THE GATHERING STORM
The UK has not encountered an economic recession since the early 1990’s. This has been a period of sustained economic growth that is unprecedented in living memory.
Have we reached an economic Nirvana? Or are we just living through an unusual period? An artificially induced extension of economic summer purchased at the expense of harsh winter to come?
Perhaps the recent economic summer has simply desensitised people to the signs that a correction is likely to happen or have we moved into a new paradigm in which recessions have been eliminated by bringing the business cycle under control?
Continuous growth (the UK will shortly have reported 60 consecutive quarters of GDP growth) removes from the economic equation an important element of climatic complexity and uncertainty. The cyclical economic weather is replaced by a climate of seemingly endless summer punctuated only by the occasional shower such as the dot.com collapse.
During 2007 there has been an increasing volume of media comment about the possibility that a down turn in the economic cycle is imminent.
Most comment tends to concentrate on the economic and financial implications and say little about the corporate managerial attributes required to deal with the turbulence that accompanies the end phase of the cycle. This management deficiency is at the heart of the storm that is gathering.
In this paper I draw together some of the most compelling economic evidence of the gathering storm, consider the managerial implications, outline actions that should be taken before the storm breaks and advocate the establishment a new kind of hybrid entity that currently does not operate in the UK financial market.
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No two economic cycles are exactly the same, but there are certain features that appear to be common during the pre-recession phase. Currently, three notable events have combined to support the conclusion that we are at or just past an important turning point.
1. The current acquisition boom is characterised by growing bid premia financed by ever higher leverage.
2. The major sell off in the bond markets has increased the US yield curve rapidly by 200bp to the point at which short dated debt has increased to be priced similarly to 30 year debt.
3. A substantial fraction of new corporate debt is comparatively covenant-lite.
Acquisition activity
A boom in acquisitions priced at a recent high in offer premia is an acknowledged end of cycle phenomena. The impetus is founded on corporate ambition rooted in good cash flows and earnings growth and is fuelled by easy borrowing.
Relatively low interest rates have encouraged investors to substitute debt for equity and, at the margin, competition to lend has forced down the price of this debt in the form of covenant dilution.
In an end of cycle world many of these acquisitions will fail to yield their intended returns and some companies will default on their debt. The volume of defaulting loans will be magnified by increasing interest rates and margins at a time of falling cash flows, lenders will become more risk averse and borrowers will find it harder and more expensive to refinance their way out of default through the debt market.
Unlike the recession of the early 1990’s private equity funds, in theory, now have available substantially greater capital liquidity. On the other hand these funds have been raised on the prospect of the continuation of the high returns experienced over the last few years. Therefore, to take advantage of the opportunities to invest as the cycle turns, they will need to adjust their established positions on risk, returns, leverage and investee company management.
Bond market
The rapid downturn in the bond market in June 2007 revealed how quickly a signal of possible change in general sentiment can stimulate a selling frenzy. This indicates how sensitive the underlying market is to any sign of negativity. Market nervousness is another end of cycle characteristic.
Even if there is a recovery in confidence and bond prices the rapidity of the fall illustrates that some investors have become less comfortable with holding debt at current yields which means that they have less confidence in the economic fundamentals at this level of corporate debt and a substantial number of others are clearly hypersensitive to a bear market signal.
Confidence in the endless summer has evaporated. Investors now expect winter and do not want to be caught wearing their summer clothes.
Fragility in the bond market is perhaps more important than ever as the high levels of debt used to complete acquisitions are typically raised initially through covenant-lite bridging finance. The objective is to refinance this borrowing through the bond market in the short term. If the bond market is not as liquid or available only at rates approaching those charged for bridging finance then some large tranches of debt are going to be left in the hands of reluctant lenders who were in the transaction for the short run only.
Edward Altman of the Stern School of Business has researched the long term trends in the level of default in the US and his findings are sobering.
For example he draws attention to Standard & Poor’s report that the proportion of high yield bonds rated B minus or below has in recent years been high at approximately 34% by value whereas in 1993 the equivalent figure was 19% and in 2001 was 14%.
What magnifies the fiscal significance of these data is that the US high yield bond market had an aggregate value in 1998 of $7bn whereas in 2006 the value had risen to $1 trillion.
