Advances in medicine have continually extended the average life expectancy of the population. Advances in lending, similarly, are providing new lifelines to companies that are distressed and struggling to survive. These lifelines are emerging even as current global market volatility is making it more difficult for companies with survival issues to raise capital. This is especially true for companies in Canada, where the senior lending environment is revered globally for smart lending policies but sometimes criticized locally by borrowers for its relatively conservative nature.
The Canadian situation is further complicated by the fact that the distressed lending market is not very deep. However, even in this environment there are a growing number of lending options available to assist companies through difficult times so that they may recover.
The distressed lending market
The high level of uncertainty in global capital markets means there is a significant amount of distressed company-related activity. Total completed distressed debt and bankruptcy-restructuring activity was US$364 billion during the first nine months of 2012, a 234% increase compared to the same period last year. Of this, U.S. distressed deal activity totaled US$37 billion. There, for the first six months of the year, telecom was the most active sector, capturing 70% of the market, followed by high tech and materials with 10% and 8% market share, respectively.
A critical element of distressed company activity is the availability of capital—referred to as distressed lending—that companies can access to avoid or exit a restructuring or bankruptcy. The distressed lending market is often defined as debt with a yield to maturity of greater than the benchmark (i.e. LIBOR, U.S. Treasuries) plus 10%. The level of distressed lending is driven primarily by the overall distressed company activity. It is generally estimated that there is approximately US$250 billion of distressed loans outstanding in the U.S.
The distressed lending market in Canada is small—an estimated $5 billion to $6 billion outstanding—due primarily to the historically conservative banking landscape in Canada. However, given the demand for creative sources of funding in the current business environment, a number of non-traditional players have recognized this opportunity and, as a result, distressed lending is growing in this country.
Bringing options to the table
Prior to the development of a distressed debt market, options for borrowers were few. Historically, when a company was in financial distress its lender was confronted with a difficult choice: a) support a risky turnaround effort and pursue a long and uncertain workout, or b) initiate a liquidation process. These options could potentially tie up the company’s collateral and management for months (or years). In some instances, the borrower might be persuaded to sell all or part of the business, but in distressed situations this would often lead to significant loss in shareholder value.
Fortunately, new distressed-lending products are providing another option for borrowers and their lenders when a borrower becomes distressed. In theory, it represents a “win-win” where the borrower is given time to restructure and “fight for another day,” and the new lender is appropriately compensated for assuming the risk.
One form of distressed lending that is growing particularly quickly in Canada is distressed asset-based lending (ABL). Distressed ABL is similar to traditional ABL in that the lender will advance capital based on a per- centage of a company’s assets rather than on the financial performance of the company. As a result of this, ABL lenders dig much deeper with respect to due diligence on collateral value. Frequently, asset-based lenders will monitor inventory and accounts receivable levels as often as weekly or even daily, in addition to monitoring the value of traditional hard assets such as machinery and equipment through current appraisals.
In a distressed ABL situation, the underlying concept is similar to ABL. However, some lenders, such as Callidus and Century Services, are more likely to lend a higher percentages on assets, be more flexible on the types of assets they will advance on, and may also provide some additional term debt supported by cash flows.
Another emerging form of distressed lending is commodity-linked transactions. In these situations, which are specific to the resource sector, distressed lenders such as Sprott Resources or Macquarie Capital seek access to the saleable assets of the company, which are often the commodity itself. They then have two options: take security in the commodity itself or the future production of the commodity. This not only provides security, but may also enhance returns if the lender is able to arbitrage the commod- ity in some way. Alternatively, if taking security on the commodity cannot provide enhanced returns, a small equity position may be required to boost the return profile on the negotiated debt instrument.
Both distressed ABL and commodity-linked loans are typically provided as a bridge solution (anywhere from six to 36 months), buying a company time to right the ship. While the cost to the borrower could be in the 20%+ range, it can be much cheaper and less dilutive than issuing new equity or filing for bankruptcy protection. In cases that require a more comprehensive restructuring of the balance sheet, hedge funds, such as Cerberus and Apollo, and bond funds, such as Catalyst, can provide sufficient capital to take out existing debt (usually at a discount) and provide ongoing liquidity to fund the turnaround. Whether it’s a bridge or a more fulsome solution, CFOs contemplating a distressed loan should be aware that these are complicated deals that can be considered aggressive, so it is important to match the right lender and structure to the specific circumstances.
Future of distressed lending
Stalling U.S. growth, debt troubles in Europe, unrest in the Middle East and a Chinese slowdown are all factors that will drive continued uncertainty in 2013. This environment will likely create more distressed situations for corporate Canada. This, in turn, should drive more appetite for distressed lending, especially since it provides a vehicle for traditional banks to recapitalize or even offload troubled loans from their loan portfolios.
With Canadian and U.S. institutions looking for creative ways to increase portfolio returns, it is reasonable to expect them to structure, price and offer a greater number of higher-yielding products such as distressed debt. With this emerging growth of distressed lending in Canada, borrowers have a few more tools to perhaps find the time to fix problems that they may not have been able to address just a few years ago. However, matching the appropriate form of distressed debt to the particular situation is critical— after all, the whole idea is to save the patient, not make them sicker.
This article was co-written by Andrew Luetchford, senior manager at Deloitte’s Capital Advisory practice in Toronto.
Robert Olsen is global co-leader of Deloitte’s Capital Advisory practice, sourcing debt and/or equity capital for private and public companies. E-mail: email@example.com.