What to expect in the European restructuring market in 2023
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In this article, we explore some of the broad, as well as narrow, issues that may impact the number of workout scenarios in Europe in 2023, what these may look like, and some of the parallels and differences to previous times of economic stress in the market.
- What are the potential drivers of restructuring?
- How will recent reforms impact workouts?
- Is history repeating itself?
- What could workouts look like in 2023?
Referenced in this article
- The Part 26A restructuring plan
- Safeguard proceedings
- The Dutch Wet Homologatie Onderhands Akkoord (WHOA)
- German Stabilisation and Restructuring Framework for Businesses (StaRUG)
- Prudential Regulation Authority
- Private Debt Investor Platform
For some time now, as each new year has dawned, investment professionals and advisers have debated the likelihood of an increase in stressed and distressed opportunities and situations in a market that many see as having last been fully active in the fallout from the 2008 global financial crisis. In some years there was little debate; bull market conditions offered a huge amount of M&A activity and there was an abundance of capital to help fuel the demand. As such, the wave of restructuring opportunities remained minimal. In other years, such as 2020 and 2021, it felt only a matter of time before the markets reflected some of the economic reality being experienced and restructuring thrived. Those years appeared to be false dawns and confounded common sense in terms of the brevity of economic slowdown. The question now is this: what does 2023 look like, given that there seems to be a perfect storm of geopolitical, macroeconomic and domestic market conditions?
Given the issues faced across Europe and further afield as we move into 2023, commentators may be forgiven for thinking that this could be the year restructuring and special situations dominate market activity. In this article, we explore some of the broad – as well as narrow – issues that could drive more workouts in Europe, how these workouts may look and lessons we can glean from previous economic stress in the market.
Drivers of restructuring
Volatility in the markets and dislocation
The performance of both the equity and debt markets in the latter half of 2022 highlight the change and instability in geopolitical and economic conditions. Inflation is higher across the Western world than it has been for decades, with the ongoing war in Ukraine exacerbating the effects of this. Highly anticipated recessions may soon be upon us, if not already here, particularly in the UK.
Companies will do their utmost to maintain margins and raise prices, so the increased costs are passed on to customers, but margin compression is likely to be felt across many sectors, such as the food and beverage industry, as the cost-of-living crisis continues to grow. Metrics report a reduced footfall in restaurants of approximately 20 per cent with a further double-digit inflationary pressure, suggesting that margins have been close to eradicated. Earnings pressure will no doubt continue in 2023. As monetary policies tighten, and as fiscal support continues to be needed to address the cost-of-living crisis and increased energy costs, we can expect to see the market dislocations that appeared in 2022 continue through 2023. This is likely to precipitate more widespread restructuring than seen in previous years as investors adopt a more cautious and defensive approach.
That said, we are not likely to see the same meltdown in the banking sector, owing to increased regulation and higher capital adequacy requirements since the global financial crisis coupled with the sizeable amount of liquidity in the market. This means any sharp moves in markets are likely to come from the private sector, where there is lighter regulation. Central banks will need to exercise caution if stepping in to mitigate macro liquidity incidents, as investors may view such interventions as undermining central bank efforts to curb inflation. The intention to stimulate economic growth has equally been seen in central banks’ recent reversal of quantitative easing policies.
Volatility will continue while the debt markets remain, for the most part, shut. Inability to refinance existing structures and deal with upcoming maturities are likely to remain a concern for borrowers and in some cases lead to an increase in workout scenarios, whether in more benign terms (such as an amend-and-extend process, as increasingly seen), or something more complex or aggressive. Conversely, with no banks underwriting deals at present, direct lenders have stepped in to provide a solution – both to provide new financings to sponsors (including large, clubbed deals) and stepping into to anchor bank-underwritten deals where syndication has been slow or hung. Parts of the primary market have been offering distressed-like returns but, while the volume of low trading debt has increased, some believe that, across all sectors, companies are entering this time of uncertainty with healthier fundamentals and bigger equity cheques behind them, which suggests this high-yielding debt is mispriced and possibly means fewer restructurings than initially thought.