Altman reveals that the default rate on this debt over the 34 year period from 1971-2005 averaged 4.2% by value. The low was 0.158% in 1981 and the high was 12.8% in 2002. In 2006 the rate was the lowest since 1981 at 0.5%.
Altman comments about why the recent high level of default of 12.8% in 2002 did not precipitate a crash. The reason he gives is that the level of recovery has grown from 25% to 65% in 2006. Hence default has been comparatively easily refinanced by a highly liquid debt market. Altman concludes that this is evidence that the credit cycle has been lengthened and not eliminated.
However the hardening debt market of 2007 will not only cause an increase in default rates probably to higher than the long term average but also render refinancing less easy to achieve.
By way of illustration; in the last significant economic downturn in 1990/91 the rate for both years exceeded 10%. At this level the magnitude of US corporate bond default would total $100bn.
San DeRosa Farag of Hill & Partners believes that the default rate during the next downturn may rise to 16/18% rivalling the levels last seen in the 1930’s.
Add to bond market default the simultaneous distress in straight bank lending and these data illustrate the potential magnitude of the storm. It is a tempest that will hit the UK just as hard.
Covenant-lite lending
Covenant-lite lending is a dangerous game. It is fine when a liquid market facilitates selling down exposure and refinancing with relative ease. It is a different matter when this liquidity is constrained and what remains is priced at unattractive levels.
This should not be an unexpected problem. In 1776 Adam Smith recognised it in the following quotation;
“Sober men, whose projects have been disproportionate to their capitals…run about everywhere to borrow money and everybody tells them they have none to lend.”
(An Inquiry into the Nature & Causes of the Wealth of Nations, Book 4, Chapter 1.)
The effect is not confined to sub prime and distressed debt but permeates the entire lending market.
Banks caught holding covenant-lite lending as the storm breaks will revert to established risk management protocols and will either sell their exposure to others or will retain the lending with the imposition of conventional covenants.
The Basle 2 accord in which the Bank of International Settlements sets out the route to international convergence of the standards of financial institution capital adequacy will have a significant bearing on the conduct of lenders faced with distressed borrowers. Lenders will need to take an early view as to whether they should take a hit on their capital in the short term by recognising a likely shortfall in value and perhaps crystallise this by selling their exposure into the secondary market or to hold the position in the appraised expectation that remedial action will alleviate the distress and return the exposure to its original risk profile and value.
There is also the added complexity that results from the way in which lenders have managed elements of their risk by packaging loan portfolios and selling them into the secondary market as CDO’s (Collateralised Debt Obligations). In some cases loans have been insured through a Credit Default Swap (CDS) which can be traded.
It may no longer be straight forward to identify who owns a loan and, therefore, with whom one should negotiate in order to deal with the consequences of default. In the case of a CDS it may in the best financial interests of the holder of the instrument for the borrower to go bust as this is the precondition that triggers full repayment.
In these situations risk appraisal based on the corporate borrower’s balance sheet will be necessary but insufficient. If lenders and investors are to be persuaded to continue their exposure they will need greater understanding of the capabilities and experience of management in the remedial task of directing businesses in the unusual climate of winter.
When might the storm break?
The answer is that no one knows for certain but the markets are signalling that the storm is gathering.
My impression is that, in the UK, the storm will not break within the next year but is likely to do so in the following 12 months and it is virtually certain that there will be a dramatic rise in corporate financial distress during the next 3 years.
The US view is illustrated in a survey by the TMA that asks its members to state when they believe that default levels will rise. The summary conclusions are;
2007 Q3 & 4 20%
2008 Q1 & 2 40%
Q3 & 4 23%
2009 + 13%
Other 4%
Historically the deterioration is not a sudden phase transition in which one day it is glorious summer and the next is the depth of winter with everyone caught wearing the wrong clothes. There is a transitional period which, unfortunately, is usually recognised most clearly in retrospect and denied contemporaneously. I believe that we have entered this phase. It is recognisable by its turbulence. Some companies report higher than expected profits while others warn of shortfalls. Some seek acquisitions while others sell. Market optimists become pessimists. The selling frenzy in the bond market in early June fits this pattern well. This is The Gathering Storm.
