By Ian Borman, Partner, Winston & Strawn
With the UK government slowly lifting the lockdown, businesses are having to wrestle with some fundamental questions and prepare to navigate the choppy waters of the post-Covid-19 economy. According to the Office for Budget Responsibility (OBR), the UK is heading for its deepest recession in 300 years.
So far, UK Government’s efforts to support businesses have been loans and other forms of credit within existing legal structures. However, we are at the beginning of a new phase in the response, with UK Government proposals to relax wrongful trading rules and introduce a company moratorium likely to come into force shortly. Moves to ensure that supply chains for businesses remain functional are also being proposed, with a Government scheme to replace credit insurance with Government support and rules to stop business ceasing to trade with businesses that are in insolvency proceedings.
These schemes challenge the way businesses under stress operate and, whilst increasing the breathing space for businesses and directors under severe pressure, they also open up new uncertainties for other businesses trading with and financing those businesses.
The background to these developments is that businesses have really only begun to experience the financial impact of the enforced economic slowdown. Many have calculated that they will survive through to the end of summer, assuming ongoing relaxation through that period, but the backdrop for business recovery is stark.
To give themselves the best possible chance of surviving, business need to plan around three key corporate financing needs.
- Direct Costs
Firstly, there are the direct expenses incurred whilst shutdown continues. Businesses that have shut down quickly continue to have liabilities to suppliers, landlords and employees without income to support those expenses. Even businesses that have apparently benefitted from the disruption, such as online delivery platforms and supermarkets, have had to foot the bill on exceptional costs, many of which may not be recoverable or ultimately contribute to profitability.
These costs have depleted cash reserves, driving an almost universal search for liquidity from banks and the bond markets. Even businesses with naturally large cash resources are looking to raise funds. A small proportion of these debts are in the form of government grants, but many are being absorbed in the form of debt that will remain long after the crisis has averted.
- Ramp up
As we emerge from the crisis, it is unclear how long the return to normality will take and it is unlikely that many businesses will return to usual levels in the short term. For some it may be quick, but for others this may lead to a period where activity returns to pre-crisis levels slowly.
Through this ‘ramp up’ phase businesses will still be incurring ‘usual’ running costs. They may be able to trim maintenance and investment expenditure, but this will also harm asset condition and future growth potential. Businesses which are able to maintain investment are those most likely to be able to take advantage of opportunities and benefit in the longer term.
In the initial phase, some of these continuing costs will have been met by cash receipts from previous trading, which in the ordinary course would have been used to fund the business, investing in stock, materials and work-in-progress. With those cash receipts spent elsewhere, businesses will need to find the cash to fund working capital and restart their supply chain whilst facing uncertain demand.
Businesses also drive efficiencies by accurately predicting demand to avoid waste. As we saw at the start of the crisis, whilst supermarkets have now got to grips with the situation, they initially struggled to adjust to changing demand as they rely on just-in-time delivery and demand modelling in order to stock shelves. But a host of industries now rely on low stocking levels and supply chains to drive profitability
Without having an accurate means of assessing demand, businesses will need to make judgements regarding business levels, and perhaps lose out on opportunities where they under provide or wastage where they over-provide. Businesses that are highly integrated with their supply chain will also be exposed to any weak links in that supply chain which might fail give the current stresses.
It seems likely that, as we come out of the crisis, a substantial number of businesses will have ceased to trade. For some this will create opportunities to grow to replace those businesses, but for others it will leave them without the same customer base in the short term or for the foreseeable future. Other businesses will simply not be able to sustain the levels of debt they have incurred dealing with the crisis.
In either case, those businesses will need to create or accelerate plans to rightsize their business.
However, the process of completing restructuring plans almost always leads to costs itself. These take many forms, but in a European context the most obvious item is redundancy costs. But others would include:
- investments in more efficient equipment
- the cost of moving production lines to lower cost countries
- shut down costs of sites or business lines
- renegotiating with landlords to reduce rent to market levels
- the costs of stripping out and repairing leased premises on surrender
- refinancing costs and waiver or amendment fees
These processes typically also accelerate costs such as environmental clean-up or pensions entitlements and, as well as cash costs, have significant costs in terms of management time and consultancy fees.
As a result of the above pressures, while we may start to see an easing of lockdown restrictions, businesses are only beginning to deal with the cash impact of COVID-19.
