With a growing consensus that the economic cycle is close to peaking and high profile administrations in construction and consumer-facing sectors, business rescue is back on the private equity agenda. A panel of special situations and restructuring experts discusses how investors can protect value in a volatile economy, and where GPs see opportunity to add value when businesses come under pressure.

At the table: Gavin George, Alteri Investors; Justin Holland, DC Advisory; Jim Tucker, KPMG; Jat Bains, Macfarlanes; Chris Campbell, Rcapital; Andy Powell, Rutland Partners; Nicholas Neveling, Real Deals (moderator)

What is the view at the table about the credit cycle? Are covenants under pressure? What does this mean for restructuring deal flow?

Justin Holland:
What is a covenant? (laughter). I am being slightly flippant, but it is only partly in jest. The team I sit in does everything from new issues to complex balance sheet restructurings. On the new issue side, during the last 18-24 months, there has been a bifurcation of credit. The high quality issuers and borrowers are in really good shape and will receive favourable terms and competitive pricing, but at the other end of the spectrum there will be borrowers who just can’t catch a bid. So finance markets are choppy and we’ve noted a lot of late cycle behaviour with deals pulled or companies switching from high yield to direct lending.

With regards to what this means for restructuring and accelerated M&A, it comes back to the covenant point. Capital structures are so borrower friendly and flexible that the only thing limiting your ability to inject liquidity into a capital structure is your imagination. The only triggers for an accelerated M&A or restructuring will be when businesses run up against a maturity they cannot refinance, or run out of cash. Maturity will be the defining issue. It
will take a lot longer for the restructuring distressed M&A cycle to evolve.

Andy Powell:
The point on maturity is an interesting one. Many of the situations we have looked at will have a single covenant and will be stressed around leverage, even though they can survive because of low interest rates and cost of capital. It prolongs the capacity to stay cash positive. The benign financing environment allows companies to either restructure or refinance and kick the can down the road.

Jat Bains:
There is so much headroom in covenants that businesses can be in serious distress before a covenant bites. Often it is only when there is a cash flow issue that a management team with its head in the sand will face up to what the problems may be. What that means for special situations investors, particularly in the context of accelerated M&A, is that it happens late in the day. There is not much time for proper due diligence and the capital requirement is higher than what it would have been had action been taken earlier. It makes it tougher to do a deal.

Chris Campbell:
As Jat has outlined, what brings deals our way is cash. By the time we are called in, businesses, which would ordinarily have breached their covenants six months ago and be put into a process back then, now have an immediate funding need. Around 60 deals come across our desks on average each month and apart from the one or two carve-out opportunities, all of the others are facing a cash shortage.

Jim Tucker:
We recently produced our quarterly insolvency tracker and insolvencies are 35 per cent up on Q2. Those are mostly in the middle market, but anecdotally there is much more talk about a downturn being long overdue. That will inevitably start to drive sentiment and confidence.

Gavin, Alteri specialises in retail, where we have seen distress. What has prompted this?

Gavin George:
Retail is a bit different to most other sectors. There are the macro pressures, but there are also profound structural changes that are the main reason for distress in the sector. The amount of money consumers spend on shopping centre-style goods has been going down year-on-year for a long time now. We are spending less on stuff and more on experiences, travel, eating out and leisure. In addition to that pressure on the topline, there is the issue of channel shift. The influence of Amazon alone is huge, and it has left traditional retailers trying to cope with business models that are outdated, and adapt to a new order. That requires capital - usually quite a lot of it - and expertise. Retailers will reduce the amount of physical space and increase the digital offering, but while that is easy to say, it is difficult to do. It requires a full understanding of customer behaviour and the management of stock and orders across different supply chains, which is very complex.

Retail is undergoing a complete overhaul and a large number of legacy retailers just aren’t capable of getting there on their own. One consequence of this is that wider debt trends don’t actually come into play. Retailers haven’t been able to secure the same terms and leverage as other industries, as lenders have had concerns about the sector for some time now.

Tucker:
What I find really interesting is that, outside food, our retail team sees internet sales plateauing at around a third of revenues. Two thirds of non-food retail will still come from physical sales. That is still a massive market to go for. As ever, it comes down to quality of offering.

George:
I don’t fully agree with the point that online sales will level off at a third of the market, albeit different retail sectors have, and will continue to have different penetration rates and channel
profiles. Overall though, the experience of shopping online is just so good and seamless now. But I do agree with the point around quality of offer. There is a role for a “last man standing” in each sub-sector, that will challenge the online consolidator with a very strong bricks-and-mortar and ecommerce platform.

In Germany, for example, we have backed Babywalz, which is the dominant multi-distribution player in is category. You see it in the UK too, with Waterstones in the book category and to a lesser extent with B&Q in the DIY space.

Are there any other sectors where financial distress is evident?

Campbell:
The most obvious one is casual dining. The business model here was to expand rapidly with lots of debt, and firms went into territories that they probably shouldn’t have gone into. Add in the increase to incremental costs from rising business rates and wages, and even a little trickle back on like-for-like sales makes the marginal sites lossmaking, which becomes a bigger problem because of the leverage. We have seen four or five of these groups. There are sound businesses, but they should be scaling down from say 90 sites across the UK to 30 sites clustered predominantly in the south. They do need capital and someone to come in and help with the lifting.

