Overleveraged But Not Overly Worried

A mountain of corporate loans and related debt obligations is coming due through 2012. This so-called wall of debt has been expected to accelerate the pace of distressed asset sales as more and more overleveraged companies meet their day of credit reckoning. Instead, what had been a torrent of bankruptcies and distressed asset transactions in the marketplace is now slowing to a relative trickle. Understanding why—and taking appropriate measures immediately—can help debt-heavy businesses buy time.

According to Dealogic, some $2.5 trillion in corporate obligations is coming due between 2010 and 2012. Much of this debt takes the form of three-to five year facilities opened prior to the financial crisis. At that time, banks had the capital to lend. But the ensuing credit crunch has brought dire predictions about the fate of businesses forced to refinance over the next two years.

A frequently-aired scenario suggests that with so many banks facing balance sheet constraints of their own, it will be difficult if not impossible to provide rollovers or similar financing at anything close to prior rates, let alone principal amounts. The situation would seem to be exacerbated by broader economic conditions. The global economy may be showing signs of life, but so far, recovery is fragile at best. Markets may in fact be poised for a protracted era of merely anemic growth or even double-dip recession. The expected outcome in such circumstances: a likely second wave of distressed assets as overleveraged companies find they cannot obtain affordable financing.

Surprisingly, this worst-case scenario (for credit-hampered businesses) or best-case scenario (for buyout firms in search of distressed assets) is proving slow to materialize. In particular, three factors are delaying the anticipated pain: an economic upturn, though slow and tentative; a boom in high-yield debt; and bankers’ unexpected flexibility.

Delaying The Inevitable?

The financing wall is real. But so are the forces combining to reduce its impact. First, economic recovery, though precarious, is again propelling corporate cash flows and in many cases profitability. Look at nearly any industry to find numerous examples of companies both large and small that are back in the black or well on their way.

This is not to say that all such companies—especially those with major financing events looming in the near future—are out of the woods. Many overleveraged firms may be squeezing by with the help of cost-cutting that is likely unsustainable or by means of other, similarly short-term-focused actions. Still, the resulting improvements in operations and liquidity mean that more are looking at least somewhat healthier. Naturally, this tends to reduce pressures that might otherwise prompt these companies to sell assets in fire sale fashion or even force bankruptcy.

Next, a seemingly voracious appetite for high-yield debt is providing companies with still more essential liquidity. After reaching $154 billion in 2007, UBS reports that high-yield debt issuance fell to US$53 billion in 2008. In contrast, today’s market seems to crave these securities. In 2009, high-yield debt issuance rose to $174 billion. Moreover, in just the first three months of 2010, issuance reached a blistering pace of $69 billion. In short, investors are not only hungry for high return, but are willing to take on this marketplace’s heightened refinancing risks.

How long will the high-yield debt surge continue? No one knows for certain. Thus, the takeaway for corporations facing any significant refinancing event in the very near future is that the time to act is now. No, the business plan may not have called for the issuance of high-yield debt. But unquestionably, this is a tool that can be used to extend the maturity on the debt portfolio, essentially buying time until cost-reducing operational improvements or a top-line enhancing general recovery can kick in.

A third force in today’s marketplace—equally surprising—is the degree to which banks are cooperating with corporations to extend loan maturities or otherwise restructure debt portfolios. Those viewing the debt wall as a likely driver of further distressed asset sales reckoned that banks would have very limited capacity or willingness— to do so. But with the notable exception of real estate loans (where foreclosures are still a reality), banks appear to be far more flexible than anticipated.

Perhaps this is driven by a view that the economy is improving and that if corporate debtors can be given just a bit more time, they’ll be able to repay their obligations. Alternatively, it could mean that banks simply are not ready to accept potential substantial write-downs and losses should they default rates accelerate on loans. In either case, this is a largely unanticipated scenario. And it is by no means certain how much longer such a forgiving and cooperative environment can persist.

What Now?

For now, fewer distressed assets will be hitting the auction block. For those in the specific business of distressed asset acquisition, that means opportunities will be scarcer and deals more competitive, at least for the time being. Meanwhile, highly-leveraged companies—and buyout firms whose portfolios contain debt-challenged holdings—have been handed a lifeline. What these groups do with the gift of time and the tools available will likely determine their success over the next one to three years.

