Tue 02/14/2023 15:02 PM
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Chapter 11 filings are on the rise after the cash giveaway of the pandemic years, with bankruptcies rising 18% in the second half of 2022 from the first half, according to Reorg’s First Day. So far in 2023, 40 companies have filed for protection, a pace not seen since 2020, prior to the Covid-19 shutdown; of these, eight were middle market, with funded debt of less than $500 million, according to the First Day database.

However, the trading prices of leveraged loans and bonds remain, to a large extend, buoyed by the flood of liquidity that the Federal Reserve unleashed in response to the Covid-19 pandemic, and they do not adequately reflect the stress that many smaller firms are experiencing as they wrestle with high interest rates and elevated labor costs, according to lawyers, advisors and investors interviewed by Reorg.

Historically, a price below 80 reflected distress, signaling the recovery value of that particular instrument in the event of a restructuring. However, according to Stacy Tecklin, a restructuring partner at Glenn Agre Bergman & Fuentes LLP, in the current environment, the loans of many distressed companies are trading near par.

“In some cases a borrower may have hired a restructuring shop, but the debt hasn’t technically shifted to trading on distressed documents,” Tecklin said. “There’s a lot of distress in the market, it’s just not all trading at distressed levels.”

This means, Tecklin said, that market participants may be in for a surprise. “We’re going to see more defaults and more filings, which will trigger the distressed market,” Tecklin added.

Most economists and analysts agree that a recession, driven by the Federal Reserve’s hawkish tightening path in response to surging inflation, is in the cards. It’s not a matter of “if” but “when.” After the 25-basis-point hike announced Feb. 1, the federal funds rate is in a range of 4.5% to 4.75%, compared with the zero-to-25-bps level of the pandemic years. The yield curve, the historical recession barometer, certainly signals recession, with three-month Treasury bills some 120 bps above the yield on the 10-year Treasury note.

However, nonfarm payrolls, reported Feb. 3, showed that the U.S. economy added more than half a million jobs in January, according to Labor Department data. Wages increased by 0.3%, while average workweek hours ticked up by 0.3 hours. The report dashed the hopes of many for a near-term “pivot” by the Fed to looser policy.

This makes the outlook for middle-market firms even more challenging, sources say, leaving many of them trapped between the Scylla of higher coupon payments on their floating-rate debt and the Charybdis of higher wages. While firms have seen some relief from lower fuel costs and input prices, wages, as a rule, are much “stickier.”

Interest Rates and Liquidity Crunch

Middle-market companies are uniquely susceptible to rising interest eating into EBITDA margins. Middle-market companies issue debt in floating-rate loans, as compared with larger companies that can issue, or term out, floating-rate debt with fixed-rate bonds. The ongoing increases in SOFR, following fed funds, are squeezing the margins of middle-market firms.

According to calculations by Darius Mozaffarian, president and partner of White Oak Global Advisors, when rates were low, a typical 4.5x leverage business with 25% in EBITDA addbacks was using about 35% to 40% of EBITDA to pay off interest payments. Now, in conjunction with rising interest rates, interest payments are devouring close to 65% of EBITDA.

“Higher rates impair a borrower’s ability to service their debt and that sustained pressure is felt most by middle market companies, especially those with low margin businesses,” said Tyler Nurnberg, partner at Arnold & Porter’s bankruptcy and restructuring group.

Middle-market names also have a smaller pool of liquidity from which to draw. During the Covid years, larger companies pre-funded debt or bolstered balance sheets with some of the lowest rates in history, but those options were not generally as available for middle-market names. As Robert del Genio, senior managing director and co-leader of FTI Consulting’s corporate finance and restructuring segment’s New York metro region noted, larger companies “built up a larger liquidity war chest in recent years, giving them a cushion these smaller firms cannot afford.”

However, middle-market names could obtain relief from direct lenders, including special situations and distressed funds. Such firms are well stocked with “dry powder” and will likely be active in the middle market, given that smaller firms have less access to syndicated credit markets, according to Del Genio. This, plus a retreat by traditional bank lenders from the stressed middle-market situations, creates opportunities for newer and more limber funds.

Mozaffarian of White Oak, whose firm primarily focuses on nonsponsored direct lending, stresses the importance of asset-backed lending in the years ahead, while sidelining cash flow investments for specific industries and situations. By targeting asset-based lending against reliable receivables and putting terms in place to reject receivables from struggling payers, Mozaffarian and WOGA are fairly agnostic regarding the industries they deploy the strategy in, including cyclical consumer and industrial credits.

Direct lenders were largely absent from the last significant downturn in 2008 and 2009 and, as Del Genio notes, “have newer and cleaner portfolios and have the ability to approach middle-market situations with more flexibility than larger, regulated financial institutions.”

