Global fintech and funding innovation ecosystem

How banks can help companies restructure for growth

WEF | Michael Spellacy, Alan McIntyre, and Derek Baraldi | Sep 28, 2020

US corporate bankrupcies Covid - How banks can help companies restructure for growth

  • The banking industry has to walk the tightrope of balancing relief with financial responsibility.
  • Where private investors are unwilling to step in, governments are filling the void.
  • Structured correctly, pension funds and other long-term investors might be the “patient capital” required to support local community businesses.

The fallout from COVID-19 continues to challenge and disrupt economies around the world, but the banking and capital markets sectors can help steady the ship. Through new, innovative liquidity plays, they can support small and medium enterprises (SMEs), struggling industries, and emerging markets to ensure that all sections of the global economy emerge successfully on the other side of this crisis.

Banks and capital markets firms need to play a leading role in the three distinct phases of this rescue effort – the sovereign phase, the debt phase, and the equity phase. Government support in many countries is likely to taper off this autumn, whereupon we will increasingly see economies transitioning into phases 2 (debt) and 3 (equity). During the debt phase, banks and fixed income investors will bear the primary burden of providing capital and liquidity. Whereas private investors and public capital will be the main players in the equity phase, when businesses, unable to service their debt, will need to be restructured and recapitalized.

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Financial institutions that participate in both phases 2 and 3 will need to think beyond short-term shareholder returns and take a “big picture” approach – finding opportunities that can benefit the wider economy while making smart, responsible bets for long-term growth.

Dealing with debt

During the debt phase, financial institutions will initially need to evaluate the landscape by reviewing their existing credit book to understand their levels of exposure across different sectors, and proactively identifying where new credit is needed.

As they begin to extend debt, they’ll need to spread their risk among different credit businesses while continuously checking for viability and assessing their credit capacity. They’ll need to set criteria to decide who should get relief and who needs to be restructured, which will prevent the rise of zombie corporations that are allowed to stagger on when it would be in the broader societal interest for them to default and restructure. This will require a delicate balancing act as financial institutions will need to identify the true strugglers, while still striving to be fair and equitable.

During the first phase of economic stabilization, the banking sector, in addition to offering standard debt vehicles, has largely acted as a conduit for the central banks’ guaranteed loan programmes for SMEs. However, bank lending has remained limp since the 2008 financial crisis as a result of uncertainty, regulation, and monetary policy, which means that they’re not the market’s panacea when it comes to smoothing the passage of loans, even if they’re backed by the government. That has provided an opening for the shadow banking industry – capital markets players, including private equity – to increase their direct private lending, either in the form of debt restructuring or bridge financing. In markets like the US, direct lending by institutional credit funds has become a powerful force in SME lending and in some recent time periods the majority of credit extended has come from these sources of capital.

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In phase 2, fewer loans will be backed by the government, so the industry has to walk the tightrope of balancing relief with financial responsibility. That will be especially true when it comes to dealing with struggling sectors. This is when Banking and Capital Markets players will need to be extra vigilant of economic indicators to constantly re-assess the depth of the crisis and their capacity to extend new debt to borrowers who are teetering on the edge of medium-term viability.

Roger Bieri, Head of Multinationals Clients at UBS, says: “The first thing that we focus on is trying to understand if a company is a designated survivor, i.e. has the company performed well before the crisis, and does it has a business model that is future-proof? If the answer is no, we help these companies, together with external advisors, to review their business model and potentially restructure the business and/or find new investors."

Needed: creative equity solutions

For many businesses, getting to the other side of this pandemic will require more than credit. In the US so far this year, 45 businesses, each with over $1 billion in liabilities, have already gone bankrupt. That number could double by the end of the year. In the small and medium-sized business sector, 50% of companies now consider themselves under severe financial strain and millions have indicated they may have shut their doors for good. To help these struggling businesses, the banking and capital markets industry will need to find creative, versatile solutions in the equity phase. These solutions will need to smooth the transition from phase 2 to 3 and benefit a large segment of struggling entities, from large companies and developed nations, to smaller businesses and emerging markets.

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Bernie Mensah, President of Bank of America’s International Bank, says:

“Our capital markets colleagues are having a whole bunch of conversations with eligible borrowers about structures that give them access to the liquidity that is there and typically, you’ll see innovative structures.”

They will make use of three traditional equity vehicles. The most disruptive is bankruptcy and recapitalization, where existing shareholders are wiped out and new capital repurposes assets. The second is new equity injections from either private or public sources, typically in preferred structures that give the new investors more of the upside. The third option is converting existing debt to equity in order to strengthen company balance sheets and improve available cashflow. Through this process, lenders (both public and private) become owners.

With falling valuations and low interest rates, the current conditions present an attractive opportunity for private investors. However, being an active player during a period of restructuring will require the banking and capital markets industries to innovate and find new ways to reach deeper into severely affected sectors and go beyond the highly visible large corporate sector to support and reshape the SME sector that accounts for the vast majority of employment in most economies.

Finding solutions for smaller businesses

Banks and capital markets have devised equity restructuring solutions before, but they’ve never had to deal with the scale of challenge that this crisis presents. This moment calls for the creation of new asset classes that can attract capital while ensuring that the impact of that capital is broad based. For example, investors could take direct equity stakes in large corporations that supply liquidity to SMEs through trade credit.

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Or they could invest directly in SME-focused exchange traded funds (ETFs). Additionally, private investors and private equity firms could provide lower-risk liquidity for SMEs by taking minority stakes in businesses, which lessens the valuation sensitivity and reduces the risk of ownership by maintaining existing shareholder control. There is also a role for the public sector in making SME equity investments attractive by changing the tax treatment of returns, or providing matching funds through business development schemes.

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