The Risk Institute’s June 16, 2021 webinar, The Effects of the Wave of Bankruptcies and Consolidations, featured guest speakers Karen Wruck (The Ohio State University, Fisher College of Business, Finance Professor, Dean’s Distinguished Chair in Finance) and Ted Stenger (AlixPartners, Managing Director).
Along with moderator and Risk Institute Executive Director Phil Renaud, Wruck and Stenger spoke on the impact of the COVID-19 pandemic on small and large companies, took a deep dive into how 2020 looked compared to previous years, and considered what the impact might look like moving into a post-pandemic world.
Financial Distress and Bankruptcy – Karen Wruck
Wruck shared an alarming statistic to kick things off: 1/3 of all small businesses shut down in 2020. The question is, which of these will reopen? Have large companies fared better than smaller companies? Can smaller players make a comeback? Read on to hear expert perspectives on these topics and more.
Wruck’s presentation began with a look at re-contracting. A re-contracting event consists of a re-examination of financial structures and a re-examination of strategies and management effectiveness. With this, current contracts are determined to be either non-viable or validated to be viable with an agreement as to how to move forward. To understand this re-contracting, Wruck says, one must consider the firm’s value and the potential for conflicts of interest between stakeholders (creditors, shareholders, and employees).
Just last week, it was revealed that Washington Prime Group (owners of Polaris shopping center and dozens of other malls) are filing for Chapter 11 bankruptcy protection: but Wruck says re-contracting can be a productive process for firms (such as WPG) that cannot keep their agreements.
In May 2019, almost a year before the pandemic, Chairman of the Federal Reserve Jerome Powell said that “business debt has clearly reached a level that should give businesses and investors reason to pause and reflect.” But, as one might imagine, the situation has only gotten worse in the past two years, with U.S. corporate debt as a percentage of GDP reaching an all-time high of 55% at the end of last year.
Furthermore, it is not just the amount of debt that matters, but the quality. In the years since the 2008/2009 financial crisis, BBB-rated bonds – those that sit at the very bottom of investment-grade corporate debt – have exploded 200%, according to S&P Global. In fact, BBB-rated bonds grew to more than $3 trillion last year and now represent 53% of the entire investment-grade market.
This percentage will only increase as the two largest rating agencies, S&P and Moody’s Investors Service, are currently downgrading U.S. companies at the fastest pace since the 2008/2009 financial crisis, with downgrades outpacing upgrades three to one.
As for bankruptcies, at the end of 2020, the number of corporate bankruptcies was not that different from the 2008/2009 financial crisis. However, the industry composition was quite different, as this time, energy and retail companies were hit the hardest. The good news is that bankruptcies started to trend downwards in 2021.
As per a survey of more than 5,800 small businesses between March 28 and April 4, 2020, several themes emerged which demonstrate that small to medium-sized companies were hit the hardest during the pandemic:
- Mass layoffs and closures had already occurred just a few weeks into the crisis.
- The risk of closure was negatively associated with the expected length of the crisis; moreover, businesses had widely varying beliefs about the likely duration of COVID-related disruptions.
- Many small businesses are financially fragile: the median business with more than $10,000 in monthly expenses had only about two weeks of cash on hand at the time of the survey.
- The majority of businesses planned to seek funding through the Coronavirus Aid, Relief, and Economic Security (CARES) Act. However, many anticipated problems with accessing the program, such as bureaucratic hassles and difficulties establishing eligibility.
Also of note is that small to medium-sized companies “failed silently,” said Wruck. This wave of silent failures goes uncounted in part because real-time data on small business is notoriously scarce and because owners of small firms often have no debt and thus no need for bankruptcy court.
“Probably all you need to do is call the utilities and tell them to turn off and close your door,” said William Dunkelberg, who runs a monthly survey as Chief Economist for the National Federation of Independent Business.