Direct lending is also an attractive option for all types of lenders in the current market. Group Head of Private Credit Jeff Abrams for ORIX USA views direct lending as one of the most interesting areas in which to deploy capital this year. It has gotten more attractive on a relative basis from a year ago as spreads have widened and protections are returning to documents for lenders. Direct lenders have amassed capital in recent years to be deployed in this type of environment, notes Del Genio, and many are staffed with the savvy lenders who are needed to monitor companies and traverse a downturn.

What to Watch

At the top of the watch list for many firms are industries exposed to the consumer. Wage gains are not keeping pace with inflation; a looming challenge for many firms is an expected cutback in consumer spending this year. 2022 ended with two months of negative consumer spending, according to the U.S. Bureau of Economic Analysis, or BEA, and the engine that powered an economic resurgence for much of 2021 and 2022 appears to be faltering.

With consumer spending representing some 70% of the U.S. economy, Mozaffarian notes, a pullback here could tip the economy into a recession. He also notes declining saving rates and rising credit card debt among consumers as precursors to a pullback in spending. For companies, this will necessitate a cutback in expenses and a focus on liquidity, potentially by reductions in force.

Sources are keeping a close watch on interest-rate-sensitive sectors, as well as those that are still waiting for the other shoe to drop. Bob Gayda, partner in the corporate restructuring and bankruptcy group at Seward & Kissel LLP, says he is keeping a close eye on hospitality, big-box retailers and real estate.

“One thing that really piqued my interest was the hospitality/real estate space, where a rationalization of those situations that hasn’t happened post pandemic - in the last two and half, three years - is finally becoming a reality,” Gayda said.

Del Genio echoed the concern around real estate, citing property types such as hotels, offices and senior living as those facing additional hurdles in the months ahead. In retirement communities alone, in 2022, from the start of the year through October, 17 communities reported covenant defaults, and six reported monetary defaults, as mentioned in a Reorg Industry Update last year. Pressures on this property sector and others will mount as real estate falls into a basket of rate-sensitive industries Del Genio is keeping an eye on, which also includes financial services, autos and others that are tied to mortgage rates.

The automotive and aerospace industries are interesting for another reason, according to Del Genio. There “middle-market companies supply parts for across vast supply chains. A default or restructuring in this industry could ripple to larger credits” he said.

Sponsors Step Up

Despite the grim outlook for the economy, most of Gayda’s clients, which include investment funds and managers, among others, say that the stressed environment could mean a boon for new opportunities across various sectors.

“I think that if you look at distressed deals in 2021, and 2022, they were few and far between. And so there was a ton of competition for those transactions and so you had a race to the bottom with respect to people providing rescue capital,” Gayda said.

That being said, Tecklin at Glenn Agre noted that despite trends over the past few years that benefited borrowers, such as covenant-lite documents, there are more agreements popping up which expressly benefit sponsors.

“In defense of sponsors, they’re usually the ones who step up to the plate when no one else would, and they are getting rewarded for that,” Tecklin said.

The protections that sponsors have in place to insulate themselves when things start to go south, Tecklin said, are also leading to a rise in creditor warfare or “lender-on-lender violence.” This combination of covenant lite and the majority position held by some sponsors (at times, to the detriment of smaller lenders) is leading to an increase in litigation, Tecklin said.

One example that has spurred recent litigation is the Wesco Aircraft restructuring transaction, in which the company issued $250 million super senior notes due 2024. Bondholders have sued to void the transaction, alleging that it “favored” holders of the new notes, including equity sponsor Platinum Advisors, as reported.

For now, sponsors appear to remain ready to step in to support their portfolio companies, according to Abrams of ORIX USA. In the majority of difficult situations in the general market over the past six to nine months, sponsors have stepped up to support the companies with liquidity injections or incremental capital raises.

Naturally with a downturn, sources expect the willingness of sponsors to support companies to recede. Nurnberg of Arnold & Porter said something lenders are looking for in restructurings as of late is sponsor support, among other things.

“One is they are looking for material pay-downs to reduce their exposure, either to a borrower or in some instances to reduce industry exposure,” he said. “In addition - in instances where borrowers have an equity sponsor - lenders are asking those sponsors to increase their investments to improve liquidity and take some of the pressure off the borrower.”

In 2022, Abrams notes, private equity transaction volume was depressed, but those deals that did happen happened at a healthy multiple, giving sponsors the confidence to support businesses. How 2023 shakes out will in large part depend on the broader economy and duration before the Federal Reserve alters monetary policy after tightening over the past year. If the second half of this year brings a soft landing or a Fed pivot, Abrams says, sponsors will have more confidence to support teetering businesses.

If a tighter environment persists longer, triggering a recession, many sponsors will be forced to sell at depressed multiples, creating a cascading effect where sponsors become more reluctant to support struggling businesses.

And sponsor support may become even more vital, as lenders are less inclined than they were even six months ago to “amend and extend” existing loans following a covenant default, said Nurnberg. With secondary loan prices depressed, lenders might also have to more seriously consider restructuring efforts, he added.

–Geoff Burrows, Ellen Schneider
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