Increased rates and high leverage
Higher interest rates will be one of the key drivers for restructuring in the year ahead as companies seek to protect eroding cash flows being used for debt service. Over the past two to three years, there has been an abundance of capital available, and borrowers have made the most of such favourable conditions to incur large amounts of debt at a relatively cheap cost. Such was the demand, driven by a huge surge in M&A activity following the covid-19 pandemic, that regardless of whether companies sought public or private debt solutions, the cost to them was relatively low given where rates sat.
Now, however, given rising inflation, central banks have increased interest rates. Higher cost of capital will impact company valuations, and uncertainty where interest rates will settle will add further pressure to those highly levered companies. Companies, operating in low-rate environments for so long, may not have implemented any hedging strategies and it may now be too late to protect against such increased exposure, leading to potential stressed scenarios. For some companies it may be the case that cash flow and liquidity is significantly tightened over the next 12 to 24 months in order to meet debt service needs. Recent loan documentation (across the mid-market and large-cap markets) has no debt service or interest cover covenants and so liquidity shortfalls may well be the catalyst for a restructuring. This may be particularly the case where the credit has no financial covenant or has one leverage covenant set with a high level of headroom. This situation is of course greatly exacerbated by a diminution in EBITDA, which will show as a far greater impact on leverage than a debt denominator.
Continuing supply chain issues
One challenge all businesses have faced in the past few years is understanding and mitigating their susceptibility to disruption in upstream and downstream supply chains. The issues affecting supply chains have remained constant and interconnected, much of it stemming in the post-pandemic world from the war in Ukraine and, until very recently, the zero-covid policy in China and other global ports and airports, which have led to logistics disruptions. The rising cost of living has seen consumers cut back on expenditure, leading to uncertainty around the demand for goods. Associated with the rising cost of living, workers have demanded wage increases to help counteract the impact of inflation on salaries. Increased industrial action has added pressure to the supply chain. Rising gas prices and reduced supply has resulted in companies seeking alternate energy sources, scaling back production, or suspending or discontinuing operation.
Some larger companies have become very adept at dealing with these issues, and have become resilient by factoring risk into buying strategies and decision-making. Driving internal efficiencies and trimming down costs is another way to combat such issues and are both likely to be looked at by management teams as ways to stave off wider restructurings or as part of the holistic restructuring solution going forward. Software- or subscription-based business in the technology space will be far less impacted by supply chain disruptions and are likely to remain an attractive sector for investment.
Although many companies have managed to restore momentum out of the covid-19 pandemic quicker than expected, the long-lasting effects of it are still likely to impact companies and potentially trigger some form of restructuring. This can range from small consent requests and waivers to full-scale court processes, the latter of which was often seen as the go-to solution after 2008. Sectors such as travel, retail and leisure are still feeling the effects of the pandemic despite the lifting of all restrictions across Europe. While it is not expected that governments will re-introduce lockdowns, some businesses are still susceptible to small changes in market conditions and any downturn in activity or profitability could lead to discussions with creditors.
War in Ukraine
A huge amount of market nervousness persists over the war in Ukraine and, although there is a certain amount of ‘business as usual’ given the longevity of the conflict, the consequence of potential escalation weighs heavy on investors’ minds. As long as conflict continues, the rest of the world will continue to feel the impact of the war. High energy prices have been well publicised, and it remains to be seen whether Europe as a whole remains united in its support of Ukraine’s defence as local governments come under populist pressure to solve their own energy crises.
The effects of the war and sanctions on Russian-operated businesses (and asset managers) impacted certain companies in 2022 and this may well continue through 2023. The imposition of wide-reaching sanctions has impaired the ability to meet interest payments. Where sanctions have led to sizable parts of a company’s businesses being cut off from the rest of the group that were reliant on such cash flows, this has resulted in trapped cash being unavailable for debt service. For other businesses, it has set in motion a strong divestment M&A strategy as businesses try to ‘mothball’ their Russian assets. In addition to sanction considerations, companies exposed to oil price fluctuations may run into difficulties. Equally, some companies will benefit from any surge or fall in oil prices that may allow them to stave off any potential restructuring that would have otherwise been likely.
