Eye of the tiger: distressed workouts are nigh

It is hardly a secret that falling revenues, rising debt service costs, supply chain and other forms of inflation are causing financial distress across many Australian businesses^[1]. Add geopolitical and market uncertainties, weaker consumer activity, extra ATO activity and you could be forgiven for expecting Australian corporate debt defaults to be rising.

And you would be correct. ASIC data and our own restructuring assignments confirm that many overleveraged entities are coming up hard against closing debt horizons, some entities unable to meet coupon on issuance across a range of TLB, bond, note, royalty prepay, syndicated and other financial instruments.

What is interesting is that while SME level voluntary administration activity has increased (EBITDA <$30m), at this point in the cycle, LMEs are mostly managing to restructure, recapitalise, workout or turnaround distressed situations, with the help of old or new capital.

In the pandemic period, the solutions to resolving distressed conditions were plentiful – capital markets were relatively open; SPP, rights, placement and cornerstone investment opportunities provided the source of capital required for senior lenders to waive covenant breaches under facilities.

Post-pandemic, windows opened for distressed investors to fund situations that had traditionally sought private equity sponsor, leverage or asset finance solutions – equity cushions, amend and extends^[2], capitalisation (PIK)^[3], new lien baskets^[4], covenant-lite instruments, and "whole of capital solutions" (mostly meaning warrants or royalties). These were classic equity subordination workouts.

In 2022 and 2023, "loan for own"^[5] transactions became increasingly common, with lenders exchanging debt (deleveraging) for equity, original PE sponsors exiting the situation on a "keys back" basis. Camp Australia, Genesis Care and Accolade Wines are public examples that spring to mind. There are many more happening across the private sector space.

In 2024, so far, the market is splitting between solutions available to sponsored enterprises and those offered to non-sponsors. For the first time since 2019, USA data shows sponsor defaults are rising above non-sponsor defaults, mostly driven by rising leverage, value breaks inside debt, maturing defaults and, unlike the post pandemic period, reluctance in sponsors to provide further equity cushions to resolve defaults. Although there are no equivalent Australia data sets, our special situations experience confirms this also to be an Australian trend.

At the same time, according to Pitchbook data, the European market, a weathervane for Australia, has in the past four months seen more syndicated investment into loans than in each of 2022 and 2023, much of this activity being in refinancing and restructuring situations.^[6]

The question for us is whether distressed investors will continue to drive the restructuring market.

Traditional Australian Banks (TABs)

Since the Royal Commission, TABs have focused on retail mortgage books, business continuation across strong credits and wholesale lending. The Reserve Bank continues to view TABs as economy stabilisers, supporting the de-risking of lending across this credit sector. While other lines of credit are open, on the whole TABs are unlikely to deploy new capital into distressed conditions and, according to the Reserve Bank (March 2024), are focused on maintaining default profiles at or below historical levels.

TABs continue to show marked patience in dealing with existing distressed credits with strong restructuring plans, safe harbours and invested management teams (and, generally, strategies designed to attract new capital to paydown TAB positions, occasionally on a co-participation basis). TABs are increasingly likely to seek information around the restructuring plan, the financial adviser and legal team (preferably known restructuring participants), investment bankers and commitment of issuer/borrower management to the restructuring plan. The intercreditor is the favoured device for accommodating new money and dealing with waterfall, covenant, security and other rights arising out of the restructuring plan.

For the right type of credit, existing TABs are more likely to extend tenor, waive some non-financial covenant breaches, smooth amortisation profiles, exchange revolvers for longer termed asset arrangements and, in appropriate cases, provide space in the security packet for new money, sometimes even on a super-senior basis.

We stress that this is not a universal rule or, necessarily, change in policy, simply an entirely sensible de-risk attitude when dealing with restructuring credits.

Suffice to say that TABs are unlikely to provide new restructuring funding.

European quarterly institutional loan volume activity in €bn (estimated). Source: Pitchbook | LCD Data through March 11, 2024

The rising war chest and activity of distressed investors

It is fairly well known in our circles at least that loan-to-own distressed debt investors have been raising capital to purchase debt positions as a pathway to taking ownership of financially stressed companies via debt-for-equity swaps, and then make operational improvements to try to return assets to profitability.

The playbook these funds follow is best actioned during times of economic stress – once the debt is acquired, when value breaks inside creditors positions, the debt holders offer a debt exchange to de-lever the company (loan for own), usually preliminary to a later equity raising. Distressed debt exchanges ideally take control of majority positions over old equity, which, as part of the exchange program, can then be offered to new investors. In a mining situation, prime new investors are less likely to be retail and more likely to be strategics such as offtakers, vertical integrated parties (for example, over the past few year car manufacturers have, probably with some regrets now, taken positions in lithium enterprises), private equity or superannuation investors, mine operators and other key supply chain counterparts.

Global market trends suggest more sponsored than non-sponsored loans will see some form of distressed exchange in 2024/25. Genesis Care fell into bankruptcy in June 2023 when its private equity backers decided to hand over keys to new debt holders.

This is one example of a gathering Australian trend, where corporate indebtedness extinguishes with the grant of equity instruments (a "debt for equity swap"). In some cases, Bis Industries being one, private investors take a public entity private, providing equity cushions to support new leveraged and/or mezzanine financed balance sheets. Sponsors, especially those with portfolios and ongoing fund raising needs have to pick which businesses to keep supporting, which depends on how far they believe the business is away from achieving longer term valuation models and the speed to which that value will be achieved.