Powell:
We had a good journey with Pizza Hut and as a consequence we have had a number of casual dining deals sent our way to look at. As Chris has mentioned, the sector was overbought and the chains ended up rolling out to try and beat the interest rates on their loan notes, but the model caught a cold because they simply couldn’t run fast enough. More generally I believe there is a sentiment issue around anything consumer-related. Industrial companies are also facing fundamental uncertainty. Any business with forex exposure or complicated supply chains will be facing challenges. Forex is moving around all the time. Some of it is protected, some of it isn’t and businesses will be trying to understand their exposure. These operational issues are putting balance sheets and cost bases under pressure.

Tucker:
We have picked up on issues cropping up in five sectors. The obvious ones are retail and construction. Perhaps less obvious are consumer finance, the automotive supply chain and travel, where Thomas Cook is a recent example.

Bains:
The automotive supply chain is dealing with technological disruption and the shift to electric cars. Suppliers can suddenly find that they are no longer needed. When I speak to my colleagues at German law firms, the message is that the industry there has a lot to cope with.

Tucker:
That is the massive macro change that the automotive industry faces, as it moves from the internal combustion engine to electric vehicles. Automotive companies plan their capex programmes years in advance and hundreds of millions are invested. That is difficult when the industry is going through a transformation.

Holland:
It is useful to take a step back, look at how the cycle is evolving and compare that with how cycles have evolved previously. What were the first things to hit in previous cycles? Why are things hitting now? My view is that any business that is highly operationally or financially geared could come under pressure. Suppliers to those companies will feel that too, because the throughput will not be there anymore. If you look at the impact of the CVA, the next step has to be distress in real estate. Landlords are already sitting there, watching valuations decrease and lease payments are starting to breach LTV covenants.

Bains:
We have also noted the pressure in real estate, with a number of loans to propcos that own shopping centres in distress. It went quiet for a period, but it has come right back. Is there appetite to direct capital into these trouble spots?

Holland:
You do have to stratify the market because there will be different scenarios in the large cap and mid-cap space. There will be different appetite from special situations sponsors and the more liquid distressed investors too, depending on the dynamics of any given situation. There is also a price for everything, and there will be a level at which an investor will buy in if there is comfort the scope is there to make a return. It also comes down to whether a business has a reason to exist or not. If it does, some investors will be ready to step in, but even if it doesn’t there will be other investors who will see value in the inventory and receivables book if the price is right. Ultimately, the market is still awash with capital, so there will be capital ready to deploy into a variety of situations.

Gavin, do you see fewer players looking at retail rescues? How are you filtering opportunities?

George:
We look at a very broad range of opportunities within the pan European retail space – from performing retailers to those facing significant operational and financial challenges so our competitor set can vary depending on the type of situation. What is clear though is that there are fewer financial sponsors willing to underwrite retail sector turnarounds than three or four years ago, whilst trade players remain very active. Generally, trade buyers have the capacity to pay more but take longer to execute. We position ourselves as high on certainty and speed of execution but are unlikely to be the highest bidder. With respect to the second question, we do spend a lot of time filtering and that selection is based on our operational playbook of value creation drivers. We have deep expertise in portfolio rationalisation, ecommerce, sourcing, pricing and organisational design and less experience in rebranding and relaunching, so we tread carefully in situations where that is the fundamental requirement.

Powell:
We don’t filter by sector as a rule, although we have been in and out of retail and that is one area we are unlikely to go into now for the reasons outlined by Gavin earlier. Generally, we will aim to look at each situation on its merits. It always comes back to whether there is a plan and growth story. The business may be broken today, but what is the story around what can be done to improve it? If that is the story, we will be interested. The challenge is always around whether there is enough time to do due diligence and probe the plan thoroughly in what may be an accelerated M&A process. We want to source opportunities earlier in the restructuring process and I would be interested to hear what others have seen in that regard. We, for instance, have had a couple of deals shown to us that have been driven by banks. In these cases the banks are getting involved much earlier and working to facilitate something consensual rather than taking acute action. It feels like a more constructive way of doing things, and provides more time to look through a business and decide whether you can turn it into a growth story.

Campbell:
For us the challenge is always whether lenders bring things to us too late for us to fix, or so early that we can’t get in at the right price. What we are really good at is deliverability and getting a deal done within a few weeks. That is where we find a lot of value. We have found that if a business had backing from a financial sponsor or a debt fund, a situation is managed much more proactively. Our experience is a bit different to Andy’s when a clearing bank is the primary financier. We have found that banks can be reluctant to take action.

What can be said about the debt fund approach to distress?

