Bob Dylan wrote The Times They Are a-Changin’ in 1964. The song is as relevant today as it was in 1964.
In three short months, our lives have been turned upside down. Since the arrival of COVID-19, the 11-year bull market in North America ended and the world entered recession (or worse). According to the International Monetary Fund (IMF), global GDP will suffer its largest decline since the Great Depression. There is massive and growing unemployment. Our daily commute involves walking from the bedroom to a den or a living room or a basement. We rarely leave the house. We don’t know when we will return to our offices. We entertain virtually. We line up to go to the grocery store. We have a new lexicon: who had heard of “social distancing” and “PPE” in January? We don’t know when “normal” will return or whether this is the new “normal”.
The short and long-term impact of the pandemic crisis is unknown. It varies from industry-to-industry, but mostly it’s been negative and dramatic. There have been several formal restructuring proceedings in numerous industries, from tourism and travel to automotive to retail. There will be many more. Some industries have seen some benefits, such as technology (i.e. on-line retail, Zoom), but they are few and far between.
In the context of the pandemic crisis, we thought it would be worthwhile to discuss how COVID-19 has affected some of the situations we’ve seen over the last few months. The discussion that follows highlights some emerging themes, how stakeholders are responding to the crisis and the challenges we’ve experienced.
- Based on various situations we have been working on, lenders appear to be more accommodating than prior to the crisis. This may be because they have limited options. Similar to the credit crisis, there are no buyers for their borrower’s businesses or assets at a reasonable valuation. Lender accommodations can take several forms, but most often lenders are permitting principal and interest deferrals on term loans and similar facilities. Some lenders are also permitting borrowers to operate beyond the limits of their revolving facilities. Accommodations are commonly for an initial period of 90 days. In certain instances, accommodations have been contingent on support from other stakeholders.
- Borrowers are managing liquidity by entering into forbearance agreements with their senior lenders, stretching vendors, laying off employees, eliminating all non-core costs and seeking relief under government programs. Forbearances that started in March are now being extended as the crisis continues. The forbearance works when liquidity is manageable; however, it is evident that when businesses “re-open”, sales will be well below the levels required to remain viable, resulting in increased liquidity needs. With limited opportunities to transact, lenders and other stakeholders will need to decide whether to support an unprofitable business or to take a deep loss.
- Over the last several years, we have seen many highly levered businesses saved at the last moment by private equity firms or lenders of last resort. In the present environment, these firms can no longer invest fresh capital in these businesses. (Many of them are having their own challenges, with several suspending distributions.) This, again, means lenders are left to fund a turnaround. We have seen Schedule 1 banks indicate that they are prepared to own equity in return for providing fresh capital.
- Several retailers have obtained court protection since the outset of the pandemic crisis; however, for the most part, liquidations have not commenced. Retail liquidations typically generate strong recoveries as there is a direct channel to the consumer. Over time, court officers, landlords, retailers and liquidators have agreed to the rules which govern a liquidation. But what happens when a retailer can’t access its inventory because malls are closed? Generating the volumes required for a successful sale is virtually impossible in the COVID-19 environment when only a handful of customers are allowed into a store at one time. This will lead to longer sale periods, resulting in increased costs (such as rent and wages), which will materially erode recoveries. And the logistics of the sale are complicated. Will customers be permitted to try on clothes? Will all sales be final? Who will conduct these sales, particularly for large retail insolvencies? The American liquidators who run many of the significant Canadian retail liquidations are not presently allowed into Canada.
In addition to the above issues, retailers are having challenges recalling employees because CERB benefits exceed their wages. Employees are concerned about the commute to work (some don’t want to take an Uber or public transit). Most soft goods retailers are now sitting with out-of-season merchandise and the large number of distressed retailers means that the market is flooded with excess inventory at depressed prices. These issues and uncertainties will combine to significantly reduce recoveries. It also means that liquidators are likely to work on a commission basis versus the guaranteed deals which were the norm in this sector prior to the crisis.
- In terms of landlord-tenant relations, both parties appear to be waiting to see the level of activity over the coming months. Many tenants, particularly in the retail sector, have suspended paying rent and many will not be viable if they need to pay rent under the terms of their existing leases. Landlords may have few options but to negotiate lease amendments, which has historically been anathema to landlords. A spike in vacancies is not in the interest of landlords. Landlords cannot survive collecting 15% to 20% rent (the widely reported collection rate for May in retail malls) but tenants cannot survive on the terms of their existing leases, at least in the short term. A new paradigm may be required.
- The cannabis sector was distressed pre-COVID-19 and it continues. In many instances, stakeholders appear to be enjoying the inventory – many continue to have lofty valuation expectations. Most of the cannabis companies continue to struggle with high costs, a lack of volume and limited capital. We expect the industry to continue to downsize and consolidate. Notwithstanding the challenges in the industry, in a recent CCAA filing where we acted as Monitor, several strategic investors performed extensive diligence suggesting that there is still significant interest in the sector.
- Our experience also reflects that COVID-19 has accelerated the decline of certain businesses. In one of our recent filings, a distributor of books, newspapers and magazines was sold to the sole remaining Canadian wholesale distributor. The distributor was a successful business that operated for decades. Not long ago, there were as many as 33 distributors in this space in Canada. A significant period of consolidation began well prior to COVID-19, however, the onset of COVID-19 greatly accelerated the decline of this business because its customers were forced to suspend or reduce operations. Additionally, as a logistics business, the distributor’s business was labour intensive. Between sick employees and employee concerns about COVID-19, continuing to operate during COVID-19 became impossible.
- Our recent experience in the agricultural sector suggests food security may be a major theme going forward. The effect of COVID-19 has been limited on the sector, with some exceptions, such as the meat processing industry. Domestic food producers may benefit post-COVID-19 as the pandemic illustrated the need to have control over supply in this sector. This contrasts with the auto sector. Auto sales were on the decline prior to COVID-19 and the industry continues to transition to electric vehicles, both of which impact parts suppliers. Our recent experience suggests that auto suppliers with global operations are not only dealing with declining volumes, but they also have significant supply chain challenges, which puts at risk their ability to supply on a “just-in-time” basis. With record levels of unemployment, it’s hard to imagine consumer demand for high-priced items, like automobiles, improving any time soon.
- Due to a lack of buyers, illiquidity, and significantly impaired first-lien debt, we can see an increase in “quick flip” transactions. We were recently involved in a situation where a transaction was completed on the first day of a proceeding, without a prior sale process, and we’re recommending this solution in another situation. We see this trend continuing as most businesses require liquidity immediately, lenders are often deeply impaired and there is no realistic prospect of selling the business during COVID-19. Lenders and other stakeholders are only prepared to advance fresh capital if they own substantially all the equity in the business.
- Various government programs have been made available in response to COVID-19; however, our experience is that there is uncertainty as to the terms to the programs and how the programs are to be rolled out. Many distressed businesses were suffering prior to Covid-19 and accordingly, their pre-Covid-19 financial situation makes them ineligible for relief under these programs. The wide-scale roll out of these programs remains a work in process.
The effects of COVID-19 have been dramatic and the crisis continues to unfold before our eyes. Virtually every sector of the economy has been affected, mostly for the worse. The ability to transact at a reasonable valuation is challenging, if not impossible. Selling businesses and assets in this environment will require creativity and patience. This means that stakeholders may need to be more accommodating; however, liquidity demands may be so onerous that the old adage “my first loss is my best loss” could become a prevailing theme. One thing appears certain: our personal and professional lives are likely to be shaped by the crisis for the next several years.