At a recent roundtable hosted by Real Deals dealmakers and advisers discussed what lender attitudes and a consumer downturn mean for the special situations community.

At the table:

William de Laszlo
, Agathos Management
Gavin George, Alteri Investors
Christopher Priebe
, Cebile Capital
Simon Gordon, 
JTC
Jat Bains, Macfarlanes
Tristan Craddock, Rutland Partners
Hugh Dorins, 
SIA Group

It seems like more deals are coming to the special situations market, especially in consumer and retail. Why are so many of these businesses struggling?

Gavin George:

There is a lot happening in retail and the shake-out we are now witnessing has been on the cards for many years. There has been structural change in the way we shop, and it is not just about channel shift. The amount that consumers spend on shopping centre-type goods as a percentage of total spending has been going down year-on-year for the last 30 years. We are in a privileged position as we operate across western Europe, with our main markets in the UK, Benelux and DACH regions, and it is important to point out that the dynamics for retail businesses are very different in each of those regions.

The Netherlands remains buoyant following a housing recovery and consumer confidence is at +20. Germany is flatter, but still at +10. The UK, on the back of Brexit uncertainty, is very negative at -9. If you look at the UK most of the distress has come in the last 12 months. There are sadly businesses in the UK that just don’t have a reason to exist. Even with the greatest will in the world there is not much you can do with them. Others, like department stores in major catchment areas, do have a future.

Hugh Dorins:

It is interesting to hear how retail is faring in different jurisdictions. In the UK retail is more mature and it does feel like the consumer is over-shopped. There are too many retailers. It would appear there are more town centres with traditional high streets in the UK when compared to other parts of Europe. The number of traditional bricks and mortar retail units in the UK isn’t sustainable.

Another significant factor is business rates which are high compared to Europe. It is an extra layer of cost that online competitors don’t bear to the same extent. The latest business rates revaluation came into effect in April 2017. It has generally led to higher rates in busy high streets, coupled with a reduced impact for online retailers who generally have a smaller property footprint.

In 2017 Marks and Spencer’s turnover was £9.6bn (€10.8bn) and paid £184m in business rates compared with Amazon UK who had a turnover of £7.3bn and paid £14m, which is around ten times more for M&S, the bricks and mortar retailer.

Tristan Craddock:

And it isn’t just the rates. There has been cost inflation across the board, with labour costs a particular challenge. Consumer confidence has played into it too. I think the UK has also undergone a faster transition to online shopping, which has accelerated the problems physical retail is facing relative to the rest of Europe. There are still successful consumer companies out there, but what they require is a model to make the structural shift to digital.

William de Laszlo:

The big question is when retailers and restauranteurs are going to wake up and accept that their business models need to change? It is hard to believe, but you will still encounter large retailers with national brands that are only generating ten per cent of their revenues online. They are going to get crushed. As an investor you need to see a strategy that is going get a business to a point where 80 per cent of revenues are online and just 20 per cent from physical stores.

George:

We are looking for specialist retailers that have something defensible against online competition and where there is a rationale to have a show room or physical touch point with the customer, and the brands see value in paying for that.

We own a company called BabyWalz in Germany. We have shrunk the physical footprint dramatically with sales staying the same. Around 80 per cent of its sales are now online and the business has had strong support for its physical stores from the big baby brands like Stokke and Bugaboo.

The challenge that comes with increasing the proportion of your sales online is that there is so much more price transparency, so you do lose margin. This is great for the consumer but means you have to drive efficiencies elsewhere in the operating model.

Dorins:

On your point about reducing a business’s physical footprint, is it easier to relinquish the hard estate in some countries than others? Clearly this can be difficult in the UK.

George:

There are differences. In both Germany and the Netherlands the leases are much shorter and often you can give notice. The UK, historically, had a precedent of long leases (circa 25 years) and rents are upward only. Outside the UK  there is no need for a process like a CVA.

What does this backdrop mean for special situations firms with respect to dealflow?

de Laszlo:

What is interesting is that the number of transactions going through advisers and onto the special situations houses has remained flat, but the number of opportunities where we are aware of complexity or distress, or where we are watching to see what develops, has increased. These opportunities are increasingly coming from Agathos’ broader network of operating partners, direct from management and other miscellaneous sources, increasing as the pendulum shifts towards the end of a cycle.

George:

The volume of potential deal opportunities in 2018 is definitely up, but although there is lots to look at our challenge is finding the businesses that have a reason to exist and are recoverable.

Typically there is also a value gap between the vendor and the buyer. The bottom line is that hope tends to triumph over realism in setting the price if you are the seller!

Priebe:

We are closer to the end of a cycle than the beginning so there should be more special situations dealflow coming through.

To what extent does the attitude of lenders determine how many deals come to market?

Simon Gordon:

It comes down to a bank’s risk profile. We have seen examples of banks with a higher risk appetite taking control, cutting off the worst performing parts of the business and reducing debt. So doing what a private equity investor would do. More conservative banks will take the haircut and look for a buyer to pass the asset on to. It is case and lender specific.

