Lock-out: interest rate rises could trigger restructurings while volatility in capital markets is hampering refinancing
Three years on from the collapse of investment bank Lehman Brothers and a banking crisis that prompted a worldwide recession, the outlook still remains bleak for companies.
Global GDP is estimated by some analysts to remain stagnant at about 3 per cent this year and next, down from more than 4 per cent in 2010. Recession is still expected in peripheral eurozone economies such as Spain and Italy, according to analysts at Citi. “Recession appears to be a more likely outcome now in Europe and/or the US than three to six months ago,” says Jonathan Stubbs, equity strategist at Citi.
While last year in Europe, earnings upgrades outpaced downgrades, today the situation is reversed, with downgrades outstripping upgrades, according to the Citi analysts. As economists lower growth forecasts, earnings expectations are being reset as economic activity slows.
This year, the story in the corporate world has been one of haves and have-nots. Companies that built up strong balance sheets during the crisis have almost unparalleled levels of cash. In one stunning example, computer maker Apple emerged this summer as having more cash than the US government itself.
But for many smaller companies, particularly those that are consumer facing, the economic crisis is still real.
“As the impact of the staggering post-Lehman concerted fiscal stimulus began to take its effect on the global economy in 2009 and 2010, many were lulled into thinking the worst was over,” says Jonathan Coltman, restructuring partner at KPMG.
“This stimulus also clearly helped some companies to stagger on and put off hard restructuring decisions. Unfortunately, the stimulus is now waning and nations themselves are being dragged into financial crisis. The resultant impact on demand patterns, confidence and prospects of growth is only just emerging.”
Corporate restructuring specialists say deleveraging on the scale required over the coming years will be a long, hard and socially draining process, and will have to take place against a backdrop of heightened, political, social, financial and environmental instability.
“Increased volatility and instability are also here to stay,” says Mr Coltman. “The coming decade will be one of the hardest in living memory for CEOs, CFOs and boards to build and protect corporate value.”
In the UK, corporate insolvencies slowly fell over the course of 2010 from their peak at the height of the recession in 2009, according to R3, a trade body for the insolvency industry. However, since the start of 2011 they have begun to rise once again.
In early 2011 the steepest rise in insolvencies has been among the real estate, wholesale and retail and manufacturing sectors.
UK company insolvencies rose to 5,974 by the second quarter of this year, having fallen to 5,383 in the fourth quarter of 2010.
Constraints in bank lending and a sluggish economic recovery are both factors in the increase in corporate failures. “Recovery is one of the most difficult times for businesses, as it takes time for a return to growth to translate into tangible relief for businesses, yet creditors tend to be more aggressive in their pursuit of debtors,” says Frances Coulson, president of R3.
The first half of 2011 gave many corporates hope, as credit markets rallied, with high yield bond issuance reaching its highest levels.
This return in lending appetite among banks and institutional investors also helped support a revival of mergers and acquisitions activity, as the outlook became more certain.
But in recent months, capital markets have been choked off once again by renewed sovereign debt crises in the US and Europe. Equity and debt markets once again shut to those companies seeking funding for growth or debt reduction. Bankers have already started warning that there may be no new corporate listings in Europe this year if the uncertainty continues.
“If this negative sentiment, flight to safety and associated volatility continue, then we can expect another round of financial and operational restructurings to deal with pending maturities that are faced with limited refinancing possibilities,” says Andrew MacCallum, managing director at Alvarez & Marsal, the restructuring specialist.
During the first half of 2011, the high-yield market was active and allowed companies to chip away at refinancing an impending “wall” of maturities that come due between 2012 and 2014.
“The high yield market was providing much needed refinancing capacity in the face of the refinancing wall,” says Mark Sterling, restructuring partner at Allen & Overy, the law firm. “That’s now shut and may not open for a while, given the volatility in the capital markets. This leaves billions of dollars of debt due for refinancing with no obvious source.”
And while global interest rates remain suppressed, some restructuring professionals fear the impact of their eventual increase on companies.
“If interest rates rise and debt service costs crank up – with more groups becoming unhedged, a material interest rate rise could trigger a lot of restructurings,” says Richard Tett, restructuring partner at Freshfields, the law firm. “There’s a pent up supply of restructurings around Europe that are currently limping along – performing fairly well operationally, but just waiting to be restructured when the markets improve or liquidity or lenders’ patience runs out.’
Financing is still available for the strongest companies. Many have taken advantage of cheap debt and bought back shares. In August, more US companies were set to buy back shares than in any month since the peak in 2007, according to Birinyi Associates. Companies in Europe and the UK have also stepped up buy-back programmes, according to Thomson Reuters data.
In recent weeks, companies including AOL, brewer Molson Coors and retailer Lowes have announced plans to buy back their own shares.
Analysts at Citi urge chief executives to consider capital or corporate restructuring as a way of creating value for shareholders. “Given the macro nature of the market, de-equitisation, through spin-offs or buy-backs, offers CEOs the opportunity to focus on self-help value-creation strategies,” says Mr Stubbs at Citi. “Get smaller, get smarter, get a higher share price.”
Companies have taken note. Divestments rose to a record share of global mergers and acquisitions activity this year, according to Dealogic data. Spin-offs and asset sales accounted for about half of global dealmaking, up on last year. In the US, such activity is up more than 40 per cent on the first half of 2010.
Steve Frobisher, business turnround expert at PA Consulting Group, says companies need to take advantage of the disruption.
“Companies need to secure enough capital to prosper, either by raising capital or by a ruthless focus on cash in the business, including selling off surplus assets,” says Mr Frobisher.
“They need to create portfolios of winning businesses, remembering the adage: ‘The best way to create value is to stop destroying it.’ This means exiting or re-engineering value-destroying lines of business.”
This year, US companies were most aggressive in taking advantage of the weakness of others. In the first quarter of 2011, US companies accounted for almost half of global M&A activity, up from about a third in 2010.
“Companies need to be aggressive in pursuing market share, as there will never be a better time,” says Mr Frobisher.
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