The Connection Between Inflation and Restructuring
As inflation accelerates at a pace not seen in the past forty years and equity markets continue to whipsaw, it’s worth thinking about what the ramifications will be for restructuring activity and the world of distress more broadly.
Given that I’ve had virtually no free time over the past few months – which may give away the answer as to whether there’s at least a tangential connection between heightened inflation and restructuring activity – these will just be a few notes for you to consider.
My underlying assumption is that if you were to ask most people in finance whether they’d expect greater restructuring activity and generally distressed situations to arise in an inflationary environment they would say that this is obviously true and that an impact would be seen quite quickly.
Directionally, this strikes me as being correct. But it likewise strikes me that persistently high levels of inflation, matched by rising yields, won’t result in as immediate and large a rebound in restructuring activity as many think. Further, it will require a shift in mindset regarding what options are really on the table for right-sizing debtors and who to keep your eye on when doing distressed screens.
To that end, let’s briefly cover some ways that inflation can cause an uptick in restructuring activity (one related to dealing with maturity walls, one related to general liquidity).
Dealing with Maturity Walls in an Inflationary Environment
Over the past nearly two years we’ve had unprecedentedly tight credit markets matched by a massive inflow of capital to private credit and direct lending funds. Predictably, as everyone chased whatever modicum of yield they could get, many out-of-court and in-court situations resulted in debtors maintaining high leverage, while also getting the benefit of looser credit docs and lower cash interest payments.
In fact, you have cases like Pennsylvania REIT that emerged from chapter 11 in December of 2020 with a higher level of leverage than they had pre-filing. SVP – that ended up becoming the majority owner of another REIT, Washington Prime Group, through their chapter 11 process in 2021 – held a relatively small secured stake in PREIT and initially objected to their PoR saying it lacked feasibility and would set them up for having to file again shortly (which seems prescient given that PREIT just recently issued a going-concern warning!).
While more nuanced due to the settlement issue involved, Mallinckrodt will also emerge from chapter 11 with slightly more leverage than it went in with based on their current Plan.
Anyway, what we’ve seen over the past few months is the beginning of a reversal in high yield and distressed debt spreads. For example, CCC-rated spreads have widened ~150 basis points since the beginning of the year (remember this is the spread off the treasuries curve, so the actual yield on distressed paper has risen sharply when accounting for the rise in treasuries in conjunction with the widening spread).
But what’s more interesting than what we’ve seen in secondary market pricing is what’s happening in the primary market.
Just $900m of high yield debt priced last week, bringing the total for the first three weeks of April to just $6b. This is the slowest pace of pricing since April 2008. Further, consensus forecasts for high yield pricing this year are continually being slashed and now stand at around ~$250b (whereas $450b priced a year ago with yields on issuance being at a record low of ~4.8%). What is pricing right now - like the unsecured notes tied to the buyout of Oldcastle - is being done at a steep OID with a yield of 11% (proving that even when things are getting priced, they aren’t getting priced well).
This is all compounded by dealer inventories being incredibly low and with dealers actually being net short high yield. The wariness of banks to hold rate-sensitive paper is also reflected in more general measures like HYG, which has seen outflows of more than a third from its peak (it's now back to early 2019 levels).
Anyway, the point is that no one likes to try to catch a falling knife, and right now we’re starting to see the signs that stressed (or distressed) debtors are no longer going to be able to push back maturity walls as easily as they have over the past few years.
What we’ll likely see moving forward is out-of-court and in-court deals that involve substantially more equitization, higher yield on any new money debt, more aggressive tactics by creditors via looking to do non-pro-rata uptiers or asset transfers, and potentially the return of tighter term sheets (although my personal view is that we’re in a new normal when it comes to term sheets – everyone just cares more about initial pricing).
Where you’d expect to see this first play out is with struggling sponsor-backed companies, which is what we’re now seeing with a few different debtors. For example, right now there’s a battle brewing over Envision Healthcare – backed by KKR and being advised by PJT – over how it’ll move forward even though it has a reasonable liquidity position currently. PIMCO is looking to transfer assets to an unrestricted sub to lend against, which existing lenders are (predictably!) not thrilled about the prospect of (sending assets to an unrestricted sub is explained in the Serta case study in the members area, if you're curious).
Likewise, with Service King – backed by Blackstone, being advised by PJT on the debtor-side and with HL and Evercore advising two different groups on the creditor-side – it looks like we’re going to see an out-of-court deal with substantial equitization and a bit of new money placed.
Ultimately, deals still need to get done, credit funds need to deploy cash, and banks need to make markets. However, to use a very Bloomberg-daytime-television cliché, with inflation starting to bite everyone has suddenly adopted a much more defensive posture. No one likes holding a sizeable, not overly liquid, piece of a debt priced at a yield of 5% that’s now at 8% and rising.
Dealing with Working Capital Pressure and the Idiosyncratic Nature of Inflation
As we’ve observed over the past year, inflation doesn’t touch every industry equally and likewise it doesn’t affect the underlying economics of every company in a given industry equally (see: Talen Energy and their large hedging losses).