Will reforms over the last few years impact workouts
The Part 26A restructuring plan in the UK has been a successful and welcome addition to the previous restructuring tools available in the UK. Plans, together with schemes of arrangement, are still the processes favoured by many foreign companies. One reason for this is the certainty that the UK restructuring tools have been able to provide. Despite being launched relatively recently, there is already a very helpful body of case law on the restructuring plan that gives good visibility as to process, execution and court decision-making. Traditionally seen as a tool for large companies only given the costs involved around valuations, it will also be interesting to see how many SME companies try to avail themselves of the plan in 2023, as Houst did successfully in 2022.
One development to be monitored as 2023 progresses is whether newer regimes in Europe start winning a greater market share and become forums of choice – something that is an increasing possibility given recognition issues deriving from Brexit in the UK. Celsa in Spain has already used the in-court regime showcasing the new creditor class formation and cross-class cramdown. France has seen the implementation of new accelerated safeguard proceedings. The Dutch Wet Homologatie Onderhands Akkoord (WHOA) and German Stabilisation and Restructuring Framework for Businesses (StaRUG) remain relatively untested to date. While debate continues as to whether the Dutch WHOA will be suitable for large cross-border restructurings, it would be surprising if the StaRUG is not used in the near future given the pipeline of German companies facing stressed situations, particularly in areas such as real estate.
In the UK, it remains clear that valuation will remain a key driver in restructurings. Evidencing value and whether creditor classes are in or out of the money will likely be the area most susceptible to challenge and litigation, particularly given the varying metrics of valuations and their respective alternatives. Focus on valuations will never be far from centre of attention when attempting to show the ‘no worse off’ test under the ‘relevant alternative’ for the purpose of any cross-class cramdown being used. To date, the court has used its discretion carefully to sanction the plans and implement cross-class cramdowns (and has declined to sanction a plan). Case law has shown that arguing about valuations without any credible evidence, or with spurious or fanciful valuations, will be given little consideration and time by the court.
It will be interesting to see if there continues to be a decline in investors looking to buy hold-out positions. Prior to the UK insolvency reforms, investors sought to take low-cost positions in order to frustrate a consensual process or try to take ownership with a view to an onward sale. The new moratorium and cross-class cramdown described above are the main contributors to this decline and have resulted in more consensual processes, which we expect to continue in 2023.
We also expect secondary market purchasers to take advantage of depressed pricing in non-distressed scenarios. Buyers will continue to be both borrowers and sponsors, to de-lever balance sheets or build discounted equity and pull to par creditors.
The advent of a moratorium makes it more difficult for an existing lender to seek enforcement action in relation to existing debts, and processes to date are more collaborative, at least across the majority of stakeholders. As a result, buying into a capital structure to try to force an insolvency filing no longer presents such a powerful threat. As described above, a dissenting junior creditor with no credible valuation or realisable economic value is likely to have its hold-out value vastly reduced through the cross-class cramdown.
Is history repeating itself?
Several key differences between the covid-19 pandemic and global financial crisis that meant the former did not usher in the slew of restructurings we saw in the wake of the latter remain in place today, meaning we may not be likely to see a full wave of restructurings.
