The Looming Problem
The UK government’s immediate, albeit temporary solution to tackle the economic challenge created by COVID-19 has been to laden the economy with debt. This has provided the much-needed respite while the country seeks to understand the short, medium and long-term impacts of COVID-19 and the appropriate response.
The effect of this strategy has positively supported the survival (at least in the short term) of a number of corporates across the UK, and with that the continued employment for many people. It is unclear what the future economic landscape will be for the surviving corporates. However, what appears to be certain is that the quantum of debt on balance sheets has increased and is likely to increase even further. While the UK government has promoted the extension of support provided to UK corporates, to date, this has resulted in excess of £80 billion of additional borrowing across both government-backed loan schemes and VAT deferrals.1
We estimate that a large proportion of the UK corporate population is currently facing a significant increase in redeemable debt and will need to consider how this will be repaid. The inevitable worsening of gearing ratios will increase anxiety. This, combined with liquidity concerns from depleting cash reserves to working capital constraints and unpredictable changes in supply and demand due to COVID-19, may impede the ability of corporates to effectively manage their day-to-day operations.
Subject to general economic performance, we may witness an increase in loan defaults. This could result in corporate failures, which in turn would negatively impact stakeholders, including shareholders, employees, suppliers, lenders and the UK government directly.
It may also become increasingly difficult for corporates to obtain additional funding to support future growth at an equivalent rate to that seen in the market over recent years.
Equity or Debt?
Given the likely increased levels of gearing, a refinance to address loan defaults and/or looming cash flow pressures may become more difficult due to lender appetite, market contraction and potentially insufficient security.
The change in the wider economic landscape following the COVID-19 crisis is likely to present opportunities for distressed debt providers, which in turn is likely to lead to an increase in debt service costs for corporates and, in some circumstances, potentially result in formal restructuring processes to enable value extraction. Consequently, the most appropriate solution may be to turn to shareholders and seek equity investment to recapitalize the balance sheet. While this may be possible for large corporates, it is increasingly difficult for small and medium-sized enterprises (SMEs) and mid-market companies that may not have sufficient funds to support such a request.
Aligning Stakeholder Interests
External investment is a tool that is sometimes seen as a last resort for many SME or mid-market businesses. However, in the current climate Duff & Phelps considers that it should be proactively developed as an option that could provide corporates with competitive advantage, potential to increase market share, access new markets and benefit from sector expertise.
Perhaps the most important consideration between a debt or equity solution is the relationship which it creates. Debt is often a short-term relationship with a lender on specific terms, whereas equity is more akin to a marriage, where partnerships and common purpose need to be aligned.
If structured correctly, such investment could also provide corporates with a stakeholder that is financially committed to the company’s goals and strategy for longer-term value enhancement, as opposed to the uncertainty surrounding the actions of a lender who may take a more short-term view to a company’s trading difficulties to protect its own interests.
When raising either debt or equity, it is necessary to have the business fundamentals in the best possible shape in order to attract inward investment.
From a macro-economic perspective, we must avoid lasting damage to the UK economy and confidence and a decline in global competitiveness. We must seek to harness the entrepreneurial power and innovation that is at the heart of our economy while ensuring those companies with sound prospects, which have been thrown off course by the current pandemic, are given the time to bounce back and thrive, rather than simply survive.