By Ian Borman, Partner, Winston & Strawn.
The slow relaxation of the UK’s ongoing lockdown is presenting another blow to businesses already struggling in the coronavirus crisis. According to the Office for Budget Responsibility (OBR), the UK is heading for its deepest recession in 300 years.
So far, UK Government schemes to support businesses have provided loans and other forms of credit within existing legal structures. However, we appear to be at the beginning of a new phase in the response, with UK Government proposals to relax wrongful trading rules and introduce a company moratorium likely to move forward. Moves to ensure that supply chains for businesses remain functional are also being proposed with a Government scheme to replace credit insurance with Government support and rules to stop business ceasing to trade with businesses that are in insolvency proceedings.
These scheme challenge the way businesses under stress operate and, whilst increasing the breathing space for businesses and directors under severe pressure, they also open up new uncertainties for businesses trading with and financing those businesses.
The background to these developments is that businesses have really only begun to experience the financial impact of the enforced economic slowdown. Many have calculated that they will survive through to the end of lockdown, assuming ongoing relaxation throughout summer. But the backdrop for business recovery is stark.
Business managers and owners will need to navigate three phases to get their business trading again:
Direct costs incurred whilst shutdown continues: Businesses that have shut down quickly continue to have liabilities to suppliers, landlords and employees, without income to support those expenses. Even businesses that have apparently benefitted from the disruption, such as online delivery platforms and supermarkets, have had to foot the bill for social distancing measures, additional employees and managing disrupted supply chains. Many of these costs will not be recoverable or ultimately add anything to profitability.
Ramp up: As we come out of the crisis, it is increasingly clear that the return to normality will be slow and it is unlikely that business will return to pre-crisis levels in the short term. Through this ramp up phase, businesses will need to pay employees, acquire stock and meet usual running costs whilst planning for uncertain levels of business. They may be able to trim maintenance and investment expenditure but, if taken too far, this will also harm asset condition and future growth potential. Businesses that can maintain investment are those most likely to be able to take advantage of opportunities and benefit in the longer term.
Rightsizing for recovery: Many companies and groups of companies will find that parts of their business are uneconomic or simply that they will have to focus their efforts on saving parts of their business and not others. These measures can be complex and are discussed in more detail below.
It is worth noting that, in the initial phase, some of the direct costs have been met by cash receipts from receivables as a result of previous trading, which in the ordinary course would have been used to fund the business, investing in stock, materials and work in progress. With those cash receipts spent elsewhere, businesses will need to fund huge amounts of working capital while facing uncertain demand. To some extent, prior to the crisis we had already seen an increase in supply chain financing and asset based lending based on receivables, stock, and even plant and machinery. This looks set to continue, and the latest UK Government proposals certainly suggest that they are seeking to support supply chain financing as well as direct credit.
Meanwhile ongoing costs have depleted cash reserves, driving an almost universal search for liquidity from banks and the bond markets with even cash-rich businesses looking to raise funds. A small proportion of these debts are in the form of government grants or direct funding of salaries, but many are being absorbed on to balance sheets in the form of debt. These debts will remain long after the crisis has averted and in some cases terms are unclear.
Businesses may have little choice but to incur liabilities in the short term. The UK Government proposal referred to above is designed to make it easier for businesses to do this even if they are in crisis. However, businesses will need to think very carefully about what their balance sheets will look like coming out of the crisis and how they will fund liabilities long term. Businesses crippled by debt service will not be able to invest for the future in a world that has been changing quickly in the face of technological developments and shifting trade barriers.
One option is to arrange for sales of valuable assets to fund the business. This can involve the sale of a division or specific assets that is not required for the business or, for instance, the sale and leaseback of freehold property. Obviously, prices for assets is subdued at this time, but there may simply be no choice.
Businesses may be fortunate enough to be funded by existing lenders or shareholders, but others will need to access additional sources of funding. On the debt side, options for most companies will be either bank debt, non-bank lenders or debt capital markets funding. For those with higher leverage, all of these can be accessed as unsecured or secured debt and in the form of asset-backed loans. Asset backed loans are increasingly popular since they offer improved capital treatment for regulated lenders and help to control leverage. If an equity funding is required, the right solution will be more bespoke and depend significantly on the size of the company. If helpful, advisers can be a useful source of introductions to new sources of financing, and we often find that reaching the right individual in an organisation is as important are choosing the right organisation to approach.
However, increasingly it is becoming clear that the scale of the balance sheet challenge means that shareholders and lenders are going to require other creditors, such as landlords and even suppliers, to share some of the cost of getting businesses back into operation.
Businesses may find themselves in a position where their historic liabilities are simply too big to be solved with additional funding, even though they have a profitable underlying business or part of the business. For these businesses they will try to reach a consensual agreement with their creditors, but this may not be achievable without threatening or going through a formal company voluntary arrangement or an insolvency process. Those processes therefore form the backdrop to any negotiation with creditors, meaning that understanding the outcome of such a process is an important first step.
If handled correctly, a restructuring can be used as a tool to reach a fair position for all creditors of a company and allow all or a part of the underlying business to survive. Ideally this may involve accelerated sales and consensual amendments to agreements rather than insolvency, but businesses may, in the end, need to go through a formal process.
Restructuring, even on a consensual basis, incurs significant costs, including redundancy costs, equipment investment, costs for moving production to lower cost countries, shut down costs, landlord renegotiations and refinancing costs and waiver or amendment fees. Where a formal process is required, it is likely that advisors’ fees will significantly add to those costs.
Directors of companies going through these processes need to take ongoing advice to ensure that they are not exposed to personal liability. The UK Government’s announced relaxations will make it easier for directors as they navigate a difficult business environment, but those measures have not yet been implemented and so the exact scope of the relaxation is still not clear. In any event, the news rules will require interpretation and directors will want to have advice on their scope before relying on them.
Most importantly, as we go through this continuing crisis, businesses need to be alive to the changing environment, including both challenges and opportunities. The most impressive management teams are seeing the crisis as an opportunity to renew their businesses and ensure that they are flexible for whatever the rest of the year will bring.