There are a range of "names" known across our industry with major debt maturities falling due over the next 12-18 months, each of which will need to consider whether equity value remains on the balance sheet, breaks inside debt or can be restored while engaging in some appropriate form of restructuring. Each of those companies should be undertaking some form of restructuring or turnaround, both to protect stakeholders and for directors to establish to a future constituency that they understand fiduciary duties.

Why would anyone seek value creation through distressed buyouts/loan acquisitions?

As with all private equity, distressed investors, use one of a number of strategies to improve profitability, including:

• Improve liquidity and/or resize balance sheets by injection of new capital (equity), debt for equity swaps, sale or refinancing of assets, debtor securitisations, fleet financing or other means to attract liquidity.
• Amending cash cycles, negotiating new credit or supply terms, credit support with key suppliers (especially operators in a mining situation). cost cutting, resizing workforce, surrendering leases, removing "waste" and other cost-out programs.
• Asset or business sales/closures; online offering and other business pivots.
• Engage safe harbour masters, financial advisers to assist with the above and to ensure the enterprise is compliant with safe harbour, fiduciary, market practices.

In all these steps, the operational private equity team, along with the financial and legal advisors to the issuer/borrower, although adding extra cost, are very much part of the value enhancement. Once the business is stabilised that value can be accessed in the form of new capital, growth, M&A or even (longer term), recapitalisation in the public markets, for example by IPO.

Some of the tools and common practices

Structuring – Typically, a buyer will want to structure an asset acquisition because it can pick and choose the assets that it wishes to acquire and can leave behind liabilities, including unknown or contingent liabilities. A “hive-down” or “carve-out” of the assets into a newco, and the purchase of the shares in the newco, may also be attractive to the buyer.

In many situations, this is not possible. Schemes of arrangement (equity) have been popular devices for many years. In the coming period, we anticipate seeing more creditor schemes, some with and others without equity side approvals. A scheme might make sense to deal with class action risk, in addressing third party claims, ensure statutory novations or undertake other forms of reorganisation addressed in Pt 5.1 of the Corporations Act. In more extreme cases, valuation exercises will essentially mirror alternate DOCA and section 444GA style arrangements.

Warranties + Insurance – Another feature of distressed M&A transactions is that buyers do not typically receive warranties from sellers; moreover, if the company is in a formal insolvency process, administrators do not give warranties. Even where warranties can be obtained, there is often going to be doubt about whether the seller will be able to stand behind the warranties if a claim arises.

Anti-Embarrassment – It is common for sellers to include an “anti-embarrassment” clause in the sale documentation: a requirement that the buyer makes an additional payment for the sale assets if certain trigger events occur – usually the sale of the assets or a substantial part of them within a period after the distressed sale, typically between one and three years after closing of the sale.

FIRB and Anti-Trust – In the context of distressed M&A and with the likelihood of sector consolidation as stronger players buy weaker players or weaker players look to survive through mergers, competition law will also be a key consideration for many deals.

Key takeaways

Australian restructuring practices are constantly evolving – during and after the pandemic, older style asset liquidation and/or DOCA recapitalisations gave over to M&A style capital raisings to fix balance sheet and revenue problems, at least when LMEs were involved.

More recently, equity exchanges have been common across LMEs unable to secure equity cushions or new sources of capital when facing near-term liquidity, deleveraging or credit maturity events.

Those situations are often consensual and more easily undertaken when the LME is controlled by one or a few private equity investors. Those investors, if unwilling to provide new capital into the business are usually sophisticated enough to hand keys back and to be diluted out of the capital structure. In those situations, new shareholders take control of the LME, usually in consideration for the composition of some part of capitalised debt. Once the transactions complete, a partially or fully deleveraged entity continues in business under new ownership.

New situations with non-consensual arrangements, are just starting to emerge in the Australian market. Whether these arrangements present as schemes of arrangement, credit foreclosures via receivership, section 444GA transfers via Voluntary Administration or shareholder approved dilution or conversion instrument, each also provide for an equity exchange and a newly formed equity constituency.

Private capital funds with senior credit positions in distressed Australian business are very much the eye of the tiger – focused, calm, confident and with all the tools available to resolve distressed situations by taking control of equity in those situations. Australian businesses that allow maturity or liquidity events to come without planning lie at the fore of a private capital-led transfer of risk and wealth to its senior lenders.

With planning comes the ability to change that storyline.

^[1] A company is classified as distressed when it faces an immediate risk of not being able to meet its financial commitments (which can either be a liquidity event or lead to an insolvency according to the section 95A Corporations Act definition). For the purposes of restructuring assignments, the ability of an enterprise to meet financial obligations is often in the gift of existing lenders, business stakeholders, equity supports and new money and the ability of a management team to convince those stakeholders that a non-insolvency based process will lead to better outcomes than an insolvency solution (also a test that partially provides safe harbour protections to directors choosing to trade on a distressed entity).

^[2] Financiers change interest, amortisation and tenor profiles of existing facilities, usually on the basis of some form of fee, PIK or other equity compensation.

^[3] Interest and/or fees are capitalised to some future date, sometimes as late as a bullet payment at the end of the financing term (which is often extended to smooth out the impact of amortisation or cash-coupon on forward cashflows). This is especially common when the enterprise is in a pre-ramp up stage, with revenue deferrals to some measurable future period.

^[4] For example, when the borrower is encouraged to refinance and/or sell specific plant + equipment to raise working capital and/or paydown debt. Priming assets in favour of new money weakens security packets so has downside risk to old money. A good example is Scotts Refrigerated Trucks.

^[5] Once the swap completes, the creditor becomes a (usually) majority equity holder, the debt being discharged, released or extinguished. There are innumerable tax and regulatory issues to be resolved in most swaps, particularly if the transaction is FIRB reviewable or involves a dual listed entity.