• Special Situations Advisory
Article:

Rethinking value creation for distressed companies

27 August 2021

The COVID-19 pandemic has given rise to a wave of companies who will face considerable financial pressure. As the economy transitions into what has been described by many as ‘the new normal’, stressed and distressed businesses will need to reassess their financial position and available options.

In particular, companies who have relied on government, landlord, shareholder and bank support over the course of the pandemic may be facing uncertainty surrounding their future cash flow position and ability to access capital in the current market.

Notwithstanding the effects on revenue and profitability, companies who have negotiated rent relief (deferred rent), deferred PAYG or GST payments with the Australian Taxation Office (ATO) or bank loan deferrals may find themselves with a highly leveraged balance sheet.

However, multiple sources of potential capital available in the market presents an opportunity for distressed companies who act quickly to set themselves up as an attractive prospect for distressed capital investment.

In our opinion, the Australian operating environment has created somewhat of a perfect storm for both distressed companies seeking capital, and the growing number of investors and funders in the distressed market – providing more financially viable options to companies before undertaking a formal restructuring process.

“With uncertainty around ongoing government incentives and stakeholder support, businesses in distress or experiencing cash pressure can rely on BDO to support management teams to reduce the risk of business failure and improve the likelihood of the best solution for all stakeholders” - Andrew Sallway - Partner, Advisory

Opportunities in an evolving Australian Market

In today’s environment, companies and their stakeholders are rethinking traditional restructuring solutions and utilising alternative sources of debt and equity - accelerated M&A and the changing lending landscape are key drivers of this change.

Opportunities in accelerated M&A

Even before the pandemic sent the global economy into a tailspin, private equity funds (special situations funds) were training their focus inward on creating value for their portfolio companies and signalling more interest in distressed M&A. Trade buyers may also emerge as companies who hold strong market positions in their respective sector or cashed up balance sheet’s may be looking to competitors or businesses in their supply chain facing financial distress to take advantage of synergies in expanding their existing business.

In our opinion, the pandemic has only magnified this trend as investors understand the denominator for so many companies in distress following the pandemic is not due to an unviable business strategy or management capability but the sudden lack of liquidity deriving from a swift drop in demand.

While ordinarily a distressed sale would require a company selling the business or assets at a significant discount from market price, it is also an effective means of raising quick capital in order to meet short term debt repayments, avoid foreclosure and keep credit lines open with lenders. Particularly for companies where there is a risk of trading while insolvent following the pandemic, this may be an important measure to increase available funds to repay debts.

A changing lending landscape

The banking landscape is also undergoing a significant period of change, with traditional lenders (big four banks) undertaking a more conservative, risk based approach to working capital facilities and private debt. This has resulted in a shift over the past decade with the introduction of non-bank lenders and private debt funds taking a growing market share in private debt markets. Again, we consider this shift has only been escalated by the pandemic, as Australia’s big four banks (despite the support provided to borrowers to date) will be unable to support the market on their own moving forward.

As non-bank lenders are smaller and subject to a different set of regulations than traditional banks, they are able to provide more flexibility in their approach to lending and the circumstances of a company in distress. Distressed companies may also prefer to work with non-bank lenders as they are often able to provide introductions to strategic partners and otherwise assist your business grow.

“As cash flow pressures increase, companies need to act quickly to understand their ability to access alternative sources of capital” - Duncan Club - Partner, Advisory

Redefining 'Distressed'

Traditionally, distressed companies were entities seen to be on the brink of insolvency or facing timely formal restructuring proceedings. However, the COVID-19 environment and its associated external factors have created a new class of distressed companies.

This new class represents businesses with strong underlying business models that have been adversely effected by the pandemic and as a result find themselves facing a situation of financial distress. This inclusion broadens the spectrum of distressed companies to encompass the many stages of financial distress, varying from a company simply concerned about its current cash flow position through to a business needing to utilise a formal restructuring process.

Key impacts of the pandemic

Reduced Working Capital

Working capital converted to cash by collecting trade debtors and selling down inventory.

Reduced Demand

Significant market disruption across multiple industries such as Tourism, Hospitality & events leading to reduced demand.

Disrupted Supply Chain

Both in respect to import/export markets and viability of suppliers/ customers.

Cash Flow Concerns

Internal avenues for raising or preserving cash flow may have been exhausted (such as working capital or further equity investment from existing stakeholders).

Accuring Liabilities

Creditors not being paid within terms and overdue statutory liabilities.

Reliance on Government Stimulus/Stakeholder Support

Being reliant on support to meet essential liabilities such as wages, superannuation & rent.

Strained Stakeholder Relationships

Negotiations in respect to deferral and payment of liabilities throughout the pandemic with creditors and customers may leave relationships worse off.

HOW CAN BUSINESSES ACT QUICKLY?

  • Evaluate the security position in a worst-case scenario and understand the full extent of post–pandemic liabilities including negotiated deferrals, underperforming business units and potential bad debts.
  • Prepare a short-term cash flow forecast, which is stress tested, with the aim of understanding the cash runway and peak funding requirements. Look to assess opportunities to reduce the overall working capital requirement, and forcing “what-if” discussions with management.
  • Explore the potential capital solutions or strategic options available.

For more information, please contact our Special Situations Advisory team.