Corporate restructuring: living in the bubble

The last 12 months has seen around 23% of UK listed corporates issuing profit
warnings, the highest annual count since the impact of 9/11, SARS and the foot
and mouth outbreak.

Underlying inflation is above the government’s target of 2%, broader price
inflation measures are forecast to remain above 3% and interest rates have
increased three times since August 2006 and are widely expected to continue to
rise further in 2007. The prognosis further afield is not that great either as
continental Europe is forecast to show only modest (sub 2%) GDP growth in the
major economies.

The US economy too is facing a potential hard landing as a result of the
collapse of residential house prices that is having a consequential impact on
consumer spending, the mainstay of the US and the global economy, accounting for
approximately 30% of worldwide GDP.

Despite this level of corporate profit warnings, driven by sluggish growth,
an increased cost environment and expectation of rising interest rates,
corporate restructuring activity is very close to an all time low, with global
defaults at less than 1% against a long term average of around 4%.

Breaking point

Can this state of affairs continue? Certainly the major investment banks and
hedge funds operating in ‘alternative’ investing appear to expect defaults to
rise and so restructuring activity to pick up.

There has been a spate of ‘rainmaker’ poaching and defections in the past few
months as institutions seek to create experienced teams in readiness for a
downturn which, when it comes, is expected to be wholly different from anything
seen in previous cycles.

This suggests three important questions: what is holding down default rates?
what might drive up default rates to at least the long run average of around
4%?; and what shape will the next wave of restructurings be?

The major factor in holding down default rates in the current cycle is the
huge amount of liquidity allocated to ‘alternative asset’ classes (for example
private equity, CDOs, CLOs). This is the direct result of asset managers seeking
to diversify from equity and bond markets to higher yielding asset classes.

This, in part, is due to the low level of volatility in the equity and bond
markets – the average closing position on Vix (the Chicago Board Options
Exchange Volatility Index) in 2005 and 2006 was 12.8, around 17% below the 2004
average.

A lot of this money is finding its way onto the debt capital markets –
investment in junior tranches of senior debt (B and C), junior debt (mezzanine,
bonds) and the emergence of new debt asset classes (second lien, PIK, PIYC) by
institutional investors has increased dramatically in recent years.

The growth in second lien investment by additional investors from 2004 to
2005 was around 160%. In the first nine months of 2006, there was further
growth.

This wall of money has had a number of far reaching consequences: yields have
fallen dramatically; leverage has reached new highs; debt structures have become
more complex and repayment deferred; and banking covenants are increasingly
‘light touch’.

High level impact

The impact of this is that even if a corporate underperforms against the
original investment case, it is unlikely that it will default – any covenants
available to lenders are likely to have significant headroom and the longer term
of most debt structures means that there may be no significant cash call on the
corporate for two to three years post investment.

As a result, the liquidity is driving default down by the nature of the
‘generous’ terms in the debt capital markets. Even in those cases where default
looks likely, the market is so liquid that corporates can simply refinance –
often avoiding an otherwise impending default but taking on greater leverage at
lower pricing and with (usually) lower covenants. As a result, the new issue
market is effectively a refinance market at present.

The question of when the downturn will arrive is really a question of what
will cause this liquidity to dry up. A single credit crunch or large default is
of itself unlikely to trigger a wholesale withdrawal of capital.

The Ford / GE credit event in May 2005 – where parts of the capital markets
anticipated announcements of proceedings in those businesses – was shrugged off
in the credit default swap markets in a matter of days.

The collapse of a hedge fund could cause investors to bail out of alternative
asset classes – but the collapse of Amaranth in September 2006 following more
than $6bn (£3bn) of losses in the gas derivative markets, causing the
liquidation of over $2bn of secondary debt positions, passed by unnoticed in
terms of the continued flood of money into the system.

Recently, market theorists have reported a correlation between forward
long-term interest rates and current equity volatility – this points to a rise
in equity volatility (increased risk, enhanced returns) over the next 12-18
months.

This would tie in with the beginning of cash repayments on recent leveraged
finance deals (over 90% of all European LBOs were funded within the past three
years, and most will have the first significant amortisation after two or three
years).

So, if money moves back to equity when volatility increases to the point that
decent returns are available, and this takes money out of the debt capital
markets, reducing the ability of underperforming corporates to refinance their
way out of trouble, we could see an upturn in activity.

Increased complexity

While it is difficult to see when the next upturn in restructurings will
come, we can be certain that how restructurings will be conducted will be
different from previous downturns.

The emergence of increasingly complex debt structures, coupled with the
emergence of CDOs/CLOs, credit default and related derivatives and an active
below par secondary debt market, has brought a new breed of stakeholder to the
negotiating table and often these new stakeholders will have a widely different
agenda to the original stakeholder group. Careful management of the situation by
experienced workout professionals is essential in delivering a successful
outcome.

In the meantime, restructuring teams remain busy on a sector basis, with
automotive supply, retail, packaging and chemicals expected to be busy over the
next 12 to 18 months.

Keith McGregor is a corporate restructuring partner at E
&Y