The following is a guest post from Stephen R. Levitan, managing director of debt capital markets and capital solutions at Oberon Securities. Opinions are the author’s own.
According to the RSM Middle Market Business Index, survey participants think the economy is strong and will get better over the coming months. At the same time, commercial bankruptcy filings grew 36% through the first nine months of 2024. How can we reconcile those seemingly contradictory facts?
Certainly, there is a lingering effect of COVID-19 on sectors like hospitality, and we can easily identify the impact of stubbornly high borrowing costs on teetering leveraged buyouts. There are also factors like the change in work patterns post-COVID hitting commercial real estate, local shops and eateries and cost inflation pressures. However, these factors do not tell the whole story, and there are many idiosyncratic causes that individual firms might point to as precipitating factors.
When trouble arises
Business leaders naturally will have a bias towards optimism, but changing circumstances require that they also consider downside scenarios. Hope is not a strategy and being intellectually honest allows management to consider contingency plans that could save the business.
Middle-market firms are far more likely to experience financial and operational distress than larger firms. When they do, creditor recoveries are typically lower and the risk of outright liquidation is significantly higher. Turnaround restructuring plans, often involving expertise hired from outside the company, can often mitigate these worst-case outcomes and stabilize the business.
One key is to know what you do not know, both as a manager and as a company. For example, large companies often have a finance team to monitor markets, anticipate funding needs and optimize capital structure and debt cost. Smaller firms typically have a CFO who is most likely strongest in reporting functions, often not supported by any treasury function at all. There is a lot they will likely not know.
Management needs to focus on running the business when trouble arises. Vendors, customers and employees will all need more time and attention, while competitors will take shots at a weakened player that needs to be addressed. This is where the focus has to be maintained. Someone else — an investment banker — will be needed to deal with funding and capital structure issues. That outside assistance should be retained as soon as a potential problem arises and much sooner than one might initially anticipate, as options fall away and those remaining become more costly as the company approaches a crisis inflection point.
There simply isn’t time for a firm to build those capabilities organically, and it represents a diversion of resources that are critically needed elsewhere to ensure that the firm not only survives but is not hobbled by the effects of its financial difficulties.
Know the warning signs
Understanding both the capital structure and restructuring processes, knowing how creditors respond when things sour and knowing the parameters of what is realistically possible are skills few have unless they have been through it before. Companies — especially those that are run by founders who have devoted their entire lives to the business — need advocates who can reduce the emotional temperature and work constructively with workout people, lawyers and other specialists.
Investment banking transactions — asset dispositions, mergers, financings and restructurings — usually take months, not days to negotiate, structure and implement. Banks do not like negative surprises, can be slow to respond to requests for relief and can cut off funding if the company violates the terms of the lending relationship (and no, it makes no difference if the violation is a financial or technical one once things turn sour).
Here are a few warning signs to keep in mind:
- Is operating performance short of projections for more than a quarter?
- Have there been sudden changes internally or externally that suggest material negative effects on future performance?
- Do you have reliable cash forecasts that show an unfunded shortfall that your existing financing sources cannot or will not cover?
- Are key employees leaving? Are suppliers tightening terms?
- Are customers delaying orders or diversifying their sourcing?
- Do you have debt due within 12 months that has not already been refinanced or for which negotiations are not already very advanced?
- Do you know if your lender has marked the loan down on its books?
- Has your loan been classified or transferred to special assets for oversight, or has the lender taken actions to protect its interests? Are there new faces showing up at meetings with the bank? Has your relationship banker expressed interest in reducing exposure to your company?
In some ways, restructuring advisory is like nuclear disarmament talks — the stakes are high and everyone knows that the outcome is really bad if the situation needlessly goes sideways. While there are situations where bankruptcy is necessary to resolve unsustainable debts, leases, etc., your advisors may identify options short of bankruptcy that can produce favorable (and sometimes better) outcomes at considerably lower costs.
Management should always be concerned that there is a risk especially relevant to lower middle market and middle market debtors that the process ends with a company liquidating or being sold at auction for substantially less than might otherwise have been realized, costing jobs, management’s legacy and significant amounts of money.