As a banker in the late 1980’s I witnessed similar pressure build, with increasing acquisition premia and deal leverage at fine margins with weak covenants. The leverage was not as high as today, covenants were not as light and the margins somewhat larger. When default was followed by corporate financial distress I moved to a different side of the table to lead and restructure corporations that encountered difficulties and learned an immense amount about how companies got into and out of distress and how debt instruments, that performed adequately in the summer, unexpectedly exacerbated the distress encountered in the winter.
Even though my business is not economic forecasting, monitoring the changing economic cycle is of considerable importance to my remedial management work. As a result, I have formed the conclusion, with others, that many of the conditions that preceded the recession of the early 1990’s are once again developing.
Fourteen years have passed and now, once again, we are seemingly treading the same path towards a financial correction but the market’s remedial management competency, accumulated in this previous period of turbulence, has been dissipated.
Many of the private equity deals that have underpinned the recent increase in acquisitions have been concluded by individuals who are impressive financial engineers but who have little direct experience of the events that led to and occurred during the last recession when companies descended into financial distress in large numbers and, because of their debt burden, at a pace that their management was unable to control.
Neither corporate management nor their investors and lenders want to encounter these problems but unfortunately many will do so. Only a minority will recognise the onset of the changing weather and take meaningful steps to learn from what happened previously how they can manage their current risk. Those that do so will direct businesses that emerge stronger than their competitors and produce higher than average returns in the period that follows the storm.
Investors and lenders should not take a relaxed view of the future when a recent study by Burston Marsteller revealed that in excess of 75% of CEO’s were not confident that their company had plans that were sufficiently robust to deal with most future events.
Dealing with remedial issues has, like many other functions, a learning curve and many involved but inexperienced individuals will need to move rapidly along it. But the onset of a period of distress is the wrong moment to have to reinvent the protocols and necessary techniques. It is a time to seek out experience.
Is the storm inevitable?
The Bank of England has taken the view that credit expansion needs to slow if inflationary pressure is to be moderated and their policy of gradual small increases in the base rate may have achieved this objective. But the balance is crucial. In a tax neutral environment small increases in interest rates will be no deterrent to further borrowing. Too great an increase or rates held at a high level for too long and moderation may turn to contraction.
Get it right and we may avoid a sharp recession and slow aspects of the economy for long enough to allow the components that are out of proportion to regain their sustainable balance.
But there will be unattractive side effects in the corporate arena.
The interest rate sensitivity of highly leveraged transactions (HLTs) is not unrecognised and neither is the potential for problems to be magnified by the combination of higher interest rates and below plan operational performance. Those companies that have encountered problems over recent years have benefited from the generally moderate financial climate in which refinancing has not been an insurmountable obstacle for most. This will no longer be the case.
The Gathering Storm will not only lead to more companies encountering liquidity problems as their margins diminish, their debtors slow down payments and a greater proportion of their cash flow is consumed by finance charges, but the financial climate will also be less propitious and refinancing will no longer be an easy option.
Much criticism has been directed at the private equity industry for creating an unstable situation of debt dependency but it is not their fault. They have done no more than to exploit the availability of cheap credit and buoyant share prices both of which are conditions they have not created. However they are unlikely to sponsor the refinancing of distressed companies with the same level of enthusiasm. They have skilfully diverted a large proportion of their financial risk to the banks who have, as always at this point in the credit cycle, competed for the volume market in corporate debt, recently with ever more covenant-lite loans governed by loan agreements that have never been tested in a climate of financial distress.
These banks will be the first to experience the chill wind of the gathering storm and will be left to find a solution alone. The private equity house may lose its investment but for many this will be preferable to underwriting the bank’s losses, although some will wish to participate in the heavily discounted refinancing of other people’s damaged investments.
To avoid the worst consequences of de-stabilising events steps should be taken now by lenders and investors to reappraise major exposures, to establish what should be done if a crisis emerges and to put in place a process for monitoring HLT borrowers more closely. But the key learning from the previous downturn is that most of the risk lies in the behaviour of management.
Management Behaviour
Anecdotal evidence reveals the following sequence of stages in the management behaviour in a business that encounters difficulties:
• Denial
• Concealment
• Discussion and negotiation
• Confrontation
• Collapse
Managers respond emotionally to perceptions that are either advantageous or threatening to their corporate survival. Their instinctive response to threatening events tends to be to seek out safe havens and clear vantage points and, in the confrontation stage, to respond irrationally in the panic that often accompanies the perception of being surrounded by calamity as events spiral out of their control.
