Navigating a distressed Market

There are many factors affecting our ability to predict outcomes in the distressed/special situations markets. So when this timely and thought provoking roundtable piece from Real Deals came into my Inbox a few days ago, I thought you might like to share its (verbatim) contents – see below. I have added some commentary of my own in relation to some of the points made.


My angle throughout will be that of the need to bolster, support or change management – board level interim, permanent and non-executive, for all of which Tyzack Partners is very well placed.


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by Talya Misiri   26th November 2020


The current environment is nothing new for special situations investors and their advisors; but the macro-economic crisis has given special situations investors a lot to consider. In a recent roundtable, a group of experts discussed the current deal environment, CVAs, corporate carve-outs and how government support slowdowns will impact the special sits market going forward.




Ben Slatter – partner, Rutland Partners


William de Laszlo – founding partner, Agathos Management


Jat Bains – partner, Macfarlanes


Ian Corfield – partner, FRP advisory


Andrew Johnson – director, Paragon International

  1. The volume of special situations and distressed deals in the European market has not been as high as expected in this environment, why is that?


Jat Bains: Due to the impact of the pandemic on the economy, from an advisors’ perspective, a lot of our work has been primarily around crisis management. For example, this includes helping corporate clients to understand where pockets of liquidity may be and how directors might navigate their duties in the current circumstances.


But it is fair to say that perhaps there hasn’t been as high a volume of transactions quite yet, and certainly, looking at some of the government’s statistics, insolvencies are heading in a downward direction in comparison to the previous year. I think part of that is down to a lack of triggers. There’s been plenty of lender forbearance particularly with high street lenders trying to do their best to support businesses; a lot of support in terms of liquidity from government schemes; time to pay from HMRC; the job retention scheme; CBILS, etc. So, there are plenty of reasons why businesses have been able to get by and the exceptions to that are where you’re in specific sectors in areas where there are more immediate challenges, and that’s where we’ve seen more transactions.


Ian Corfield: Jat’s right. FRP has been relatively busy on restructuring mandates in the last few months, especially in consumer reliant sectors, but the imperative to make critical decisions that drive activity was temporarily taken away from many boards of directors when the Government extended the moratoria on debt enforcement and forfeiture in late September 2020. As a result, and aside from some of the high-profile failures and CVA processes, much of our work has been supporting directors and stakeholders to navigate difficult conversations, covenant resets and importantly options analysis. Often our work is what I refer to as a ‘guardian angel’ role where we’re supporting a party to ensure their position is protected in a transaction and being ready to take a more prominent role if needed. This status quo will continue until there is a market and/or political trigger.


As it stands, I think that trigger is whether the moratoria on enforcement and forfeiture is extended again beyond 31 December 2020. I suspect it will be, but directors have to start making decisions well before then just in case. And if not, then I would expect to be very busy on restructuring and insolvency mandates shortly thereafter.


  1. William, as a PE investor, what opportunities have you seen? Has it been a challenging environment for you?


William de Laszlo: Like most investment funds, we initially focused on our portfolio companies to ensure they were well supported and fortunately they have all proved resilient and all managed challenging trading and operational conditions really well. On the point around why we aren’t seeing an influx of deals, I think it’s relatively straightforward: there’s been a huge volume of government-backed capital available to companies, which has ultimately resulted in a lot of businesses which might have been facing issues pre-Covid not failing because they’ve now taken on government backed loans. I think there will have been a number of examples where businesses that were most likely going to fail – perhaps because their business models have become inappropriate for the market they are operating in or they were already trading with an inappropriate capital structure, and they have been negatively impacted by Covid but been able to take on these loans – they will inevitably need their balance sheet restructured as a result.


The Government’s objective continues to be to ensure liquidity is available to banks and businesses, as per the extension for CBILS applications, and to maintain productive capacity in the economy, with the furlough scheme also recently being extended. This is not a bad thing because it’s ultimately supporting businesses and jobs, but it’s got to stop and be repaid at some stage.

  1. Ben, what opportunities has Rutland seen and has this changed since the outbreak of the pandemic? Will there be an influx of opportunities and deals once these loans and schemes come to an end?


Ben Slatter: We’ve seen similar to what Will has described. During the early stage, we were focussed on monitoring our portfolio and making sure that it was under control. Out of our portfolio of seven, we’ve had three of the businesses undergo covenant resets and the banks have been good to deal with and very supportive. None of our businesses needed extra liquidity.


