As we hunker down at home in an unprecedented time of worry and unpredictability, I cannot help but wonder if any business with any type of credit exposure will emerge from the COVID-19 pandemic totally unscathed. And if the numerous off-the-record conversations with alternative lenders and other capital markets experts I’ve had in recent days are to be taken at face value, I probably shouldn’t confine the application of this thesis to corporate borrowers. Everyone in the capital stack is likely to feel the heat: senior lenders, second lien lenders, bondholders, and equity sponsors will all realize some peril. And, to be safe, we should add landlords, mortgagees and trade creditors to the list while we are here. It’s messy.
Compounding the enormity and velocity of the economic impact of the virus are the dizzying array of government loan programs, backstops, grants and other possible forms of relief that are emerging and evolving minute by minute. These new sources of subsidy and liquidity—which are making us all involuntary participants in modern monetary theory overnight—may be available to some of COVID-19’s economic victims but not others. There are so many questions, with answers continuing to develop in real-time.
For bankruptcy and restructuring professionals, it is a time of consternation as even the most time-tested of traditional strategies can’t be presumed to be reliable. We are, at least arguably, entering a completely new era with new rules, new timelines, new modes of valuation, new “players,” and, perhaps most significantly, a dramatically different buying market for distressed assets.
The list of technical FAQs grows longer with each passing day. Can businesses with little or no revenue forecasts be financed at any level? Will existing secured lenders be subordinated (by force of law or necessity) to “emergency” loans? Should vendors extend trade credit anymore? Will landlords default on mortgage covenants for lack of inbound rents? Will the OCC relax Dodd-Frank bank balance sheet regulations to give regulated lenders more flexibility with troubled credits? Will loan covenant defaults really be enforceable any more? Will there be any distressed asset buyers if deal financing dries up?
Answering these questions with any degree of confidence will take time—something nobody seems to have at the moment. But one very broad-stroke outcome is almost certain to emerge in many post-COVID-19 distress scenarios: creditors will end up owning some stake in their borrowers or holding “debt” that looks very much like… equity. To put it a different way, many in the capital stack will be bumped down a rung or two.
In the restructuring and structured finance world, we often see companies emerge from Chapter 11 or out-of-court restructurings with squeaky clean balance sheets that are the product of a true “debt for equity swap.” The concept is simple enough: noteholders or anyone else holding true “debt” get demoted down the capital stack and—forcibly or via agreement—end up owning equity in the debtor in lieu of fixed-income debt. They get to participate in the upside-down the road (dividends!), but lose the security of contractually mandated debt service (payment of interest and/or re-payment of principal). As debtholders move down the stack, they raise their risk tolerances for want of a better option.
But debt-for-equity can come in many other forms, and I believe we will see “swaps” wearing many different labels as the ultimate end game in many restructurings in the coming months (years). Noteholders will be forced to trade notes with fixed cash interest terms for cash-flow notes, PIK notes with huge balloons and other features that ultimately yield something that looks more like a dividend on equity rather than interest on debt. Creditors of many persuasions will become literal or de facto owners, with their abilities to recover on their original extensions of credit tied firmly to their borrower’s go-forward prospects.
This means that in many upside-down balance sheet situations, existing equity will need to recognize that they will be wiped out. But business owners (especially those who are active in management) should not presume that all is lost in every case: there will be many situations that present an opportunity for “old” equity to participate in “new” equity post-restructuring.
As business owners, lenders, landlords, vendors, and other stakeholders assess this burgeoning and truly unprecedented crisis, it is our role as professionals to triage each client’s individual circumstances and develop a pragmatic strategy that, in the immediate term, prioritizes liquidity, endeavors to keep people employed, and preserves going concern value. For borrowers and issuers, a significant and high-priority component of this triage approach will include the use of government loan and stimulus programs, in real-time, as they become available.
Stuart Laven is a bankruptcy and restructuring attorney and a Shareholder in the firm. He represents corporate debtors, senior lenders, private equity funds, strategic acquirers, and other significant stakeholders in all phases of the Chapter 11 process, as well as in non-bankruptcy and out-of-court restructuring alternatives. He has represented major constituencies in restructurings, asset deals and distressed financings in jurisdictions nationwide in a variety of industries, including health care, transportation, automotive, telecommunications, commercial real estate, retail, construction, and pharmaceuticals. Mr. Laven devotes a portion of his practice to representing lenders and agricultural restructurings and bankruptcies across much of the Midwest, including all U.S. Bankruptcy Courts in New York, Ohio, Michigan and Wisconsin. He is the founder and author of The Farm Bankruptcy Blog.