😎What to Make of the Credit Cycle: Pros Say😎
A deluge of Fed-infused cash ended the party before it really got started.
In Sunday’s Members’-only edition, “💥The Default Rate Ticks Down💥,” we discussed the craziness that is going on in the markets these days. Among other things, we noted how (i) Oaktree Capital Management’s Howard Marks now advises caution after a short-lived bullish fever, (ii) SVPGlobal’s Victor Khosla is optimistic that 2021 will be rife with distressed investing opportunities, and (iii) JPMorgan Chase & Co.’s ($JPM) 2021 high yield and leveraged loan default outlook looks a lot more tempered than people might have expected just mere months ago. The pandemic is surging and people are losing their marbles but, hey!, the equity and capital markets are raging so, like, whatevs. 🤷♀️
To help make some sense of it all, we reached out to some of our Members to hear directly from them what the hell is happening here. We started by asking the following:
“What has been the most surprising theme/situation you've followed and/or experienced since the pandemic hit?”
We had one rule: “smart brevity” (to borrow from Axios).
You can be the judge as to whether the responses were one or the other or neither. 😜
Image courtesy of Rachel Albanese
“The willingness of leveraged credit markets to take a flier on some really high risk credits continues to amaze me. The number of CCC/C rated issuers has doubled in 2020 but yields on that rating cohort have fallen by 300 bps since January despite elevated economic risks. This makes little sense to industry veterans like me, while huge volumes of low rated debt issuance have really put the brakes on this default cycle. Market commentators and the media punditry have devoted considerable verbiage trying to justify these huge rallies based on fundamentals, but that’s a stretch—it’s all liquidity-driven. The only fear in financial markets these days is FOMO.” — Michael Eisenband, FTI Consulting Inc.
“Most surprising situation I have followed: Mall owners (by themselves or in partnership with a brand management company like Authentic Brands Group) buying out of bankruptcy some of the big name retail brands that populate the malls. It’s a bold move and time will tell whether it is successful. Most surprising experience: The post hoc realization that I had filed the very first chapter 11 case in the country attributing COVID-19 as one of the factors that led to the bankruptcy (Valeritas).” — Rachel Albanese, DLA Piper LLP
“The irrational exuberance for shares of bankrupt companies that resulted from unprecedented day trading by retail investors. It made bitcoin feel so 2019.” — Vincent Indelicato, Proskauer Rose LLP
“Between the (i) PPP loan money providing pandemic bridge funding, (ii) regulators giving commercial banks a 6-month free pass on downgrading credits, (iii) commercial banks being cautious of the bad PR of aggressively enforcing rights against a company that received government funds (i.e. PPP “grants”) during a pandemic and (iv) the near total stagnation of distressed company sale transaction due to the huge economic uncertainty of the pandemic, distressed consulting work has ‘unexpectedly’ dried up in Q2-Q4.” — Dan Dooley, MorrisAnderson
“Lender on lender aggression and intra tranche warfare in out of court restructurings. To the surprise of many the unwritten rules for honor among similarly situated lenders have been increasingly tossed aside.” — Sarah Borders, King & Spalding LLP
“Continued expansion of credit in percentages exceeding the expansion of my waistline.” — Sean O’Neal, Cleary Gottlieb Steen & Hamilton LLP
“I’ve been pleasantly surprised by the resiliency of some industries and the way leaders have flexed quickly to mitigate the disruption they’ve experienced. Some of that was likely muscle memory from past restructuring cycles but even there the leaders recognized the need to run a play quickly. In automotive, this was certainly the case and a good example of quick action proving very effective in mitigating some of the risks. Others have gotten creative and government subsidies around the world have been important as has the fact that credit markets stayed open.” — Pilar Tarry, AlixPartners
“2020 has been quite the banal year; after all, who among us could not have predicted the Kobe crash, that everyone in the world would be locked in their homes, that the bedrock of our democracy would be challenged, and that the Four Seasons doesn’t only denote a luxury hotel in Houston with a fantastic golf simulator? All of my predictions and dreams of 2020 came true, with very little surprises. All kidding aside, within our field, perhaps the most surprising theme of 2020 (to me) is that bankruptcy courts now will truly question the “independence” of independent directors. And I view this as a positive development; given that the same subset of professionals show up in many of the large chapter 11 cases, it’s important that bankruptcy judges continue to look past titles to determine whether the substance of their findings are appropriate. This requires all of the restructuring professionals to continually evolve how we approach cases, improve on past practices, and ensure the integrity of the bankruptcy process. In other words, we must actually deserve the $1,500+ rates that many of us now demand.” — Daniel Simon, DLA Piper LLP
