2009 vs 2020: The Real Issue for Over-Leveraged Corporates Is Not Debt — It is This

Published 16 September 2020 by Audra Walton

In an effort to shore up their strained balance sheets, corporations across Europe are increasing debt to dangerously high levels. In fact recent research showed that one in five firms (21 per cent) is now a “zombie firm” because of rising corporate debt since lockdown, meaning its profits at best only cover its interest payments and at worst do not even cover those liabilities.

This is hardly a surprise. Borrowing is the go-to mechanism for financing operations under stress. It is also an attractive option considering government interventions brought corporate borrowing costs down. But as CMi2i’s latest research shows, excessive debt comes with a bigger price tag than the cost of interest. The idea that debt will allow these companies to survive the rough seas of the crisis until demand begins to rise and they can de-leverage into safer waters, is a nice thought, but not a likely reality.

We need only look to the previous economic crisis of 2007 to see what happens to companies that over-leverage. CMI2i recently examined the Euro Stoxx 50 index constituents pre-2007, tracking what happened to them in the aftermath of that crisis. The research showed that those companies that over-geared not only often underperformed but also faced activist campaigns, and in a few cases, were either taken over or nationalised.

Debt will be the world’s Hydra of Lerna—the multi-headed water monster that served as the entrance to the underworld in Greek Mythology.  Even as economies begin to return to normal, and companies start to enjoy the calmer waters, the consequences of the heavy debt that corporates incurred whilst fighting to survive will pop up out of nowhere just like the heads of Hydra—but in this case, taking the form of activists, fire sales, and nationalisations.

The Hydra was eventually slain by Heracles, but our world doesn’t have a divine protector who we can turn to in this unprecedented crisis. With that said, corporates do not need to be resigned to a terminal fate. There are things that can be done to help ensure the investor base isn’t being seeded with activists, that share prices are fairly valued, and that decisions are made with the support of investors. 

One idea was recently posited by the FT’s Martin Sandbu in an article called “The Corporate Zombies Stalking Europe,” in which he describes the current predicament corporates find themselves in:

Many companies’ balance sheets have been hurt so badly as to put in doubt their ability to return to normal, let alone contribute to renewed growth. Even an unrealistically best-case scenario — where the virus recedes and activity bounces back — leaves serious problems. Welcome to the zombie economy. The steepest downturn in generations forced many European companies to run down cash reserves and increase debt to the point where their solvency is threadbare. 

The solution he offers is recapitalisation and debt restructuring. He writes:

The solution is to inject new equity, either from taxpayer support in return for partial ownership stakes, or from creditors through expedited insolvency procedures that restructure companies without liquidating them. Subsidised terms can limit dilutions at small or family-owned companies if that is desired.

Whatever the solution—recapitalisation, debt restructuring, or something else—it is likely that shareholders will need to vote and agree on it at an AGM or EGM in which boards and investors can have a dialogue about the path forward. Which bodes the question, why wait until legally required to hold a general meeting to engage investors? The introduction of the virtual AGM/EGM has made these affairs much more affordable, and there is a huge upside if managed well. Imagine including investors in defining the options available before nearing insolvency, rather than hitting them with two bad options at the end of a painful road? Moreover, garnering the support, input and analysis of institutional investors has always proven crucial in fair valuation. Now is no different. The trick is in identifying as many shareholders as possible to avoid any activist surprises.

The saying, ‘Communication is key to success’, seems to be an apt one for boards and management to remember this year. Shareholders may be more forgiving than you think, but corporates need to communicate with them, solicit their opinion, and get them onboard. Without that engagement, there will be no avoiding the Hydra for most.

Written by Audra Oliver, audra@cmi2i.com

About CMi2i

CMi2i is a leader in capital markets intelligence, specialising in the world’s most accurate Equity & Debtholder identification service. As an issuer agent, CMi2i supports issuers and their advisors with investor relations, M&A, shareholder activism, capital restructuring and reputation management goals. The company has supported more than 1000 corporate transactions, 1200 AGMs and has over 500 clients worldwide. CMi2i’s LIBOR Solution provides an end-to-end service for issuers wishing to identify bondholders and solicit their approval for the new rate.