Credit-starved companies should take immediate advantage of today’s unexpected opportunities. This begins with a critical review of maturing debt obligations to understand how much debt is coming due and when. Next, the goal is simply to extend these debt horizons further into the future. Work with creditor banks to negotiate rollovers or additional financing. Pursue the issuance of high-yield debt. But in both cases, do so with haste because no one can be certain how long such windows can remain open.

Extending the financing horizon buys time for the business entity to improve its performance. The next step, then, is to begin a program of operational restructuring and enhancement. Debt-laden standalone corporations as well as buyout specialists whose portfolios include overleveraged acquisitions should comb their fundamental business operations in search of measures that can reduce costs, boost earnings and generally improve performance.

An important place to start is with working capital management. Companies that take the time to look more closely at this issue are often surprised by how much capital is needlessly deployed throughout the organization. This may take the form of excess inventories, underutilized capital equipment or even excess receivables. With a more disciplined approach to working capital, companies can reduce the total capital deployed, thereby trimming their total financing needs.

Other Focus Areas

Firms also should use any added time to take another look at their cost structures. For most, the simplest cost-cutting measures to implement (though often the most painful) have already been taken. For example, almost certainly, payroll and many other cost elements are already at a bare minimum. However, many such actions may have been taken out of a sense of dire need as opposed to reflecting the requirements of an ongoing enterprise. Moreover, companies cannot “cost cut their way” to a new capital structure.

With refinancing pressure somewhat abated, now is the time to right-size cost choices. That is, companies should seek to create a cost structure that might take a bit longer to implement but that is more strategic and sustainable—and therefore more attractive to investors down the road. In particular, now may be a good time to consider creating more of a variable cost-based business by outsourcing non-core business processes.

The supply chain is another place to seek operational improvements. Look here for opportunities to negotiate lower prices or higher degrees of service for the same cost. Through closer collaboration, it is often possible to find the means to reduce costs for both customer and supplier. By sharing production schedules or sales forecasts, for example, both entities may be able to operate with leaner inventories.

Not to be overlooked is the possibility of deleveraging through the sale of non-core assets. Such a move may do more than merely reduce financing needs. It also can sharpen management focus, making it easier to drive profits from core assets, and improve the ultimate attractiveness of the remaining business. While considering such a move, don’t forget to consider various alternative structures such as a tax-free spinoff. Although meeting the requirements for tax-free status can be tricky, such structures can be highly effective in realizing greater value from various assets.

Act Now!

Bad news for those specializing in the acquisition of distressed assets: Te pipeline, at least for the time being, is slowing. But the causes of this phenomenon bring great news for overleveraged, standalone companies or buyout firms with one or more debt-heavy investments in their portfolios. In the face of the imminent wall of maturing debt, capital market forces are granting respite.

Smart investors will act now. This begins by speaking with banks that—at least for now—appear willing to extend maturities or perhaps offer other concessions or adjustments that relieve refinancing pressures. Strong action may also include the flotation of high-yield debt. In both cases, there is no time to waste, as either source of refinancing capital could dry up in a heartbeat. Finally, use the time to implement an array of operating improvements. Revisit everything from working capital needs to cost structure, supply chain and perhaps even potential partial divestment.

For highly leveraged companies, asset sales will no doubt be essential to long-term survival. Given a recovery that is tepid at best, very few of the significantly debt-laden firms will be able to grow into their current capital structure. The marketplace seems in need of the sort of fundamental restructuring that is often best accomplished through M&A. Thus, while acting now to extend the maturity on their debt portfolios, debt-heavy companies should prep for deleveraging through divestment over the next six to 18 months. While today’s conditions may stave off fire sales and bankruptcies for now, overleveraged companies should understand that they are on “borrowed time.”

Michael Scott is a partner in Ernst & Young LLP’s Transaction Advisory Services U.S. Restructuring Services Group. Based in Dallas, he works with companies and their creditors to develop operational and financial restructuring solutions. He has worked across a broad array of industries, including financial services, oil and gas, retail, wholesale, healthcare and manufacturing.