Distressed debt in a developing recessionary environment

3 min read 18 Oct 22

High inflation is being fuelled by supply chain disruption caused by the pandemic, high energy prices caused by the war in Ukraine and high employment. High inflation is forcing Central Banks to aggressively increase interest rates. A consensus is emerging that the combination of rising interest rates and energy prices will trigger recession in the US, UK and Europe. With recessionary pressure developing, what could it mean for businesses and their balance sheets, and how can patient capital play a role in the current environment?

It has been more than two years since the onset of the Covid-19 pandemic. Government programs to support businesses during the pandemic are being removed. At the same time, many of the structural and behavioural changes caused by the pandemic remain. Many businesses that struggled to stay afloat during the pandemic face an uncertain future.

Now, inflation is soaring to 40-year highs, driven by rising energy prices and supply chain disruption.

Central banks are increasing interest rates to combat inflation. The recent rate rises in the US and the UK are some of the most aggressive seen by major central banks in decades, and are forecast to continue until the end of 2022. There is a strong historical correlation between aggressive interest rate rises and recession1.

“These challenging market conditions will affect many companies, particularly those that are carrying a lot of debt.”

Meanwhile, governments have withdrawn support schemes designed to support businesses during the pandemic, including furlough or rent moratoriums. As these measures are rolled back and interest rates and energy prices continue to rise, the impact on corporate balance sheets is likely to be significant. 

The impact of rising interest rates and recession risk on markets

Market volatility has increased and credit spreads are widening. At the same time when many companies may need additional capital to help them trade through a recession, capital markets have been disrupted and become more difficult to access. With corporate leverage levels at cyclical highs and the capital markets disrupted, some businesses may struggle to refinance. If this trend persists, some companies will need to look for alternative sources of capital.

In light of these market conditions, compelling investment opportunities are emerging in distressed debt and special situations, including opportunities to provide rescue finance, participate in corporate restructurings and buy the debt of good companies at attractive prices (market dislocation trades).

The particular risks faced by over-indebted businesses

These challenging market conditions will affect many companies, particularly those that are carrying a lot of debt. Over-indebted companies are expected to struggle with debt burdens, which were taken-on in more benign times on the assumption of a smooth recovery from the pandemic. Companies in the Food, Industrials and Consumer sectors are already illustrating signs of stress, with the price of their loans and bonds falling. These sector-wide sell-offs can lead to mispricing and investors who have both deep analyst resource and restructuring expertise can identify compelling investment opportunities.

It is also possible to assist over-indebted enterprises with sound underlying business models by restructuring their balance sheets and/or providing rescue financing to unlock their fundamental value.

Structural changes caused by the pandemic have resulted in the misallocation of capital. Investment opportunities will emerge as capital gets reallocated to the companies with new business models and assets that will be more valuable in the post-pandemic world. Investors with flexible capital and expertise across all assets classes and sectors will be well-placed to capitalise on these opportunities.

Biliana Sourlekova, Director - Restructuring and Debt Solutions Teams, explains: “Given the volatile market conditions there are many sound businesses that are being caught-up in the wider sell-off. There are also many companies that have a clear reason to exist but who will face short term issues and balance sheet stress as recessionary pressures increase. These short-term problems are soluble and provided they can access flexible capital and restructuring support, investments in these companies have the potential to generate attractive risk-adjusted returns. Investors with flexible capital and specialist restructuring expertise will have opportunities to identify and unlock deep value from good businesses.”

The current situation may worsen before it gets better, but with the right kind of restructuring and refinancing expertise, investors will be able to help struggling businesses, and drive compelling returns.

1 National Bureau of Economic Research

The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.