These natural human behavioural responses underline why better results can often be obtained by the early installation of new management that is free of the emotional attachments and history that stimulates this behaviour.
A confident prediction of difficulties ahead is possible when concealment is no longer an option and companies need to enter into external dialogue about their financial problems. To get to this point early was the purpose of loan covenants. Covenant-lite lending serves only to extend the concealment phase.
In the pre-recession phase of the last downturn, the management teams of those companies that succumbed early, often approached their funders to provide additional finance during the latter part of the growth phase when, like now, finance remained readily available and due diligence was less exacting. This new finance, raised in the form of short term debt or a rights issue, was usually sought to resolve a temporary liquidity problem which persisted as, in a deteriorating climate, the anticipated improvements failed to emerge.
Balance sheet modification will be necessary but expensive and will no longer be sufficient as these companies will have become operationally damaged by their financial distress. Rehabilitation will require a new business model to replace that which sets its single most important objective as the servicing and repaying of debt in order to reduce borrowings.
It is insufficient to refinance a business in this way and then expect that its problems have been resolved and that the status quo ante can resume. The extent to which the operational damage that was incurred as the company ran into problems can be repaired will dictate the structure, strategy and timescale of the recovery.
De-leveraging may be necessary but if the raison d’être of a company is to be the earliest possible repayment of borrowings this would place the short term economic interests of lenders above the medium term interests of shareholders, employees, customers and suppliers. To do so will impede the attraction of new equity to the refinancing and impose a low investment, free cash flow maximising strategy that necessitates specialist short term orientated management.
The alternative is to implement a new structure determined in part by the need for less leverage but directing more attention towards the creation of greater economic value in order to offer attractive potential returns to an enlarged equity interest.
To begin this process in the initial post restructuring phase and in a changed operating climate requires both new faces in the boardroom, who are not associated with the period leading to default, and the attributes of a different style of management to that which preceded the turning point that led to default.
Management that presided over the pre default phase may regard a successful refinancing as validation of their previous activity and will implement something similar in the recovery phase. This rarely works and explains why so many initial refinancings are followed by further default.
Response of Lenders and Investors
Too many lenders and investors are reactionary and prepare inadequately for the consequences of a downturn and seem to believe that by acknowledging the possibility of a gathering storm they will invoke it. Being unprepared for the resulting cascade of problems leads to the adoption of the very crisis management investors and lenders find abhorrent in the companies to which they are exposed financially.
UK bankers do not possess the authority to remove inadequate management, they can only exert influence. However this influence is often sufficient to motivate those with the necessary authority to make management changes.
Directors sometimes feel that manoeuvring a lender into a position where it can either extend its exposure or incur a loss through insolvency is a position likely to result in new facilities. Too often they have been correct.
By withholding this liquidity related increase in exposure until the borrower adopts a more desirable management profile the lender can exert the pressure necessary to bring about meaningful management change. This is often the way in which hedge funds act.
Shareholders are often only made aware of the severity of a company’s problems when other sources of finance have been exhausted or have imposed conditions involving the introduction of new share capital.
Collectively shareholders may be in a position to make management changes but individually they are often not sufficiently close to the company to form a view which leads to change prior to the emergence of a crisis.
No change is frequently a consequence of not knowing who might replace the incumbent management team even though the shareholders may have lost confidence. In addition there is insufficient time for the conventional recruitment process to provide the necessary people; therefore, at a time when experienced remedial management is required, the inadequate but readily available is often appointed.
Most certainly these, readily available, individuals will have limited exposure to the remedial management process and the company’s difficulties may worsen during this period. Remedial management is a specialist activity and, given the long economic summer, there are very few executives in the UK who have been successful in turning around several companies in a variety of industries. The wise investor or lender will capture these people in advance of the storm breaking.
What is remedial management?
The task of management is different when a company encounters difficulty and, although the egos of many managers would dispute this, the skills that need to be applied are not those that good managers apply in stable times.
The planning time horizon shortens considerably and the corporate objectives differ in that how the company emerges from the phase of distress is as important as survival.