The rise of private debt meant many companies were able to navigate their way more easily through the pandemic – those that had borrowed from credit funds found their lenders to be collaborative and understanding to their situation. The onset of an unforeseen force majeure did not render these companies bad overnight. The credit funds who, given their take and hold approach, diligence the assets to a high degree, backed their underwriting and chose to support their portfolio companies. This was done through several means, including the following:
- Amendments to financial covenants. Either resetting ratios or waivers for covid-impacted testing periods allowed management teams breathing space to focus on running the business without the threat of significant default or enforcement hanging over them. Such resets often came at a price, whether through an upfront fee, margin uplift (reflecting the heightened risk), or maybe even a new minimum EBITDA or minimum liquidity covenant;
- Lenders’ willingness to follow their money. The need for liquidity is crucial at times of stress or distress and borrowing money is a key way to maintain liquidity. CFOs are likely to draw down revolving credit lines that provide a committed source of capital. Some companies may have wide general purpose committed term debt lines that can also be drawn. Others may have alternate debt capacity or need to seek consent from existing lenders to incur new debt. New money considerations are discussed in more detail below.
We do not expect the situation now to be wholly different subject to some nuances. It was very easy for creditors to understand and sympathise with borrower covenant requests when such covenants were impacted by an event that drastically reduced profit, in some cases overnight. Today there is no such one-off event but rather the culmination of many factors from geopolitical issues to local fiscal policy. Companies that have foreseen this and implemented strategies to protect against them will fare well. Others that have not may have financial covenant breaches that will need to be worked through with lenders.
That said, credit funds will continue to support their borrowers, whether through new money needs or amendments to existing documentation, where the situation allows. Private capital is, though untested, expected to be well positioned to overcome a relatively deep recession given its patient approach, which often aligns more with financial sponsors than traditional bank lenders. It has significant strengths and unique characteristics versus traditional bank-lending, which has perpetuated the growth of the asset class in recent years, resulting in the asset class continuing to grow as fundraising continues (albeit at a slower pace in the current market conditions). Globally, up to the end of the third quarter of 2022, $174.3 billion of private debt had been raised. While the year-end number will be higher, this may still down on 2020’s number of $201 billion and certainly 2021’s number of $273.5 billion. The volume of ‘dry powder’ and the speed with which it can be deployed means that private credit will still be called upon for new money and more liquidity-bridge type situations in 2023.
Another differentiating factor this time around is the cost of borrowing. Capital available over the past couple of years has been cheap and borrowers have not thought twice about incurring more debt that necessary. Now, however, with current rates and further rises possible, borrowers are thinking twice about incurrence, especially in stressed circumstances where the cost of such capital has always been higher. Lenders are also more wary of providing such capital and it is likely that companies with significant leverage find it harder to tap such capital, or not unless other document flexibilities are either permanently or temporarily deleted.
Government support and market sentiment
The mood music in the UK from the government and the Prudential Regulation Authority during the pandemic was very much one of company survival. Governments preached caution against premature action by creditors, the key driver being to protect companies (and jobs) as going concerns. This was backed up with huge fiscal and monetary support initiatives that supported the markets through the pandemic. Such support has not and could not continue indefinitely, and governments have commenced a process of trying to balance the books and will not provide the same financial stimulus again particularly in having to deal with the ensuing energy crisis. That does not mean governments are encouraging enforcement strategies but rather a sensible investment approach – a message that is slightly contrary to that previously given of caution and precipitous behaviour.
Despite this, default rates are unlikely to stay as low as they have been. Years of very low rates and excess liquidity led to an environment in which defaults occurred rarely. Default rates post the global financial crisis fell dramatically. Government support during the pandemic meant there was no increase to such levels. We expect more corporate insolvencies throughout Europe in 2023, whether through a rationalisation of economic value through capital structures, court-led processes or wholesale ownership changes. Fitch has predicted rising default rates across the US and European high yield and leveraged loan markets. Estimated rates in Europe for 2023 are 2.5 per cent for high-yield and 4.5 per cent for leveraged loans versus 2022 (November to date) of 0.7 per cent and 1.3 per cent respectively. It is worth noting that these numbers are still well below the rates in 2008–2009 (22 per cent and 14 per cent respectively). Higher interest rates and weak capital access will result in distressed debt exchanges being above historical averages. Fitch includes amend and extend transactions as distressed debt exchanges, and it is to this and other liability management exercises that we turn when analysing what the restructuring landscape will look like in 2023.