“Access to cash. Other than the pandemic itself being the most surprising situation we, as Americans (and, more globally, as a people), have faced in our lifetime, the amount of “helicopter money”from the U.S. Government available this year has been outstanding. In addition, an incredible amount of capital has been deployed through the private equity markets as a way for investors to likely take advantage of low-asset valuations in certain sectors.” — George Klidonas, Latham & Watkins LLP
“No one really has a clue how to value a business with the COVID trough. This can be used as an aggressive tool by companies to threaten cram down at temporarily absurdly low valuations. But savvy lenders can also try to structure a bankruptcy process where the temporarily low value makes them the fulcrum. This fight means so called valuation experts have to convince the court about the present value taking an unknown future into account. Retail, malls and restaurants are the obvious candidates for this gamesmanship.” — Randall Klein, Goldberg Kohn
“The prognostications of the restructuring industry. An inevitable recession has been coming for 3 years now, but on Thanksgiving Eve 2020, the Dow surpassed 30,000 for a brief minute. When the pandemic hit, there were plenty of great quotes about the imminent wave of bankruptcy filings that would overwhelm the restructuring industry. Outside of oil and gas, which was screwed before the pandemic, that wave has not materialized. Reminds me of being disappointed in the waves at the Jersey Shore as a kid after seeing Point Break!” — Chris Ward, Polsinelli
“One is the number of non-restructuring folks that expected wave after wave of chapter 11 filings early on in the pandemic when those in the restructuring community knew that the significant uptick in chapter 11 filings (other than those companies/industries already on the precipice) typically trails black swan events like the pandemic. The second is the willingness of lenders/borrowers (outside of industries that were already distressed (e.g., retail/O&G) to work together to ride out at least the initial shock and cash crunch associated with the pandemic.” — Adam Paul, Mayer Brown LLP
“I think the positive impact of the the Cares Act/PPP flattened the economic curve much more than I thought it would heading into the summer. Many borrower’s management teams and advisors responded aggressively to take advantage of that respite. Specifically, I think the impact of the consumer stimulus was palpable across the economy and either resolved many issues, or significantly kicked the can down the road.” — Lawrence Perkins, SierraConstellation Partners LLC
“I’ve found the extent to which the sponsor and/or management’s relationship with lenders has impacted a Company’s ability to weather COVID somewhat surprising. Because so many lenders are facing an increased demand for concessions like deferred or PIK’d interest and requests for liquidity infusions, lenders have been forced to choose among companies that they want to continue to invest in and support. In a time when there is so much uncertainty regarding what the world will look like on the other side, we’ve found an increasing number of restructuring outcomes depend on relationships; if lenders have a good relationship with the sponsor, they’re willing to kick the can down the road – give covenant waivers, a quick liquidity infusion, or even agree to a fulsome restructuring that provides upside to the sponsor. If not they get aggressive and put pressure on the company – force a sale, sweep the board, etc.” — Cristine Schwarzman, Ropes & Gray LLP
“On a macro level, the greatest surprise was the “great divide” the COVID-19 pandemic caused our nation. Historically, crises have brought us together as a country. Except for the well-deserved, unified support for our first responders and healthcare heroes, this is the first time, in my lifetime, that a crisis at home and abroad drove us apart. On a micro level, while there are losers (hospitality, airlines, movie theaters) in the economic meltdown, there were a surprising number of winners that resulted from the pandemic (e-commerce, home improvement, at-home fitness), that we generally would not expect to see in an economic recession.” — Steven Korf, ToneyKorf
“In the market, it was how quickly we went through three distinct mini-cycles. In the first few months of the pandemic, it was all hands on deck, and we all found ourselves working around the clock. Companies were suddenly in a zero- or low-revenue environment and needed emergency liquidity or covenant relief; creditors across capital structures were working together to stabilize and save businesses. Then, we transitioned into a second mini-cycle as these stabilized businesses addressed medium-term questions: What does a right-sized capital structure look like in uncertain times? How do we convince twice- or thrice-burned credit investors to take part in yet another rights offering to provide long-term liquidity?
And now, with most impacted companies having been stabilized – and with investors and advisors alike having rested up a bit – we are right back to a wave of opportunistic refinancing and liability management transactions.