Some of the opportunities that we saw in the early days were actually businesses that were already failing pre-Covid and Covid just accelerated that. Those were never going to be interesting opportunities for us. We’re starting to see more interesting opportunities now. Many businesses have funded themselves by squeezing working capital and receiving help from the various government initiatives. Further funding requirements will increasingly need to be met by longer term solutions and equity funding. There will be no shortage of opportunities to look at.


Tyzack: Non-distressed funds have been very busy under the radar since March – sharpening their Zoom/Teams skills and working more closely than ever to support their exhausted management teams, both operationally and providing balance sheet support. The results have been pretty impressive. They quickly recognised the need to sustain portfolio value, operating performance and also liquidity to protect their equity positions. But this cannot last – either weaker managers will need to be replaced and/or non-core divisions will need quietly to be disposed of.


  1. To what extent are companies turning to CVAs or similar solutions?


Bains: We have seen a lot of CVAs in the market. For example, we were involved in a CVA of Buzz Bingo over the course of the summer. It’s proven to be a tool that a lot of businesses have relied on to deal with issues around being over-rented and/or needing to reduce the size of their property portfolio. Not only are we seeing a lot of activity around CVAs, we are also seeing them be encouraged. R3, the trade body, for example, recently issued a template form of CVA for SMEs, which is designed to defer liabilities (as opposed to write them down) and allow businesses to gain breathing space in a cheaper, more straightforward way.


One issue that I see coming is that a lot of the restructuring deals that have happened are having a significant impact on landlords, who will have their own debt obligations to service. They are getting very heavily squeezed and there will quickly come a point where it is unworkable for them and they themselves need to be restructured.


More broadly we’re certainly seeing a lot of high-profile transactions, certainly in sectors like retail, casual dining, pubs, gaming, that sort of space. Those are sectors that have had to deal with things sooner rather than later because of the direct effect of lockdowns.


Corfield: Traditionally, CVAs get viewed as a simple financial reset where liabilities are commuted, and the business goes again. However, typically, there is no fundamental change in the strategic or operating model, and that is one of the key reasons why CVAs don’t always work, resulting in further rounds of negotiations or follow-on insolvency processes.


Whilst a Covid-driven era is probably one of the few circumstances where a financial reset may well be an acceptable answer, the opportunity to simultaneously re-engineer a business strategically, operationally and financially to create a resilient model for the future should be grabbed with both hands.


The challenge that companies and directors face is that as of 1 January 2021, in the absence of a further extension of the moratoria I mentioned, it will only take one creditor or, as commonly seen at the moment, one landlord in a portfolio to say “I’ve had enough” and start winding-up proceedings. at that point the whole situation could collapse like a house of cards. So, right now I would say there is a risk we might suddenly find a move back to accelerated M&As, pre-packs or old-fashioned administrations.


Tyzack: Increasing creditor frustration with CVA’s and the recent demise of Arcadia, Debenhams and many other famous brands brings this home sharply. Insolvency processes will provide investors with a wealth of opportunistic deals across the sectors which are clearly most vulnerable as well as other businesses, in part or whole, which have not been alert enough to plan effectively for the long haul. Not to mention the zombie businesses which still have useful assets. Rapid board level management change here will be essential.


  1. When it comes to deal sourcing in this environment, what are the challenges? While the market may be dense; how do you identify good quality deals?


Slatter: The disciplines that we always would have used to assess good deals remain exactly the same, we are looking for good businesses in resilient markets and the opportunity to make a difference. In a large number of cases, Covid is making a financial assessment more challenging; the impacts of Covid, positive or negative, can be widespread on the performance of the businesses and assessing underlying profitability can be difficult.


We’re starting to see information memorandums come through with material “Covid adjustments” and some of the presentations that are being put forward are highly questionable. So, unpicking that is going to be challenging and the market assessment is absolutely key: What is the path to recovery and what does the revenue and outlook like going forward? Where do they get back to and in what timeframe? Businesses that have shown resilience and growth during this time will be in high demand.


Corfield: If you’re looking at companies during good times, it’s not necessarily an indication of how robust the management team is. Whereas I think the last six to nine months is actually a really interesting test of how good the management team are and even if the business is not in a good place, you can back the management team.


Slatter: It’s absolutely true, you put these management teams under stress and pressure and you can see how they truly perform. Managing change is a core requirement of the teams we back.


