation’s coronavirus shutdown and seeking to avoid recognizing bad loans, are abetting distressed borrowers by liberalizing the terms of their revolving credit facilities. These factors suggest companies with stretched balance sheets may enjoy greater ability to ride out a short recession without tripping a covenant and needing to restructure.
- COVID-19 Will Foster New Restructuring Mechanisms. One early development: Companies are delaying their Chapter 11 bankruptcy proceedings for 30-60 days to take actions that enable them to better compete against peers not under court protection. Restaurant company CraftWorks Holdings and retailers Modell’s Sporting Goods and Pier1 Import employed this strategy, striving to “re-operationalize” a subset of their most profitable locations or operate only their online operations. If executed successfully, these strategies can keep vendors and landlords at bay. It is unclear, though, how far bankruptcy courts will go to approve this strategy. Still, it is a development to watch.
Nuts-and-bolts aspects of restructurings may also be under strain. Bankers have pointed to the difficulty of closing transactions when travel is reduced or when it is impossible to complete site visits and physically verify inventories, always critical to closing asset-backed facilities. And recent difficulties in completing debtor-in-possession, or DIP, loans for credits including Sanchez Energy, CraftWorks Holdings Inc., VIP Cinema Holdings Inc. and LSC Communications could constrain this source of in-bankruptcy liquidity – traditionally seen as lower risk – just when beleaguered credits need it most.
- Changing Asset Values Will Impact How to Restructure Workouts. Dramatically changed asset values will complicate transactions. For example, what is the value of Class A office space when teleconferencing shows that employees can work remotely without impacting business performance? What is the collateral value of a portfolio of consumer loans when unemployment nears 20%, or of a machine for an asset-backed loan if its condition cannot be physically inspected?
- Smart Companies Will Safeguard Their Most Enduring Asset: Their People. Edelman’s Special Report: Trust and the Coronavirus conducted in early March showed that workers trust their employers most as sources of information. The study noted employees rate their employers as the most trusted source of COVID-19 information, consider them better prepared to deal with the handling of the coronavirus than governments, and trust them to respond effectively and responsibly to the pandemic. Employers must not squander this irreplaceable asset and should be forthcoming and candid with their teams. Employees will remember and be grateful later.
- Transparency Is Especially Important for Companies Accepting Government Money. Reflecting popular sentiment that Wall Street‘s Great Recession bailout was accomplished at the expense of Main Street, expect fierce scrutiny of companies that receive government loans and other supports. Shake Shack and Ruth’s Chris Steak House for example, quickly returned their Paycheck Protection Program loans when public outcry erupted against public companies, having access to other liquidity sources, that accessed the first tranche of this program when many smaller, private companies were shut out.
The staggering reality is the federal government doled out trillions of dollars at lightning speed. It is likely that mistakes were made. When the dust clears, we expect investigations, hearings and inquiries to follow. Transparency as to a company’s rationale and motivations will be key to navigating these hurdles.
- The Specter of Systemic Bankruptcies Is Real. All participants in the restructuring ecosystem will examine their options amidst the potential of systemic bankruptcies. Harvard Economist Larry Summers views the possibility of systemic bankruptcy as more than a theoretical threat. He notes that economic time has stopped because of the pandemic, but the nation’s financial clock, comprising the sum of individuals’ and companies’ interlocked financial obligations, is still ticking. Retailer bankruptcies, for example, will ripple through to owners of regional malls, textile and apparel firms, and even local providers of cleaning supplies, while consumers huddle at home.
Nobel laureate economist Joseph Stiglitz anticipates that if government aid fails to stem the tide, the fallback should be what he calls “super Chapter 11.” It would resolve the problems of many companies at once under the auspices of a government-appointed supervisor. It also would be fast, tend to keep management in place and give more consideration to workers and less to creditors than in conventional bankruptcies.
Because these are deeply uncertain times, restructurings will receive greater public and media attention. Although, as one noted restructuring banker put it, “Nobody wants to be blamed for putting a company in bankruptcy,” restructurings will take place.
For that reason, management teams and their advisors must create a constructive restructuring narrative able to withstand intense public attention. Developing a robust, thoughtful, and integrated communications strategy for all audiences — creditors, investors, employees, consumers, regulators, local communities, even competitors – is equally important, components of which may include:
- Gaining support from regulators and local government officials ahead of a filing. On announcement, companies can leverage these relationships to assuage concerns of employees, customers and other audiences through social and traditional media.
- Focusing on employee, supplier and customer retention throughout the restructuring process. This could include public disclosures before a decision is reached regarding how to recapitalize a company’s balance sheet. Increasingly, companies are announcing they are exploring a range of strategic alternatives, well ahead of the actual filing or transaction. Such announcements give management teams sufficient time to educate these audiences about COVID-19’s financial impact and industry headwinds, minimizing the shock when a decision is announced.
- Recognizing the frightening response to the “B-word.” Bankruptcy is often equated with “liquidation,” “close of business,” or Chapter 7 by non-financial audiences. Use the word “bankruptcy” sparingly, and spend ample time educating stakeholders on the meaning of critical words like: “restructuring,” “recapitalization,” “reorganization,” “interim liquidity,” and “emergence,” “turnaround,” “revitalization,” and “transformation.”
Jeff Zilka, Josh Hochberg and Arielle Patrick are senior executives of the U.S. Financial Communications and Capital Markets practice of Edelman, the world’s largest communications firm. Visit Edelman Restructuring & Bankruptcy Communications.
John Jannarone, Editor-in-Chief