Additionally, creditor-on-creditor crime is back in vogue. We observe sponsors (and even public companies) using white-hot credit markets to craft and then utilize advantageous documents, bankers proposing ever-more-complicated capital structures, and investors – tired of being on the receiving end of aggressive maneuvers – organizing early to either defend themselves or get a piece of the action.
So the most surprising thing to me in the market right now is that – even as we prepare to lock back down for a few months, and as unwieldy capital structures teeter under debt loads that have only gotten worse in 2020 – the credit markets rage on, like I am sure we all wish we could at this year’s nonexistent holiday parties.” — Damian Schaible, Davis Polk & Wardwell LLP
“Aside from the fact that my older colleagues are so Zoom-proficient? I've been amazed at the reaction of markets in 2020 — commerce has been upended the world over, political volatility and protests at a fever pitch for most of the year — yet my adjacent screen is showing the Dow breaking over 30,000 and credit markets are white hot. A lot of market principles are standing on their head right now.” — Lance Gurley, Stephens Inc.
“The most surprising theme for me has been brand loyalty going out the window in the early days of the pandemic - in times of shortages (of paper, flour, cleaning supplies), any brand and any location became good enough. That's already starting to have interesting ramifications for manufacturers and sellers in terms of product line breadth and redundancy. Second place, more people are playing guitar!” — Ted Gavin, Gavin/Solmonese
“I’m impressed by how quickly and easily an industry full of hard-charging, type-A personalities has shifted to zoom calls, wearing golf shirts and with kids and pets running around in the back. I think since we’re all in the same boat, no one fears looking like he’s not the most focused person or working harder than everyone else. I think it might be the most significant silver lining in this whole situation.” — Jon Tibus, Alvarez & Marsal
“The massive liquidity injection by the Fed into markets unprecedented in that it allowed the Fed to buy corporate bonds directly to prop up markets, including junk rated bonds. This has allowed hundreds of companies to borrow from the bond and loan markets even though those markets don’t have a good sense of how COVID will impact long term leverage. Essentially, the market has ignored COVID and is looking to 2021.” — William Derrough, Moelis & Company
“Adaptability. The major theme has been adaptability. The companies that were able to quickly adapt business models have been able to gain market share and thrive. For example, an accelerated move to e-commerce and buy on line pick up in store (BOPIS) have allowed certain retailers to gain share.
Flexibility with Chapter 11. The flexibility judges are giving debtors that contradict Chapter 11 as we know it like deferring contractual rent. It has been surprising what companies have been able to get and what has had to be shared with the Courts to get such flexibility.
Thriving Businesses. While some businesses are suffering, many are thriving. Consumers are forced to stay at home and have found all sorts of ways to spend money. Some of this could have been predicted due to short-term demand spikes (e.g., canned good, Lysol), but other less predictable and maybe more permanent (home offices, home gyms/Peloton, vacation at home) that will have interesting impact past post-COVID.
Capital Markets. Many institutional lenders pulled back on capital when COVID first broke out, but the capital markets stabilized quickly and many capital providers quickly realized the pendulum swung too far. Now lenders across the capital structure are being increasingly creative to deploy capital in the market. For borrowers seeking to raise new or incremental financing, expect questions on business durability, particularly in light of further shut downs.
Buyers of Businesses. Non-traditional buyers have been increasingly active and deep pocketed buyers of distressed assets, particularly in the consumer space. We’ve been surprised by higher than anticipated proceeds in a number of recent situations. We’re currently working with companies to assess how to better leverage their IP assets outside of a process to generate incremental liquidity or better position the business to realize value.” — Bob Duffy, Berkeley Research Group
“When I joined Paul, Weiss earlier this year, every day seemed like its own adventure. It wasn’t just the seemingly endless stream of restructuring advisory work—it was the striking sense of urgency that appeared to be the new normal. There was economic turmoil across the board, and it felt like that would continue for the rest of 2020. But as it turns out, while there has certainly been a lot of Chapter 11 activity since the pandemic hit, parties have also pursued a wide range of refinancing, recapitalization and out-of-court restructuring options – not just revolver drawdowns and requests for covenant relief, but also new (often short-term) debt, equity raises and PIPEs or preferred equity investment by sponsors – to support and create runway for companies impacted by the pandemic. And as you’re not shy to note, some of these companies have accessed markets more than once since the pandemic hit and will likely need to access the markets again—or file—before it’s over.” — Andrew Parlen, Paul Weiss Rifkind Wharton & Garrison LLP