De Laszlo: We have pivoted our thesis for Fund II, which is ultimately focused on supporting good businesses experiencing some kind of complex situation and SMEs requiring recapitalisation and funding for growth. The key to this will be to find and collaborate with strong management teams. Those are the businesses that we are really excited about partnering with as they’ve managed to steer their business through this complete anomaly in our lives, and those are the people you want to be backing.


Tyzack: Agreed, but there are many SME’s with good brands, products or services and happy customers which are suffering from indifferent or exhausted management. There is nearly always at least one weak senior link in the chain. Businesses with a pathway to growth should be snapped up for realistic prices and turned around quickly. Flexing strategies and changing key managers with e.g. a new Chair, NED or great sales people, should be on an interim basis while searching for permanent executives. This will take time which these businesses do not have.


  1. Has the DD process evolved since the outbreak of the pandemic? What additional areas are you taking into consideration? What should PE firms consider?


Bains: We are seeing a good amount of M&A transactional activity being done through a formal insolvency process. We helped, for example Epiris acquire Casual Dining Group after the administration earlier in the year. In those sorts of processes, time is incredibly short – you can do the best you can around diligence, but it’s tough. Ultimately that has a knock-on effect for pricing.


Andrew Johnson: Certainly, since the onset of Covid, when underwriting a transaction whether it’s distressed or not, insurers are focusing more attention on the granularity and scope of a buyer’s DD. They are concentrating on the impact of Covid and related developments on the target company from a legal, compliance, HR, business, insurance, financial, and operational perspective in order to provide as wide insurance coverage as possible.


In particular, they are analysing in greater detail the quality of the buyer’s due diligence around the target company’s compliance laws with laws relating to Covid; the impact on employees; compliance with any government recovery stimuli packages; supply chain management; any pension plan liabilities; material contract performance; whether the correct insurance programmes are in place and the maintenance of any debt obligations by the target. Obviously how the distressed deal is being structured, either solvently or insolvently, will dictate which liabilities are being carried across and any insurance coverage will be reflective of that.


Slatter: We completed the successful exit of Armitage Pet Care recently and the whole process was virtual, which was actually very efficient. I think on the acquisition side, most of the diligence can be done remotely, but you’ve got to get in front of management teams directly. An informed view of the people you are investing in is critical and you can’t form correct judgements on management teams just via video call interactions.


  1. What sectors have faced the greatest headwinds during this period? And how long will they continue to face these for?


Corfield: The first thing is that there’s a genuine risk that we’re going to see round two on the restructuring interventions that have already taken place. A CVA will have been approved on the basis of future trading performance assumptions that are no longer valid due to this second lockdown which, although only 4 weeks, could easily be extended for a longer period of time despite potential good news around vaccines.


If you’re a leisure business for example, and you don’t know when you can reopen and even then what will the consumer spending capacity and behaviours will look like, it is hard to understand financial needs and seek capital provider support.


The second thing I would mention is that on a few occasions we have had conversations with purchasers on accelerated M&As where their plan would be to buy the business and then CVA it afterwards to try do the restructuring in the way they want to do it. I think that investors are looking at more creative ways to obtain value. In terms of sectors, we’re still seeing more casual dining, hotels and hospitality generally facing headwinds especially where there is complexity in the capital stack. Similarly, I expect there to be further pain on the high street. Sectors such as financial services, specifically peer-to-peer and alternative lenders, and infrastructure assets such as oil and gas will come under pressure as UK PLCs and consumers seek their new balance.


Slatter: Adding to what has been discussed, other sectors that will face challenges include aerospace and automotive. But critically, there will be a ripple out impact on suppliers to all of those sectors directly impacted. This will be seen across a whole swathe of SMEs, so there will be lots of pressure in these businesses. We will avoid situations where it will be difficult to predict a base level of demand.


Tyzack: This lack of predictability can only be increased by an inevitable headwind of equal ferocity – Brexit – whose impact remains anything but clear so close to 31st December – deal or no deal. Uncertainty is a dirty word even for many investors used to opportunities in stressed scenarios. However, bringing in a sector specific new Chair or Non-Executive on shortish contracts can de-risk uncertainty and provide that degree clarity of strategic vision which worn out boards may well have lost sight of.


  1. And what sectors are most attractive to you at the moment?


De Laszlo: For Agathos, we look at all sectors. In our first fund, we invested in several manufacturing businesses, which is a sector I am particularly passionate about, but we also had some success with logistics and business services businesses and looked very closely at businesses in most sectors. We can deal with complexity or imperfection, so would look at sectors that have faced the greatest challenges such as hospitality, events, leisure and education. Again, this comes down to really trying to find good businesses with good management teams and back those management teams. A lot of great businesses have taken on inappropriate capital structures just to survive, so that needs to be rectified.


