Since the end of the first quarter, the Covid-19 pandemic has driven increased volatility in commodity prices and has dramatically weakening demand for certain metal commodities. This dynamic has, in turn, challenged companies across the industry. Although the degree of economic impact has varied across the metals and materials supply chains, the ramifications on capital markets and liquidity have been significant.
Amidst drastically reduced economic activity, companies have had to carefully navigate immediate pressures while at the same time preparing for the future.
Companies can employ a number of strategies in order to successfully weather the storm, including strengthening liquidity, preparing for lender negotiations, seeking out restructuring options, or modifying their capital spending plan for opportunistic M&A. Actions taken depend on a variety of factors, including respective companies’ overall financial strength, their relationships with their lenders and other capital providers, and their appetite for targeted acquisitions. One thing is certain; proactive measures should be on the minds of business owners and sponsors alike.
Any level of reduced economic activity – however temporary – will stress any business. Throughout this crisis, the priority of metals and materials companies has been first and foremost to protect their workforce, particularly since many businesses were classified as essential and managed to avoid government-ordered shut-downs. Additionally, many companies acted quickly to maximize liquidity by preserving capital, reducing costs, and prioritizing the operation of lower-cost assets.
These actions are now paying off and will continue to yield benefits through what Livingstone expects to be a prolonged decline in global commodity prices and lower demand over the next 12 to 18 months. As a result, companies are taking a cautious approach to capital spending.
M&A activity in the metals sector was down in the first quarter of 2020, with deal value and volume declining 31.6% and 3.8% year-on-year, respectively. Major deals already in progress pre-pandemic continue to close while strategic buyers, private equity sponsors and family office investing arms remain highly interested in performing businesses. Further, distressed companies and troubled assets are likely to receive support from banks, governments, or suppliers to survive the crisis.
While capital available for acquisitions will be under increased scrutiny, Livingstone anticipates companies with strong balance sheets will seize the opportunity to grow market share. Companies may expand their geographic footprint by acquiring junior players, diversifying into new services or capabilities, or taking the opportunity to rethink supply chains in the wake of Covid-19.
Additionally, the benefits to scale and diversification remain, irrespective of market cycle, and buyers with strong balance sheets have indicated a deep desire to leverage a strategic advantage to opportunistically deploy capital in these uncertain times. Importantly, this does not always mean distressed values, but it does require additional preparatory work to ensure acquisition targets stand out from the crowd.
Preparing for Lender Negotiations
Livingstone has multiple financing transactions currently in market and has held extensive conversations with a broad range of debt providers, revealing several consistent themes. Summarized below are multiple considerations that businesses and private equity investors should heed as they prepare for and, ultimately, approach lender negotiations.
- Prepare to share daily and weekly operating metrics, as well as 13-week cash flow forecasts, with lenders during the near term
- Understand the operational and financial impact of social distancing requirements on the business, as the prevailing assumption is that most provider businesses will not return to pre-COVID levels during the short-to-intermediate term (which will impact pro forma leverage levels)
- Lenders will view amendments and debt restructurings relative to current market leverage and pricing for new, healthy debt issuances. New deals are being underwritten to (i) 0.5x to 1.0x of lower leverage relative to EBITDA and (ii) 100 to 200 basis points higher interest rates relative to pre-COVID levels so debt restructurings will undoubtedly receive less favorable terms.
- Lenders will not unilaterally solve liquidity issues and over-levered situations; assuming or proposing such in a negotiation is ill-advised and will force lenders to pick “winners and losers”
- If lenders elect to provide liquidity in support of the business, the lender will likely look to extract meaningful value through fees, rates, and warrants, among other terms
- If the lender elects not to provide liquidity this action immediately puts the company “in play,” thereby creating a catalyst for a sub-optimal outcome for equity holders (e.g., a forced bankruptcy filing, lenders exercise stock pledge, debt sale, liquidation, etc.)
Potential Strategic Options
Combining; (i) lenders’ expectations for lower leverage with (ii) a high likelihood that the business will have reduced EBITDA suggests that, in most instances, a “like-for-like” debt refinancing will not be viable, and incremental junior capital will be required. To that end, depending on pro forma leverage levels, potential options include:
- Low leverage deals. For businesses that were modestly levered pre-COVID, the solutions could include (i) contributing new capital while negotiating an amendment with the incumbent lender or (ii) transitioning from a senior bank structure to a unitranche facility if negotiations break-down.
- Overly levered deals. For more highly levered businesses, owners will need to evaluate all strategic options. Importantly, the following options exist along a continuum and should be explored in a parallel process.
- Invest incremental equity. Additional equity support will always be well received by lenders and will result in the greatest amount of negotiating flexibility in return
- Pursue structured capital. There are numerous investment firms focused on providing non-control growth equity, structured / preferred equity, and junior debt. The security from these investors will include a combination of PIK interest and either warrants, a liquidation preference, or other features that will be dilutive to existing equity, but will negate the need to contribute additional capital.
- Seek a majority equity partner. If the business is fundamentally healthy but its balance sheet is broken, consider seeking an investment from a new equity partner with the existing owners retaining a minority position. The new equity dollars can be used to pay down debt though the new equity partner will require operational control.
- Consider a strategic combination. Partner with a complementary business that has an unlevered or less levered balance sheet. The larger scale will be attractive to lenders and, depending on relative size of the two businesses, may result in a minority equity position for the higher levered practice.
- Evaluate a full sale. In some situations, the value maximizing outcome will be to pursue an exit as opposed to seeking new capital and/or completing a debt restructuring.
- Explore bankruptcy filing or alternative restructuring mechanism. Certain businesses will be in such financial distress that a bankruptcy or similar-type process (e.g. Federal or state receivership, assignment for the benefit of creditors, etc.) will need to be evaluated. To the extent negotiations with existing creditors crater and none of the above options are available to the company (at least not within the required time frame), the company may need to consider these measures. While no business owner relishes the thought of bankruptcy, at the point of insolvency, the company’s board has a fiduciary duty not just to equity owners but to all stakeholders. In many situations, hiring experienced professionals to determine and develop the optimal path forward that provides the maximum recovery for all stakeholders may be the (only) prudent decision.
The COVID-19 pandemic has forced difficult decisions during the last few months. And, with the end of the second quarter around the corner, many businesses will face challenging negotiations with financing providers that could ultimately dictate the success or failure of the investment.
To ensure a fundamentally-sound business prevails through the crisis and the optimal outcome achieved, the best course of action is to proactively communicate with lenders and begin preparing to pursue all strategic options available in the M&A and capital markets.