Bains:
It is not as if there is a massive wave of restructuring going on, so there are no firm conclusions to be drawn yet. That said, from what I have seen so far, I believe it is fair to say that
direct lenders have much more flexibility than banks. They are willing to support where they see reason to do so, whether that is because of faith in management or the active engagement of a financial sponsor. They may even lend more to a company in trouble if they see a plan to back. If there is an absence of those elements, however, it is possible that they will be much more aggressive. But we have to wait and see. It will also be interesting to see how the workout strategies of the bigger debt funds compare to those of the smaller ones. Bigger players will have the expertise and infrastructure to manage portfolios through difficult times.

Smaller players that are very focused on growing their assets under management, and taking on more risk to do so, may find that they have more challenges to deal with and that can start to become difficult, particularly if they don’t have the right skills in their business or advisors to help manage a restructuring process.

Holland:
When trying to understand when lenders will take action, it is worth looking at the incentives of the various lenders. In 2007 and 2008 the banks and CLOs were strongly incentivised to kick the can down the road and amend and extend because nobody wanted to take a mark at that time. There will be similar dynamics in play now. The larger credit platforms will have the nous and restructuring skill set in house. If they want to take the keys they have the resources to do that. For the smaller shops raising first or second funds it could get tough. They may be reticent to take action, because many of them have added leverage at fund level to deliver the promised returns as they may be lending at a six per cent to seven per cent yield. And as we all know leverage works really, really well on the way up, but goes really, really badly on the way down.

George:
We haven’t actually seen that much deal flow coming from the debt funds at all. A key source of deal flow has been normal M&A processes falling over, often due to a value gap, and we have then approached the stakeholders to offer a solution. We will usually know the lenders, the shareholders and the management. The businesses are typically retail companies backed by sponsors between 2007 and 2010 that are in an old fund and haven’t performed as well as the GP would have wanted. All those who did the deal have also probably moved on. So the firm wants to sell, but can’t always get the price it wants. We have done a lot of work on these legacy PE assets across Europe. We can step in and have conversations about what can be done and are able to offer a collaborative solution.

Powell:
We also track broken auctions and the first question we ask is why the process has broken down. Is it purely because of a price gap, or is it a function of something more deep rooted? The fact is that everything is taking longer, so even if something is not broken it can still end up badged as such because of the time delay.

Campbell:
In many of the broken auctions that come ourway, management is in denial and calls in a local corporate finance adviser to run a process. We will get the call when there is a buyer, but cash is running out. That opens an opportunity to come in and do the deal, because we can move quickly.

Tucker:
We also see the value gap, but what is interesting is that most of our accelerated M&A processes in the mid-market are getting away. When there is a stressed situation, the value gap is closing. What we have also seen is that investors will distinguish between the “Badco” and the “Goodco”, and you can still get a deal done without going down the pre-pack route.

Bains:
We have seen this exact scenario with hotels, pubs and restaurants. The good and the bad is split and a deal gets done on a totally solvent basis, although the landlords don’t always like it!

As we go into 2020, what tools will distressed companies turn to?

Tucker:
Good underlying businesses will continue to find money. It will not always be at a price that they like, but the refinancing option is very much on the table. If you are a company that can’t find new money then what do you do? The best option is usually the least bad, so we have seen the CVA used more regularly, but I sense that we could see more pre-packs next year.

George:
In our sector, where retailers have a flat top line and pressure on the cost base, the CVA has been a very popular way of compromising at least one set of creditors, namely the landlords. More recently, the CVA has also been used in some quite innovative ways, broadening it to include other creditor groups – some retailers have had success in using the process to cut business rates, for example. That said, my sense is that the trend may move away from CVAs and back towards pre-packs. Firstly, the level of challenge CVAs face is climbing, so it is becoming much harder to get a CVA through.

Secondly, CVAs have very poor long term success rates in UK retail. Whilst they offer a short term sticking plaster and the chance to kick the can down the road, circa 75 per cent have
failed, the majority within two years. More fundamental restructurings, notably pre-packs, have arguably resulted in more cases of proper transformation.

Campbell:
We have used the CVA and it is a very useful tool, but sometimes I think it can be a sticking plaster, with not enough structural change to the business. For the reasons Gavin mentioned, I also think we will start to see more pre-packs.

Bains:
CVAs have been seen as a cure all for retail. But, there is still some room to refinance out of trouble. If that isn’t an option then you are looking at balance sheet restructuring or accelerated M&A. It would be helpful if companies looked at these scenarios concurrently rather than in sequence, because that is when it can become too late for a special situations investor to step in.

Holland:
If you look at the restructuring toolbox the two key things that will decide what route you go down are the stakeholder group and the jurisdiction. If a company is sponsor-backed and it can
bring a bond document or credit document to an adviser, there is a good chance the equity can be saved or defended because of documentation flexibility. On the jurisdiction point I think Brexit and the uncertainty it has caused, as well as historical competition among the various EU countries, has pushed countries on the continent to evolve their systems and create something that mirrors the UK scheme of arrangement. That has to be a good thing.

What we have also seen is US capital structures used for European companies. So where a company has a US term loan B and there is no intercreditor agreement the only mechanism
that can be used may be a Chapter 11. Now, a French management team might not care much for availing itself of a US mechanism, but this demonstrates how competition between jurisdictions is building, which does give companies more options.