HEADLINES

• In March 2020, credit insurer Euler Hermes forecast a 43% increase in insolvencies in the UK in 2021, as well as a 26% uptick in France and 12% in Germany
• By December 2020, ratings agency S&P was forecasting European defaults rising to as much as 8% by the end of 2021

There have been fewer European insolvencies and restructurings than anticipated during the COVID-19 pandemic, but distressed deal activity may accelerate as soon as economies are finally able to reopen.

The European Central Bank's expanded €1.85 trillion quantitative easing programme, coupled with tax deferrals, state-backed loans, employee wage support schemes and a focus, among lenders, on liquidity rather than financial covenants have all helped to keep companies afloat.

Lenders have also been reluctant to foreclose on debts and crystallise losses when valuations and value breaks in capital structures remain unclear, in particular with a backdrop of regulator announcements warning lenders against hasty action in the face of COVID-19 challenges, and a number of European jurisdictions introducing legal restrictions on such action.

A new round of full lockdown measures introduced in various European countries early in 2021 has seen the further extension of job retention schemes and state-sponsored loan and liquidity measures, but as soon as these support efforts wind down and markets reset (most likely in the second half of 2021), a wave of distressed situations are expected to come to market.

Back in March 2020, credit insurer Euler Hermes was already forecasting a 43% increase in insolvencies in the UK, as well as a 26% uptick in France and 12% in Germany in 2021.⁸ By December 2020, ratings agency S&P was forecasting that default levels could climb to as much as 8% by the end of September 2021.⁹

At some point in the next 12 months, it is likely that borrowers and lenders will have to assess whether earnings are going to recover to pre-COVID-19 levels or whether capital structures established pre-pandemic (or indeed post-pandemic) remain appropriate, with higher levels of debt incurred to support liquidity through the crisis.

Some companies in sectors directly impacted by lockdowns— from aviation and leisure to hospitality—managed to stay afloat in 2020 by tapping into markets to shore up liquidity reserves.

Jet engine maker Rolls Royce, for example, launched a £5 billion recapitalisation plan that included a bond and loan package, as well as a rights issue, to navigate disruption due to COVID-19, while UK food and fashion retailer M&S raised its first high yield bond after losing investment-grade status early in 2020.

With lenders focused on liquidity, some borrowers have taken the view that cash raised now can be repaid later in the cycle when economies recover. The question is whether these changes to capital structures are sustainable and what proportion of future cash flows will be required to service these loans and bonds over the long term. If companies are found to have borrowed too much too early, this may trigger restructuring deals long after the pandemic has passed.

8%+
The anticipated rise in European defaults in 2021, according to ratings agency S&P

Troubled credits flushed out early

Distressed deals and restructurings that came to market in 2020 typically involved credits that were already on restructuring candidate watchlists, especially in the UK. Sectors facing long-term headwinds, including physical retail, real estate and casual dining restaurants, account for a large proportion of the recent casualties.

For example, clothing group Arcadia and the department store chain Debenhams went into administration in November 2020. In the restaurant space, Casual Dining Group fell into administration in July and Carluccio's was bought out of administration in May.

The headwinds faced by these sectors have prompted a knock-on effect for real estate companies, with retail and restaurant administrations reducing occupancy rates and rental income. The impact of lockdowns on rental revenue and a £4.5 billion debt pile, for example, saw the UK's largest shopping centre operator, Intu, fall into administration in August. British Land, meanwhile, reported a 15% decline in its retail portfolio as annualised rents fell by £11.6 million.

Restructuring activity in 2021 is likely to continue along sector-specific lines, though more industries could move onto watchlists if consumer and client habits show long-term changes following COVID-19. It is also worth remembering that some businesses that were performing well pre-pandemic are currently on watchlists purely because of the sector in which they operate (e.g., leisure, aviation, etc.). They may be more than capable of bouncing back, depending on how long the pandemic continues.

Considering all options

Some companies turned to very 'light touch' restructurings, for example by resetting covenants or extending maturities to bridge to an anticipated recovery post-pandemic.

Others sought out more cash from existing lenders or third parties at the senior or super-senior level to provide emergency liquidity and extend runway. For example, in October 2020, French hotel property business AccorInvest held talks with 19 banks regarding a possible restructuring of more than €4 billion of debts. In August, aviation company Swissport announced that it had secured bridge financing, which was then used to facilitate a restructuring that completed in December 2020.

Financial sponsors provided cash injections for some. Hunter Boot, best known for its Wellington boot lines, received a £16.5 million cash injection after a period of weak trading from existing shareholders, including Goldman Sachs, Searchlight Capital and Pentland. Sponsors will need to assess whether these injections were enough to stave off a more fulsome financial restructuring later in 2021.

Borrowers also made use of restructuring tools such as company voluntary arrangements (e.g., shoe retailer Clarks), schemes of arrangement (e.g., Swissport) and restructuring plans (e.g., airline Virgin Atlantic and casual dining operator Pizza Express).

A number of these processes were used by these companies to implement debt-for-equity swaps— including Swissport, Pizza Express and New Look, the latter of which was implemented despite its CVA being challenged by landlords.

Special-situations firms will also provide a route out of distress in 2021. According to Preqin, special situations fundraising in April 2020 was more than triple the amount raised in the first quarter of the year.¹⁰ These investors will be on the lookout for deals—and with restructuring activity likely to pick up in 2021, there will be plenty of options.

8 "Calm before the storm: COVID-19 and the business insolvency time bomb". Maxime Lemerle. 16 July 2020. Euler Hermes.
9 "Europe's High-Yield Default Rates Rise as Credit Cycle Turns". Fitch Wire. 30 March 2020. Fitch Ratings.
10 "Where does debt sit on the LP radar?". Op cit.

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