Craddock:

I agree with that. Lenders will behave differently depending on the situation. I think there will be more deals that come out to the special situations firms, because lenders are often not set up to deal with challenged situations.

When they wrote the loans these were great businesses, but now they are in special situations. I don’t think they have the infrastructure anymore to try and fix these problems. Of course, some lenders will be brave and lean into situations, but I expect that most will look for a specialist buyer to do the heavy lifting.

The problem for firms like mine is that by the time some of these businesses eventually come to market they have gone beyond underperforming, where a fix is very possible, and into distress, where saving the business is far more difficult.

Jat Bains:

It does depend on who the lender is. A state-owned bank, for example, will be under pressure to support a business and its sponsor.

But attitudes do change when sponsors explicitly withdraw their backing and a business is in difficulty. Some banks will try to string things out via amend-and-extend, others will look to limit their losses and exit.

What has been particularly interesting is the approach of the credit funds. As they seek fixed income-type returns they will hate anything that involves a haircut on their loan portfolio, so they are a lot more flexible. We have seen some of them be amenable to covenant resets or extensions that allow them to report back to investors that all is fine.

There is, however, so much capital in the market to deploy that the credit funds can also be much more creative and put more money in, which the banks often can’t. We have also seen some cases where a business trips a covenant and then simply refinances with someone else by way of “cure” and moves on, because there is so much liquidity around.

Craddock:

A number of these credit fund loans were done on looser covenants, so the direct lenders can’t actually step in until it is quite late. They also don’t have the same workout resources as the banks. The banks lent into the last high point and it is the credit funds lending into the next high point. It is uncertain how that is going to play out when the cycle turns because there are some very different dynamics in the market.

Priebe:

If you look at southern Europe changes to banking regulations, requiring banks to be more proactive about managing their portfolios, are throwing up a lot of opportunities. The banks just aren’t healthy enough and don’t have the expertise to take assets into workout. These banks have to do something, which leaves special situations firms well-placed to access dealflow.

George:

It is a mistake to say that it all comes down to the lenders. The stakeholder mix in a restructuring is super critical to understand. The credit insurers are very important, as are the suppliers, landlords, and then there are the staff and the pension angle which is very much in the public eye following BHS et cetera.

That said, the lenders are, of course, very influential and I have observed more appetite from lenders to engage. There are challenges around some of the documentation, as the debt can’t always be assigned to another party without consent, but the decision on whether to hold or exit comes down to whether the lender trusts the management team and believes that the business plan still makes sense.

There was a time when you would knock on the bank’s door and there would be zero interest in speaking to you. That has changed and there is willingness to talk.

I wanted to pick up on credit fund behaviour. When a refinancing isn’t an option, what are the funds inclined to do?

Bains:

A lot will depend on their capacity. Some of the bigger funds will sit alongside special situations vehicles and will have lots of expertise and resource available to them. Some of the smaller funds will lack that experience so their scope to do something more aggressive is restricted.

The bigger funds are the ones more likely to pursue their enforcement options and get into the heavy lifting. They will put money in and get very hands on, very much like some of the sponsors sitting around this table would.

Dorins:

We are working a lot more with the credit funds in respect of lending situations. Our experience is that they expend a lot more time and effort on collateral due diligence when they are going in.

They do have a very different approach to the banks. They want a lot more granular information and spend more time and effort examining the effect of their exit position and options should things go wrong. I think it does provide some insight into how they will behave if there are problems.

de Laszlo:

What we are keeping a very close eye on is the peer-to-peer and crowd funding market. I am convinced that this area of the market is going to throw up opportunity. It is quite terrifying actually. The banks wouldn’t lend to these companies and although they are higher risk, lending rates do not reflect this and the structures are covenant-lite. I don’t think the end user fully understands the risks. We are tracking this market closely because there are bound to be opportunities when this starts to unwind.

“we are keeping aN eye on the crowd funding market. this area will throw up opportunity”

Dorins:

We have also looked at some of these deals. I don’t think most of them would have passed through a traditional credit process.

Gordon:

The peer-to-peer lending funds are also partly driven by hype and the media. Crowd funding investors tend to have more of an appetite to support a business that is struggling to attract finance from more traditional channels or mainstream credit funds because the brand is exciting, or there is some kind of sentiment attached to the business, but without really understanding the risk profile.

Bains:

This is a space where the regulators are still trying to understand what is going on and I suspect that as they start to apply more scrutiny and tighten rules more opportunities for regulated, experienced investors will emerge.

Moving to fundraising. It has been tough to raise LP funds for special situations, but we have seen strong raises. Are things changing at all?

Priebe:

A turnaround or special situations strategy is still quite niche for a blind-pool ten-year fund. LPs are still predominately focused on the areas of buyout, growth and venture.