Businesses with low financial indebtedness will be best placed to raise the financing needed to meet these costs. Ultimately businesses will need to seek to remain solvent through the whole process of responding to COVID crisis.
Each country has its own definition of solvency and rules on when management can be held liable personally for trading when they know a business is or may become insolvent, but these rules exist in all jurisdictions. Solvency will generally be determined by two factors: whether a company can continue to pay it creditors as they fall due (known as the ‘cash flow’ solvency test); and whether the aggregate of the company’s liabilities exceeds its assets (known as the ‘balance sheet’ solvency test).
Generally, if a business can continue to pay its debts as they fall due it will be permitted to continue to trade. However, in some countries (notably Germany) management are require to file for insolvency as soon as they are aware, or should be aware, that the balance sheet test is being breached. It is interesting to note that now seeing modification to the insolvency tests in almost all countries.
On the surface, Government schemes to fund working capital and maintain solvency are very welcome but will need to be available to fund all of the above costs outlined above if they are going to be successful. However, if it leaves businesses with such high liabilities that they are not solvent or the medicine has the potential to kill the patient. These claims will often sit alongside stretched payables, including unpaid rent.
Businesses have come to this crisis with very different balance sheets. Some will have significant existing debt and for those it is already proving challenging to fit debts under the Government schemes alongside existing debt packages. By their very terms the Government schemes require that businesses being funded have ceased to be viable as a result of COVID-19 – at least in the short term. To the extent repayable debts under the Government schemes are going to have to be absorbed into wider balance sheets at the same time as businesses are dealing with the pressures already outlined.
Some businesses may be lucky enough to be funded by existing debt and equity funding sources, but others will need to access additional funding either from debt or, at some point, equity funding. There are a wealth of sources for healthy business to choose from. On the debt side the choices for most companies will be either bank debt, non-bank lenders or debt capital markets funding. All of these can be accessed as either unsecured or secured debt, for those with higher leverage. They can also be accessed in the form of asset-backed loans which are being used more since they have an improved capital treatment for regulated lenders and by their nature such facilities help to control leverage to manageable levels.
If an equity funding is required, the right solution will likely be more bespoke and depend significantly on the size of the company. Existing investors in public or private companies can be asked to fund companies but the most controversial aspect will be the extent to which existing shareholder are diluted by new funding. Generally, existing shareholders can protect themselves by exercising pre-emption rights and subscribing for the new capital, but this requires them to have the capital to invest in the new round.
The greatest challenge in these situations will always arise if businesses cannot demonstrate to investors that they are financially healthy or otherwise investable. This can be through a range of factors, not all of which are obvious. For instance, businesses:
- may be over-indebted, either through COVID funding or changes in the business environment. If businesses run out of cash, despite COVID funding, before business starts to recover this will be the case;
- may have other liabilities weighing on them such as environmental liabilities or defined benefit pension liabilities, or perhaps historic leases on off-market terms;
- may have ongoing litigation, which may or may not be determined in their favour;
- maybe undergoing regulatory investigations or have operated in jurisdictions that have become subject to sanctions, which makes it very difficult or impossible to access funding from certain sources. This has become increasingly likely as sanctions regimes have been changing more quickly.
All of these may ultimately mean that a business may have to cease to trade and go out of business. Or, more positively, may seek to restructure either through consensual negotiation with creditors for a debt for equity swap or other debt restructuring, or through more formal processes such as a company voluntary arrangement (CVA) or pre-packaged insolvency which allows the business to continue with reduced liabilities.
The crisis has had a different effect around the world. Some groups of companies may have divisions or regions that are impacted in different ways and, on the face of it, they may be able to dispose of or shut down part of the group. However, many groups will have cross-guarantees or structural issues that mean restructuring will have an impact beyond the part of the business that is directly affected, even where those businesses appear to be held in separate companies, making this far more complex.
The economic ramifications of COVID-19 are not yet clear, but as we move through the fast-changing crisis businesses will need to respond to the changing landscape, identifying both challenges and opportunities and adapting accordingly.
So far, the business response to COVID-19 has been broadly successful, but the challenges that will emerge as the financial effects emerge will be complex and real. The most successful businesses will see the crisis as an opportunity for renewal, while remaining flexible for new challenges as they emerge.