Johnson: From what we’ve seen, the sectors where M&A has remained resilient throughout Q2 and Q3 have been technology obviously, logistics and the real estate sales that surround that industry and healthcare where we’ve had a huge uptick.


Tyzack: Due diligence – especially on management – will uncover weaknesses in entities which have survived but have semi-hidden structural weaknesses as set out above. Business plans need to be reset; financial and operational performance will need new managers with deep experience of change in tough scenarios. Often just changing the Chair can be enough, starting in a full-on executive role and stepping back once new blood has been hired. These independent networks known to Tyzack Partners have been properly tried and tested in recent times when investors and other stakeholders have been looking for real transformation for both new acquisitions and carve-outs from tired corporates.


  1. Clearly the retail sector has been hit considerably, but a number of high street brands have continued to receive equity injections. For example, clothing retailer New Look (which put forward a CVA in August) agreed a debt-for-equity swap with existing banks and bondholders; Dutch retailer Hema had a scheme arrangement approved in August and Hunter Boot agreed a £16.5m equity injection to get through Covid. Why is this taking place? Is it purely to protect returns in the long term? What are the dangers of acting in this way?


Slatter: You put equity in when you believe in the business and you need to protect your position; that will be driven by a need for cash or a bank applying pressure to deleverage. It’s a judgement of putting money in to support a business that will deliver a return. These are larger, more high profile businesses, but the rationale behind these arrangements remains the same. They need cash or the banks are forcing them to de-lever.


Bains: I agree that ultimately the reason why new money is going in is because sponsors are looking to protect their position. I think what’s interesting is seeing what’s driving some of that. A lot of it is lender driven and the lender threat, whether implicit or explicit, that they may be forced to take control if a sponsor doesn’t back their investment – that’s causing some sponsors to take necessary action.


We’re also seeing motivation driven by other external influences as well. For instance in the travel sector, the CAA is keeping a very close eye on a lot businesses, obviously having been burnt by a lot of high profile collapses over the last few years, so they’re very focused on making sure that businesses are well capitalised and able to get through what’s happening now.


  1. Has there been evidence of more corporate restructuring/carve-outs? Are these deals done from positions of strength or only at times of financial strain and are carve-outs coming from companies in sectors facing headwinds?


De Laszlo: The corporate carve-out space is largely driven by a necessity to raise cash for the core business. We have seen quite a few come through and I think that will increase. Businesses that were bought in recent years by a large group that have not been integrated are perhaps now deemed as non-core and will be sold. But, that’s a tough place for a corporate to be in as they’re selling in a down market; therefore, as an acquirer, the question would be why sell unless you have to? This is obviously not applicable to businesses operating in sectors that have not been as affected by the pandemic.


Corfield: Unsurprisingly, during a normal lifecycle, a corporate will go on buying sprees to add revenues, EBITDA and resilience, but during tougher times, many of these subsidiaries eventually end up as unloved or non-core subsidiaries due to a change in strategy or lack of scale. And when these businesses are wrapped into large or complex lending and security structures, retention of a subsidiary becomes inefficient from a management resource and liquidity perspective too.

At the moment, corporates are starting to think: “How do we survive the next few years, what do we really need to look like, let’s get ahead of the game”. So, given where we are in the cycle, corporate carve-outs and divestments are definitely back on the agenda.


  1. When it comes to distressed and special situations transactions, what transaction risks exist? What risks do managers need to be aware of?


Johnson: The direct answer is that there is risk in every transaction and in the distressed area, that risk is even more stark but that also creates the opportunities for the likes of Ben and Will. How you mitigate that risk is the evolution of M&A insurance. At a very basic level, unknown and unforeseen risks in a target business are covered by Warranty & Indemnity policies and any risks that are driven out during the DD and disclosure process and thereby those that become known to the deal team, can be covered by contingent risk policies.


Naturally insurers, like all businesses in the Covid world, are all looking to innovate and find premium elsewhere to bridge the gap by insuring alternative risks in the M&A space. What we’re seeing insured is entirely dependent on the deal dynamics. Not every distressed deal is going to be insurable and it depends very much on whether it’s an accelerated M&A process, a carve-out, a pre-pack or a straight sale out of administration or liquidation. For a solvent deal to be insurable with anything close to being value for money, you have to have three cornerstones or pillars of an insurable transaction, namely: (a) thorough due diligence; (b) a sensible set of well negotiated warranties and (c) a thorough disclosure process.