What will restructurings look like in 2023?
In the second half of 2022 we saw a large uptick in liability management exercises. The previous ease of refinancing existing capital structures gave way to tough market conditions as pricing widened and investor demand waned. Creative solutions were sought for both performing and stressed businesses who took steps to deal with upcoming maturities without going into full restructuring processes.
We will continue to see amend and extends (the extension of maturity in return for certain other changes to documents) and exchange offers but these will be reserved for the best companies. While pricing on exchange notes is significantly higher in the current environment, the extended maturities are imperative to allow management teams the time to realise long-term goals and reduce the ongoing refinancing risk that the market is likely to experience, certainly in the first part of 2023. Some companies may implement amend and extends as part of exit strategies. Pushing out maturity allows sales processes to be conducted in a patient manner that ultimately enhances value for a seller.
Obviously, such processes need requisite consent levels and so adopting a balanced approach to any consent request is prudent. Aggressive ‘amend and extends’, including where non-consenting lenders are subject to a covenant strip, are likely to receive little traction, particularly where creditors feel the balance of power has swung back slightly in their favour. Generally, a desire to affect such transactions suggests a confidence (among all stakeholders) that these are good businesses and the markets will reopen in the short term. Away from such exercises, weaker companies with overly levered balance sheets will likely need a more all-encompassing balance sheet restructuring in court.
Will document flexibility make transactions easier?
While more loose documentation, which has been increasingly seen in the markets, will allow for more flexibility to implement restructurings and quasi-restructuring, it may also create a timing issue. In larger deals, given the lack of a maintenance covenant, it remains the case that there is not likely to be any triggers until a real liquidity need occurs. Even in the mid-market space, a single leverage covenant can be set with wide headroom and the covenant profile can require little or no de-leveraging, meaning the likelihood is that companies again, may run into liquidity issues before breaching leverage. The ‘sit on your hands’ nature of incurrence covenants means that sometimes the liquidity need is not identified until very late in the process, which sometimes makes collaborative solutions harder to achieve. Borrowers who have active and healthy dialogues with their creditors are likely to reach consensual solutions quickly if all information is available to stakeholders.
New money considerations
Subject to any consent process, a borrower’s ability to incur new money will be dependent on its debt capacity under its loan documentation. This may be of minimal value in smaller deals where the ‘permitted financial indebtedness’ baskets are often tight albeit increasingly seen with grower capacity. These baskets are often clearly defined so it is hard to push general purpose debt into baskets that have not been utilised. A lot of documents include flexibility to borrow incremental debt. This ability is often capped with either a hardwired amount or governed by a leverage ratio (which is usually set at opening leverage). This debt, however, is uncommitted and so there is no guarantee a company can raise it even if there was capacity to do so – the likelihood in times of stress when EBITDA declines is that ratio debt will be capped out and lenders will be wary lending under any fixed component if leverage is already high. This would also be the case for the ‘free and clear’ baskets seen in mid-market and large-cap financings. These allow for an amount (often set anywhere between 25 to 100 per cent of EBITDA of the group) of additional debt on top of, and irrespective of, any ratio-governed test to be incurred. Again, faced with a liquidity need, borrowers may find new lenders hard to come by. The best chance of utilising any incremental debt will be from the existing lender pool as they will know the asset better than incoming lenders and will be able to transact quickly. It may well, therefore, be that lenders (rather than documents) drive market capacity for borrowings, unless sponsors choose to deploy debt into their own structures.
As mentioned above, lenders have generally been amenable to following their investments especially if management shows the issue is a short-term one but again, the higher rate environment will mean both sides must consider liquidity funding extremely carefully in the next 12 months.
For larger companies the flexibility to incur debt is greater. The variety of baskets and quantum tend to be greater and wide reclassification rights (the ability to move items between baskets to the extent it can fall within another basket) means, first, it is easier to push general debt into the structure and, second, it is harder to police utilised basket capacity.