I would add, however, that if you have the right strategy and the right team with the right position in the market then you can be very, very successful.

You mentioned QuattroR, and that is a case in point. We advised on that raise and it was clear that local institutions in Italy were crying out for a special situations manager in the country. There was no competition in QuattroR’s market. There are larger players going for the international targets and smaller, local managers that don’t have the scale or expertise. So this fundraise, for a manager deploying tickets of between €30m and €100m in opportunities that are fundamentally healthy but have hit a bump, really resonated.

I would also say that when it comes to fundraising it pays to position yourself for complex, special situations rather than the standard turnaround. There are only a handful of turnaround managers that have LP funds. Special situations strategies, often with a credit angle, have much more traction.

“only a handful of turnaround firms have LP funds. Special situations strategies, often with a credit angle, have more traction”

George:

Why do you think that is? Is it just because there is an unproven risk/reward model for turnarounds?

Priebe:

My sense is that it could be partly because of the last downturn. There was a lot of excitement around turnarounds at the time, but the deal flow never really materialised for whatever reason and there was a bit of strategy drift. Managers secured some really strong fundraises, but then didn’t deploy for two years. LPs grew anxious and the conversations around fees started to crop up. It is a factor.

Bains:

We recently acted for a special situations manager on a fundraise and they didn’t really have any issues. There were lots of questions about how they sourced their dealflow and how they called the bottom of the market, but the trust was there because they have a great reputation.

de Laszlo:

I think reputation is so important in our market, hence our key message is to deliver what we say we are going to deliver. The special situations community is such a broad church and there is a perception that the line with turnarounds is blurry. When I look at where we add the most value it is on the way in – providing financial stability, strategic planning, improving the quality of management information and implementing systems and processes such that the executive team can focus on businesses performance and prospects.

Craddock:

This is where track record comes into it. It can be hard to articulate what we all do, but if you can show what deals you have done, how you add value and how that model is replicated across your portfolio, investors will come in because they can see that you have deployed through cycles.

Priebe:

Another point to mention is that there are around 900 firms out there doing buyouts or growth who also claim to have special situations capabilities. Investors might feel it is easier to gain exposure to special situations through existing relationships.

Are managers drifting away from the conventional turnarounds to lure LPs?

George:

I think it would be a mistake to assume that the heavy-duty restructuring is not happening. Look at retail and the high number of CVAs. Everyone politely forgets that a CVA is in fact a form of insolvency. A CVA is heavy duty but it has become politically acceptable for anyone to do it – even a listed company! That would have been unheard of a few years ago. It is happening, it is just that the higher number of CVAs mean there are fewer pre-packs, trading administrations, liquidations et cetera. The real question is whether the CVAs actually work or just buy a bit of time. That is still to be seen.

Dorins:

We have just worked on a CVA, and although millions in dilapidations liabilities could have been written off there are still changes needed to see the benefits. The business, however, has just carried on doing what it did before with administration a possible next step.

Bains:

We certainly still see plenty of heavy-lifting situations and often it comes from the sponsors who are already invested in a business. An interesting strategy to avoid the publicity of a CVA is to find ways to reorganise portfolios of assets, to separate the bad from the good, and then have private conversations with landlords of “bad” sites and try to reach a consensual agreement in a scenario where the landlord’s threat of enforcement action is relatively toothless.

Is a culture of “rescue” investment at risk because of political and media criticism?   

Gordon:

I think there has been a slight shift in public attitudes. People see that businesses are in trouble and understand that unless a buyer comes in and tries to do something then jobs are going to be lost.

George:

This is a huge issue and will often take up the most time in our investment committees, especially when store closures and redundancies are required to affect a recovery. The reputational risk is immense and then there is the political involvement to deal with. What also staggers me is the level of misunderstanding about these turnaround deals. There is high risk and the timescales are super tight. Obviously any investor is going to try and protect its capital. In practice this means that in addition to the investment case of the turnaround plan you do need to assess the downside risk and try and take security where you can. Anybody would do the same.

de Laszlo:

I totally agree with that, but I think the consumer can see that the high street is in trouble and that this can spread to other sectors. You can knock private equity, but I think I speak on behalf of the vast majority of the market and certainly the primary reason that I and my team at Agathos operate in this space is to try and fix the companies we invest in and save jobs, and in the process make significant returns for the founders or people in the business and our investors.

Bains:

As a lawyer I can see how sentiment impacts policy. The government has recently released proposals around the reform of insolvency laws. They are offering new tools that will allow companies to benefit from a moratorium, which allows for better management of creditors and improves chances of success. But on the other hand there are proposals to make the directors of holding companies liable if a subsidiary is sold and then fails. That could make corporate carve-out deals very difficult. It hinders a rescue culture rather than helping it.

Real Deals would like to thank Agathos Management, Alteri Investors, JTC, Macfarlanes, Rutland Partners and SIA Group for supporting this roundtable.