Unlike incumbent management, remedial management has no emotional attachment to assets, programmes and is not encumbered by a pre-existing relationship with lenders and creditors and is therefore able to approach the task dispassionately.
Although important the skills required are not only financial; a good remedial manager will also possess expertise in another function.
Remedial managers (turnaround specialists as they are often called) are the executives who are capable of instigating and directing multi functional, simultaneous change programmes. They are experienced individuals who are unconventional in the sense that they are necessarily not industry specific and are probably not the executive that you would select to lead a company in more stable times.
Remedial management is not something that can be accomplished by supplementing incumbent management with advisors as it requires the authority to act and the commitment that comes with fiduciary responsibility.
There are few remedial managers in the UK who have successfully rehabilitated several businesses and an even smaller number who have done so with large companies. The number who have the attributes and the experience of operating in the last downturn is in single figures.
What action is appropriate at this stage?
Prepare now. Those who suffered losses in the last period of significant widespread corporate financial difficulty recognised, but in retrospect, that the indicators of distress were apparent at an early stage but that they were excused, denied or concealed.
Those who failed to invest in gathering around them the resources able to manage these problems found themselves at a costly disadvantage. If you manage a portfolio my advice is to establish a small team with a brief to;
Identify those companies that are most at risk to a worsening of the economic environment and separate them into those likely to be at risk at an early stage and those that may continue through the first year inconvenienced but not disabled.
Do not confine the analysis to financial risk but also examine the management team and highlight those directed by a management team that may not be sufficiently flexible or dispassionate to address difficult issues thoroughly in the early stages when the problems tend to be concealed.
Companies dependent upon or dominated by an individual are a good starting point as these tend not to have sufficient management strength in depth to deal with a crisis. Often no one is strong enough to give the autocrat bad news.
Companies with no clear leader are another group of concern as the collegiate style often leads to equivocation as each director withdraws into the comparative security and obscurity of his management area.
Managers in many industries appear to have little respect for cyclical forces believing, seemingly, that their company will be resilient or that they can negotiate away any consequence of failure in their current policy. Pay particular attention to those managers who have not experienced a downturn and will not have developed the skill set necessary to deal effectively with an unfamiliar situation. For them this will be the undiscovered country.
Companies currently increasing their debt level are an important group. This is a high risk strategy whatever the justification and becomes dangerous when combined with management inflexibility. The level of debt is not necessarily the cause of a company encountering a financial crisis but, at this stage in the cycle, the increasing debt may be symptomatic of a management problem.
Negotiate now to lock in the availability and the option price of new finance both in the form of bridging finance (the equivalent of the liquidity provided by DIP lending in the US) and medium term debt facilities. Raise this partially on the basis that it is to be applied along with new, experienced management.
Gather together and retain a team of remedial management specialists. Do not rely on the accounting firms they will fishing in the same small pond for able and experienced individuals.
A New Kind of Institution
Lenders to medium sized companies in the UK tend, generally, to be locked into their exposure and consequently have to manage their portfolio with limited tools based on non intervention.
Basle 2 will render this position increasingly unattractive.
In the UK we tend to have hedge funds with substantial liquidity but without corporate management and experienced remedial managers but without significant funds.
I propose the establishment of a new form of institution that combines the risk assessment skills of an active hedge fund with the risk modification abilities of remedial management.
The institution I envisage would buy a significant proportion of a company’s debt at a discount in the secondary market sufficient to facilitate intervention in the management and restructuring of the company. New funds would be available in the form of short term debt or new equity to fund the rehabilitation plan thereby imposing an early restructuring and enhancement of the debt rating.
The refurbished debt would then be resold into the regular market at par and the equity position into the private equity market.
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To answer the questions posed at the beginning of this essay. I do not think that there is any compelling evidence to suggest that we have reached an economic Nirvana in which a new paradigm has eradicated the business cycle. We have enjoyed a long period of sustained growth, low interest rates and comparative stability which is an attractive combination to both investors and lenders but the credit cycle can be traced within this extended phase and it is this that should inform us that a correction is becoming likely.
The indications are that the storm is gathering. As it has always done, it will sort the strong from the weak and the capable from the deficient. The analogy suggests that those who take action when the clouds begin to gather on the horizon emerge stronger than others who continue to bask in the taken for granted but deceptive warmth of the fading summer.
Anthony Holmes, July 2007
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