The lack of transparency on basket sizes may be compounded if there are ‘high watermark’ baskets in the documents, which reset the hard-capped number at a higher level corresponding with the EBITDA equivalent as increased at any stage (and are not subsequently reduced). This does raise an issue for both existing and potentially new money lenders who do not have clarity on how much of any specific basket has been utilised. The largest deals may also have a ‘pick your poison’ provision that allows borrowers to toggle dividend and investment capacity into debt capacity. These baskets are freely available at any time but most likely would be utilised when there is a liquidity need (and as such leverage may already be high) when all other debt baskets have been used as borrowers and shareholders seek to retain dividend capacity for as long as possible.
The issue of all such baskets being uncommitted remains a constant and so finding a lender (and acceptable pricing) is a key factor. However, the ability to offer stand-alone credit support to such an incoming lender is a crucial factor that makes providing such new money a more attractive proposition.
Day-one lender security packages have become relatively skinny over recent years, with assets limited to shares in key entities, bank accounts and structural intra-group receivables. In syndicated lending, such assets are also often limited to certain designated day-one jurisdictions. To the extent that there are other assets of worth, these can be secured in favour of other incoming lenders assuming there is the lien capacity to grant the security. Various debt baskets are capable of being secured on both existing lender collateral and any other assets the group may own, which can have a dilutive or priming effect respectively. As a basic example, the general debt basket (which can be anywhere up to 50 per cent of the consolidated EBITDA) could be used by an incoming lender and such debt could be secured on some fixed assets or intellectual property that was of value but did not fall under the scope of the day-one lenders security package. Such financing would also be done on bilateral terms, meaning that – especially in times of stress – consideration needs to be given to any mismatch in terms and tighter covenant packages for new lenders. This makes any new money considerations far more attractive from the incoming lender’s perspective. If there is availability under any super senior baskets (usually reserved for the revolving credit facility but with a grower element) then this proposition is further enhanced. Any other desire to put money in on a super senior basis will require unanimous (or close to unanimous) consent from creditors.
The ability for non-obligors to incur debt and secure assets is seen in varying degrees in syndicated lending. Whether such entities have not guaranteed or secured their assets in favour of the day-one facilities consideration will be assessed as to what assets could be secured in favour of the new money needs. From a structural perspective, any new money that comes in at lower operating company level in a group is likely to prime the existing debt. If the assets are not being moved outside the banking group, any J-Crew protections will not stop the use of such assets as collateral. Consideration needs to also be given to the restricted payment and investment regime to understand whether assets can be leaked from the banking group and potentially be used to secure new money at an unrestricted subsidiary level.
Despite all the increased flexibility, we still expect companies to launch consensual processes that allow for new money needs to be provided by ad hoc groups of existing lenders as part of wider balance sheet restructurings.
With a number of companies already working through various solutions, the start of 2023 will see plenty of activity in the special situations and restructuring space. As discussed above, there are myriad drivers that mean we may continue to see such increased activity in this space throughout the course of the year. Dwindling government support along with the inability to continue passing costs through to customers and general consumer reticence as inflation increases all point to the fact that this could be a busier year than recent ones with insolvencies and court-led processes likely to be on the rise. This may be mitigated by the liquidity still in the market and general market sentiment. If the debt markets continue to offer little respite and refinancing opportunities, borrowers are going to have to get increasingly creative in fixing overly levered balance sheets and upcoming maturities.
This should be countered by the fact that many market participants expect the debt markets to reopen quickly and pricing to level out at more sustainable levels. At that point, all that will be needed is a narrowing of the bid-ask spread and deal volume to pick up. As history has shown, it only takes a few transactions for the markets to fully reopen and confidence to return.
 Private Debt Investor Platform.
 ‘Low US and European Default Rates Rising as Market Concern Lists Grow’, Fitch Ratings, 21 July 2022. Available at: www.fitchratings.com/research/corporate-finance/low-us-european-default-rates-rising-as-market-concern-lists-grow-21-07-2022.