Last year at this time, shortly after the 2016 presidential election, we observed the degree of uncertainty facing turnaround professionals. Although restructurings were continuing among energy-related companies — because of the severe drop in energy prices which have since rebounded — and legacy retailers, there was not much activity in the turnaround space. A surfeit of debt availability at rock bottom prices from both banks and nonbank lenders made it easy for underperforming companies to borrow their way out of trouble. And if that option wasn’t available, a cadre of deal-starved private equity funds marching steadily down-market toward smaller and riskier deals were happy to invest in anything with a pulse, however faint.
At the same time, the 2016 election was fresh in everyone’s minds, and — for the first time since the recovery from the Great Recession — risk seemed to be increasing again, although it hadn’t been reflected in interest rates. The growling government gridlock of the Obama administration’s latter years was continuing, but with an overlay of daily drama, replete with tweets, turnover among the president’s senior staff after only months in office and increasing susurrations about the role of Russia in the election. Things were feeling more uneasy and riskier, although it was hard to put a finger on it. And the stock market seemed to defy gravity, with stock prices outpacing company earnings — which, of course, is the definition of inflation. A year later, what has changed?
Limited Energy Industry Rebound
Energy-related companies have recovered somewhat with the limited rebound in energy prices, but casualties among retailers continue. Sears is still holding on, although the internet is awash with stories predicting its demise. But the rest of the economy is not experiencing much distress…yet? Bankruptcy lawyers continue to migrate their practices towards commercial litigation, lenders continue to downsize or reassign their workout staff and turnaround professionals pitch their “performance improvement” capabilities to assist otherwise healthy companies. There’s just not a lot of “turning around” going on.
On the other hand, the vague feelings of unease and mounting risk arising from the political situation have only increased — it’s almost palpable. The crisis du jour from our nation’s capital has continued unabated, but a “Teflon factor” has held up for the president so far. The investigation by the special counsel will soon have its first anniversary, and the number and complexity of international flashpoints have multiplied. Meanwhile, interest rates have begun creeping upward — historically the harbinger of turnaround professionals about to get busy. The stock market’s seemingly unending upward climb has been interrupted by sizeable gyrations.
There are also some hopeful signs on the political horizon — possible avoidance of a trade war, possible negotiations with North Korea — although these are potential solutions to crises that seem to have been needlessly created. Nonetheless, if agreements result that would not otherwise have been reached, then maybe this brinksmanship will be just what the doctor ordered. And the recent tax reform has juiced paychecks and corporate profits, at least temporarily, although the long-term wisdom of the policy is still debatable.
In the meantime, everything feels risky. The trend points mostly — but not completely — towards a softening of the economy, perhaps due more to external risk factors than intrinsic productivity. And if this, in fact, develops, turnaround professionals will get busier. But the ready availability of funds from lenders and private equity funds has not subsided, so there is little to suggest that turnaround activity will increase anytime soon. But it might.
Another phenomenon that would mitigate an uptick in turnaround activity is the regulatory arbitrage we observed in last year’s turnaround article. Regulated lenders, which survived the Great Recession (now almost a decade in the rearview mirror) and were burdened with additional stringent regulation in its wake, have an incentive to take a reserve on their books that is early and steep regarding a possibly questionable loan. That way, the loan will not be the subject of criticism by regulators. (“See? We’ve got religion — we marked the loan down already.”)
Of course, the new net value of the loan on the lender’s books still has “meat on the bone” from a liquidation viewpoint, making it an attractive acquisition for one of the credit funds that are constantly knocking at the lender’s door. These credit funds grew out of the exploding number of private equity funds when there just wasn’t enough deal flow of acquisitions The equity funds started buying bank debt — both entire portfolios and one-off loans, even mixed lending relationships with ABL, term debt and real estate.
Why should the lender go through the sturm und drang of the borrower’s turnaround, when they can monetize immediately and let the bad debt be somebody else’s problem? Ironically, the credit funds — some of the “loan to own” variety — can be far more flexible than the regulated lender that sold the loan. They bought the loan at a steep discount and have everything to gain by supporting the borrower’s turnaround so it can be repaid — at par! Now that’s a loan spread!
The result is regulatory arbitrage. And as I pointed out last year, when the next downturn occurs, banks may no longer call in the turnaround professionals the way they did during past economic dips — they may just sell the note and move on.
Time to Diversify
For all of the above reasons, turnaround professionals are well advised to add some other songs to their repertoire. Perhaps performance improvement, as many firms have done, while others have turned to M&A or other services. The large national turnaround firms have already diversified substantially and derive far less of their revenue from turnaround management than they did years ago. We may never see the type of flat-out 100% utilization of turnaround firms’ professional ranks we experienced during the downturn.
But you never know. I recommend practicing the violin, even while you learn to play the flute.