According to Yelp, at least 80,000 businesses were permanently shattered from March 1 to July 25, 2020. Within this, about 60,000 were local businesses (or firms with fewer than five locations). In connection, firms with fewer than 500 employees account for about 44% of U.S. economic activity and employ almost half of all American workers. Will these entrepreneurial individuals reinvent themselves? Is this damage temporary or permanent? asks Wruck.
Influx of aid
The pandemic resulted in the permanent closure of roughly 800,000 U.S. establishments in the first year of the outbreak – this being about 200,000 more than historical levels (at about 600,000 permanent closures per year).
Federal Reserve economists suggest that small business failures were fewer than some predicted. This is likely due to extensive government aid, including the paycheck protection program (PPP), which provided $525 billion in forgivable loans to small businesses last year, and reopened in January with an additional $284 billion in funding.
Before the pandemic, U.S. companies were borrowing heavily at low interest rates; when COVID-19 lockdowns triggered a recession, they did not pull back, borrowing even more. Non-financial companies issued $1.7 trillion of bonds in the last year, nearly $600 billion more than the previous high.
The torrent of inexpensive money has benefited all types of businesses:
- Cruise operators, airlines, and movie theaters weathered the pandemic by replacing some lost revenue with cash raised from bond sales.
- It allowed businesses to stock up on cash and save money by refinancing older debt.
- It permitted companies that were struggling before the pandemic to ease the threat of bankruptcy by issuing new long-term debt.
The question now is whether companies have merely delayed a reckoning, Wruck says. For all their current enthusiasm, many CFOs and investors acknowledge that businesses could still be punished for a normal downturn that raises borrowing costs for a longer period and does more serious damage to household finances.
The Disruptive Impact of COVID-19 – A Coming Wave in Bankruptcies? – Ted Stenger
Throughout the pandemic, the federal government injected trillions of dollars into the economy to address the crisis. To kick off his presentation, Stenger shared a few points:
- Leveraged loan default rates spiked with the virus but have since declined thanks to this aforementioned injection of cash and, in turn, an economy in the process of recovering.
- Issuances have gone up drastically over the last 10-12 years, but really spiked in 2020. This was driven by the fact that everybody who could tapped into the capital markets. Because future prospects were uncertain, management stockpiled as much cash as possible to weather the storm.
- COVID in itself might accelerate some of the M&A activity, but it will not be the primary driver. There are lots of other disruptions (like retail and commercial real estate) that will drive M&A activity moving forward.
Chapter 7 trends were stable for the four years leading up to the pandemic but dropped last year because of alternatives like Uniform Commercial Code (UCC); in other cases, businesses simply shut off the lights and locked the doors. Next year, Stenger says, Chapter 7 filings will likely return to quasi-historic levels, with the caveat being that these alternatives (like UCC) may be used more frequently.
The liquidity and cash that has been pumped into the system by the federal government have kept the number of Chapter 13 filings down. Another factor that kept bankruptcies down is the mortgage default rate that – while it has gone up – has not spiked, as expected. And due to lockdowns and restrictions on travel, personal savings rates have gone up substantially.
AlixPartners Disruption Index:
The AlixPartners Disruption Index looks at forces that displace existing businesses, markets, and value networks in favor of newer models and relationships. The index, as reported by over 3,000 senior executives, accounts for overall disruption levels as well as the number of destructive forces confronting their organizations.
It is equated by multiplying the magnitude of disruption (an assessment of how disruptive organizations have been over the last year) by the complexity of disruption (the number of simultaneous forces impacting organizations over the last year).
The results (based on the percentage who selected “very/extremely” impacted) revealed that COVID-19 was not a top concern of the C-suite for most businesses, at 25%.
Of the most concern were:
- New or evolving business competition (34%)
- Technological advances in materials and processes (33%)
- Data privacy and security related issues (33%)
- Pervasive connective infrastructure (32%)
- Automaton artificial intelligence robots (32%)
The industries that were the most disrupted and expect an increased frequency of disruption include: Financial Services, Retail, and Aerospace.
Written by Jack Delahunty in association with The Risk Institute at Ohio State’s Fisher College of Business