With distressed deals, the key is ‘time’ and how that has affected the granularity of the DD, the warranty negotiations and the population of the data room and Q&A. The level of cover available under these policies does vary dependent on the deal and they won’t work for every transaction, hence the need to manage expectations and seek advice as early as possible to not hold up the deal.


  1. As government support slows, will it be easier to identify attractive special situations opportunities?


De Laszlo: When the government schemes come to an end, I think we’ll see a massive increase in the number of businesses requiring an equity partner. In terms of how easy it will be to identify good opportunities, the big question for all of us is: What does the new normal look like? That’s the underlying question that we ask when we’re looking at new opportunities. What has happened to demand for a prospective business’s product or service, and to the market in which it is operating? How have the operations and the supply chain of the business been impacted, by the pandemic and potentially by Brexit? Has the business only been impacted by a short-term market dislocation or has there been a fundamental shift to their target addressable market? We’re going to see a cultural change in the way we work and the ramifications of that could spread across many different sectors, and we don’t really understand the full impact yet.


There will be more opportunities coming through and how we identify and evaluate those opportunities will be challenging, but we’ll work through it and are excited to be a small part of the solution.


Slatter: I agree, there is absolutely going to be a significant volume of opportunities particularly when government support schemes end. The ability to turn these into deals is partly dependent on our ability to assess them properly. We expect that with a bit more time and an element of stability, we will be better able to see how these businesses are adjusting to the new norm and how attractive they are as investments.


Tyzack: Yes. Often, however, there is insufficient time to conduct one’s ideal amount of due diligence for attractive stressed businesses. With management change in view, Tyzack is often asked to provide high level sector specific expertise in a hurry to provide analysis and to ask the really hard DD questions for investors needing a quick, deal critical decision even if this terminates the investor’s interest.


  1. How will the current macro-economic crisis affect special situations activity in the long term?


Corfield: The first thing is that the Government can’t keep extending its support forever – after all, it’s taxpayers’ money that they’re spending – and at some point, UK plc will have to be weaned. An economy is like the human body – you can only keep introducing antibiotics for so long before they don’t work anymore, or they create damage of a different kind.


Secondly, we’re going to see the rise of private credit lenders whose divergence from traditional lenders in terms of appetite and investment horizon is accelerating just at a time where that will be needed. Indeed, we have already seen new and repositioned private credit funds with multiple strategies including special situations and dislocation funds come to market. So, add in specialist equity capital who are also very much ready to invest, this is a clear sign that there will be a strong medium to long-term special situations market.


Bains: The one thing I suspect is going to come is we might see a bit more old-fashioned sales through administration. A lot of businesses have been able to get by, but they’ll be low on cash and won’t necessarily have the financial resources to go through a solvent restructuring process, so I suspect we’ll be seeing a lot more of that.


Slatter: Businesses also need resources to grow, so there will be some quite interesting ones that may not end up going through an insolvent solution, but need fresh equity to support them as they have emptied their supplies of cash resources. Rutland will be quite keen to find and support some of those businesses.


De Laszlo: The City UK estimates that by the end of March 2021 UK SMEs will owe between £33-36 bn. This is clearly unsustainable, so over the next five years, we expect to see a significant number of opportunities arising. A lot of this will be growth funding because businesses will have exhausted their debt capacity. We feel in a privileged position to have a committed fund to be able to support UK SMEs over this period. However, whilst it’s going to be a really busy market for specialist and complex situations investors, I think it’s really important to recognise how desperately sad it is that many SMEs won’t survive.


Tyzack: Indeed. Special situations investors and lenders will undoubtedly play a key role in the return to positive economic growth over the new few years once HMG has done its bit. Let’s hope that it doesn’t overuse its ability to tax its way out of trouble.


Providing the wherewithal for business growth and transformation – especially for SME’s – will be especially true for the lending side. The high street banks have kept their powder relatively dry in recent months. Perhaps they have been waiting for this month (December) to witness a key change in our markets – namely HMRC regaining preferred creditor status for certain taxes. This should sharpen banks’ pencils but also potentially give debt funds with their inherently greater flexibility a clear advantage.


In any scenario post-Brexit and post-vaccines, we are confident that our networks will be highly sought after, possibly as much as in that other perfect storm in recent history – remember 2008!


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