With many companies facing concerns over liquidity and debt as lockdowns continue, is there a way to distinguish between the winners and losers? Luke Newman, UK equities portfolio manager, gives his thoughts on the opportunities and risks for both long and short investors.
- Companies have faced difficult decisions over the past few weeks; the very short-term
focus for many being simply survival.
- While many firms will struggle to weather what is a profound change in business
conditions, there will be opportunities for investors to participate in the recapitalisation
of otherwise well-placed businesses.
- There will be further risks to equity values as governments responds to episodic peaks in infection rates from the coronavirus, with potential shutdowns and ongoing restrictions.
There are so many unknowns at present, in terms of the impact of the coronavirus and how governments are responding in their efforts to try to ‘flatten the curve’ (reduce the rate of infection).
For us, the past few weeks have been full of conversations with management teams and their advisors across a range of industries to try and understand the impact of economic shutdowns on their business models. Our attention has been drawn to the balance sheet implications of government restrictions, and the damage that too much operational leverage can do to business models with limited capacity to rationalise costs. Companies have faced incredibly difficult decisions over the past few weeks; the very short-term focus for many being simply survival. Many businesses have faced severe interruptions where, far from simply modelling a slowdown, they are looking at zero revenue.
But what is very clear now is that the ‘penny has dropped’ in terms of recognising the potential risks ahead. Questions over liquidity and leverage are going to have to be answered. Businesses will face further challenges in the absence of efficient antibody tests, or a timely vaccine, being quickly approved and produced in vast quantities. In this environment, we expect many companies to respond to balance sheet pressures.
The refinancing test
The scale or dilutive impact of any potential demand for capital is speculative at this point. But while many firms will struggle to weather what is a profound change in business conditions, there will be opportunities for investors to participate in the recapitalisation of otherwise well-placed businesses that could emerge from the current situation in a stronger competitive position than they entered.
We are considering four broad categories of potential refinancing scenarios in the current market:
- Companies that entered the crisis carrying significant debt may require significant restructuring. There is little appetite at present for banks to take back the keys and force a default so, in the short term, many debt covenants are likely to be relaxed or extended, leaving heavily reduced equity values to effectively trade as options against much larger levels of debt.
- Companies facing liquidity problems where, as a function of their activity, they have been hit very hard by government shutdowns. This would include travel-related businesses and those more capital-intensive firms that have experienced cash flow problems as new business dries up. In ordinary circumstances, we would expect a rights issue to be conducted to refinance a company’s operations. However, it can take up to several weeks to complete a rights issue, as this requires auditors and various other parties to approve the structure, suggesting greater demand for equity placings to help plug funding gaps. This presents the risk of dilution for existing shareholders, given that pre-emption rights (where existing shareholders get first refusal on any new shares issued) may not be automatically observed.
- While many businesses may not face an immediate liquidity problem, the prospects for a V-shaped recovery have moderated, and the implications of high unemployment and a gradual relaxation of social restrictions is likely to cut guidance for 2021. While the ‘lights stay on’ for what are often very high-quality enterprises, a shrinking tolerance for leverage will feed through to demands to reduce net debt over time. Any dilution risk, while not immediate, is likely to be factored into valuations, providing opportunities for long-term investors to build positions in otherwise strongly positioned companies.
- State aid seems a likely route for economically important businesses that are unable to convince investors that they can overcome the political and social restrictions of a post-COVID-19 world. While the UK government has made it clear that it prefers private capital to a state solution, rights issues for airline companies, for example, seem difficult to garner support, given the lack of any certainty over bookings, combined with the high cost of fare refunds, plane order obligations and the unwinding of fuel hedges.
Further risks balanced by opportunities
The length of the shutdowns, and how governments choose to manage business and civil restrictions, will naturally place a great deal of stress on corporate balance sheets over the weeks and months ahead. There will be further risks to equity values as governments respond to episodic peaks in infection rates from the coronavirus, with potential shutdowns and ongoing restrictions. But there will also be opportunities for investors to build long-term positions in resilient businesses sufficiently well capitalised to survive this period and create value for shareholders over the coming years. For those investors operating in both long and short markets, both scenarios present opportunities.