Debt restructuring on the horizon

The RBA’s latest growth forecasts indicate a further weakening in GDP growth and increasing interest rates. This will result in many companies, already diminished by two years of severe commercial disruption borne of COVID-19 impacts, facing continuing financial challenges. These are poised to increase due to the worsening economic climate, creating several headwinds for companies under financial pressure.

“It is critical for companies facing upcoming financial pressure to engage as early as possible with the problem.”

The second half of 2022 was difficult for many companies to raise equity at all. For companies with balance sheets under pressure, even if they were successful in raising equity at all the price was deeply discounted - and often insufficient new equity was able to be raised.

The approach of lenders has changed too, now being increasingly reluctant to simply agree to amend loan covenants and extend maturity dates. We feel this is going to accelerate into 2023 with lenders taking a much harder line now than they were during the COVID lockdown.

This places a 'perfect storm' of economic pressure to deleverage on the many companies with fragile balance sheets, so their businesses can continue as a going concern.

Companies that are entering a distressed state need to look at debt restructuring before it is too late to do so. It is critical for companies facing upcoming financial pressure to engage as early as possible with the problem.

For example, if a company knows it will breach its financial covenants or that a significant maturity date is looming, it needs to put in place a strategy as early as possible before these occur to deal with it. The later these issues are left, the more limited and potentially adverse are the options available to the company, often leaving no choice but to go into an unplanned administration.

Cash flow is of course critical to monitor but so is keeping abreast of the debt arrangements, including the maturity profile, so the debt can be effectively managed or, if necessary, restructured. The key issue is the earlier the company starts, and the more time spent in the planning, the more options are available - and these are likely to be more favourable to the creditors and shareholders.

A broad indicator of business distress across industries, and that debt restructuring is likely on the rise, is the rate of insolvency. Once the option of debt restructuring closes, a more likely scenario is insolvency - which is on the rise in Australia.

The latest insolvency data from the Australian Securities and Investments Commission (ASIC) show an uptick in insolvencies towards a “return to pre-COVID normal” or possibly even beyond that. 

The ASIC data reflect the first time a company enters external administration or has a controller appointed:

• Pre-COVID-19 (September 2013 – March 2020 quarters): insolvency average across all industries was 2,138 per quarter (8,553 per year);
  
  
• During the heart of COVID-19 (June 2020 quarter – March 2022 quarter): insolvency average across all industries was 1,098 per quarter (4,392 per year) – effectively half of the pre-COVID-19 average;
  
  
• Last two quarters (June 2022 – September 2022): insolvency average has been 1,808 per quarter – a rise of 65 per cent on COVID-19 averages but still 18 per cent short of the pre-COVID-19 averages.

Debt restructure approaches

One common strategy to achieve deleveraging is a debt restructure that converts debt into equity. This can be done as the central component of a restructure or in combination with restructuring existing debt and/or waiving actual or potential loan covenant breaches or introducing new money or securities.

There are three broad approaches to debt restructuring:

1. Debt restructuring agreed between the parties. Ideally it will be possible for a company experiencing financial difficulties to reach an agreement with key lenders and other key stakeholders such as shareholders and creditors, if required, to the terms of a restructuring agreement and a standstill agreement.  While this approach only binds the creditors that agree, it is simple and fast to implement and has limited disruption to business and adverse publicity.
   
   
2. Solvent creditors’ scheme. This is a structure where a company can continue to trade and restructure its debt through a creditors’ scheme of arrangement where a sufficient majority of creditors agree to the terms of the restructure at a meeting of creditors. While this is a relatively costly and lengthy process with strict procedural requirements, the key benefits of this approach are that creditors who do not agree to the scheme are still bound by the scheme if it is approved by the Court and implemented and allows the directors to remain in control and the company to continue trading.
   
   
3. Voluntary Administration and Deed of Company Arrangement (DOCA). If it is not possible for a company to continue to trade because the company is insolvent (i.e., unable to pay its debts as and when they fall due) and the Safe Harbour Defence is not available, then a voluntary administrator should be appointed and companies can enter a DOCA. This is an efficient, flexible and fast approach - but provides creditors with the power to determine the outcome for the company and doesn't bind all creditors.

It will be an interesting reporting season in February/March 2023 when we learn how listed companies have weathered the first half of the financial year, particularly for retail companies expecting to have strong trading up to Christmas.

MinterEllison has recently published their Spring 2022 edition of “Debt Restructuring in Uncertain Times” which provides an overview of common structures to undertake a debt restructure to deleverage the balance sheet to ensure continued solvency or restore the company to solvency. The report includes an outline of the key steps involved in the process and the pros and cons of each.  Navigating debt restructuring in uncertain times

Michael Hughes and Ron Forster are Partners at MinterEllison