For example, most distressed investors will have some healthcare providers prominent on their screens right now -- including names like Envision Healthcare, TeamHealth, Smile Direct Club, and Air Methods.
Recently healthcare providers have been squeezed not only by higher wage pressures than many other industries – for understandable reasons, given the strain on front-line medical workers over the past few years – but also by the rapid uptick in pricing for medical equipment. Further, some healthcare providers also face the uncertainty surrounding the No Surprises Act, which is meant to protect consumers from unanticipated out-of-network costs (although how it'll actually be implemented is still somewhat uncertain).
For companies that don’t have the capacity to manage down their working capital requirements and that don’t have the capacity to pass on higher input costs to consumers, positive free cash flow is quickly turning into negative free cash flow and is beginning to put a strain on liquidity. This is only exacerbated in industries that have some amount of regulation that stymies their ability to price in a somewhat more dynamic or fluid way.
This obviously makes the ability to push back maturity walls when needed more difficult and is further compounded by suddenly being in a tighter credit environment as everyone is concerned about taking on new debt that immediately trades down as yields continue to rise. This is why you’re seeing some sponsor-backed companies that still have significant liquidity, like Envision, trying to be a bit more proactive in extending out their runway by working with creditors earlier rather than later.
Should we continue to have persistently high inflation, there likely will be more idiosyncrasy in what companies end up becoming distressed. So, instead of seeing certain industries dominate this upcoming cycle (like oil and gas did in the mid-2010s and retail did in the late-2010s) we’ll end up seeing companies across industries that have similar structural issues (e.g., companies that that have commoditized products that traditionally only compete on price, companies that have had their working capital blown out by a rapid rise in a given commodity or input cost, and, of course, lots of highly levered sponsor-backed companies).
Note: One thing not mentioned above that is an obvious liquidity drain involves the rising cost of floating rate debt as rates rise to combat inflation. Due to most term loans having a floor of 1%, we’re just now starting to see this have an impact. While LIBOR / SOFR will need to go significantly higher to have a meaningful impact on the liquidity of even quite distressed debtors, it’s something to be mindful of.
Through 2020 we not only saw a large pull forward of restructuring activity, but through the latter half of 2020 and throughout 2021 we also saw quite dubious debtors being able to opportunistically refi upcoming maturities to take advantage of the unprecedentedly tight credit markets.
However, it’s important not to overstate how many maturity walls have been pushed back as every year sees a large swath of maturities coming due and the current inflationary environment will undoubtably have an impact on those.
It strikes me that the impact of inflation on restructuring will be much less immediate than many think and we’ll likely see more preemptive out-of-court solutions or pre-packs being explored as debtors recognize well in advance that they need to act in the face of bleeding liquidity and a likely inability to refi maturities coming due given the kinds of terms the market is now demanding.
If you were forced to have to say how inflation is going to affect stressed and distressed debtors moving forward in one sentence, I would say that it’ll simply reduce down a debtor’s debt capacity. This will necessitate debtors needing to slim down much more during a restructuring than they have over the past few years. Practically, this means more of the consideration in a restructuring that creditors get – whether in-court or out-of-court – will need to be equity to lighten the leverage of reorganized debtors. Further, it will probably mean that creditors will be looking for more floating rate debt as opposed to fixed rate whenever possible (so they can be somewhat insulated from potential rate rises), and creditors will be more apt to engage in aggressive inter-creditor battles moving forward.
With all this being said, you can never discount that we could be in for some cooling of inflation expectations sooner rather than later. With recent news of somewhat lackluster economic growth and a Fed that seems at least rhetorically committed to getting back to a neutral rate no matter what, we could see cracks in both economic growth and inflation sooner than expected. Of course, this is showing up – depending on your interpretation – in how flat 2s10s is right now. If we do see cracks in inflation, even if it comes along with modest cracks in economic growth, there would be significant opportunities in the secondary market. With some debt on the secondary market trading at substantial discounts due to the aggressive run up in yields recently, we would be in for a substantial price rebound if near term rate expectations were to suddenly reverse.
However, what many with cash to deploy on the sidelines are still worried about is the potential for air pockets to develop in the high yield and distressed secondary market that could cause a sudden gaping down in pricing due to the lack of liquidity in markets at present. Just how quickly liquidity has been drained has taken many by surprise.
Anyway, these are just a few late-night thoughts – hopefully somewhat coherently strung together – that may be worth mulling over. If you enjoy thinking and reading about more general economic issues, I’ve been thinking quite a bit about a Fed working paper by Jeremy Rudd titled, “Why Do We Think That Inflation Expectations Matter for Inflation? (And Should We?)” that was published last year. Pair this with the 2001 Fed paper titled, “Does Stock Market Wealth Matter for Consumption?” by Dynan and Maki that tries to tease out the impact on household consumption from the rapid rise in equity prices seen in the late 90s.