With recession predicted for a lot of economies this 12 months or next, crisis situations shall be a crucial source of business for potential investors.
What shall be crucial, nonetheless, shall be whether the goals are permanently impaired or might be reversed. Two real scenarios from the debt bubble of the early years and the next credit crisis provide helpful guidance.
Cyclical volatility or dislocation
British investment firm Candover bought hygiene products maker Ontex in 2002 for €1 billion, or 8.1 times EBITDA. The debt package consists of Moor standard senior and mezzanine loans were six times earnings.
Despite strong economic growth, Ontex’s EBITDA margin fell from 17% to 12% in three years, largely attributable to rising oil prices. Oil is a key ingredient within the absorbent powder in Ontex diapers, and the corporate has been unable to pass the price on to customers because its products are sold by Walmart, Tesco and other price setters with oligopolistic positions. Ontex is unable to ship on to consumers, and as a non-public label manufacturer with out a dominant brand, Ontex is a price taker.
But this was not a brand new development. In the past, Ontex’s profitability had plummeted at any time when oil prices spiked. Still, excessive leverage didn’t make Ontex a nasty investment. Rather, the debt package had a rigid structure with a hard and fast repayment schedule and strict interest margins when market cyclicality required more flexible credit terms.
By the time TPG and Goldman Sachs bought Ontex from Candover in 2010, covenant-light loans (Cov-Lite) had turn out to be easy tools that gave borrowers the flexibleness to adapt to such economic dislocations. This is what Ontex needed. As crude oil prices rose greater than 160% between early 2016 and late 2018, the corporate’s EBITDA margins fell from 12.5% to 10.2%.
Structural change or disruption
But there’s one other variety of emergency scenario wherein the market changes are more extensive.
Private equity (PE) firm Terra Firma accomplished a £4.2 billion leveraged buyout (LBO) of long-established record label EMI Music in 2007. In contrast to Ontex’s debt structure, EMI had all of the tricks of the PE toolkit, including a generous Cov-Lite package with unlimited stock cure rights and extensive EBITDA adjustments. But the deal turned out to be disastrous.
The Internet revolution had upended the recording industry, and EMI had struggled to adapt for years. To change EMI’s fortunes, Terra Firma planned to lift capital within the bond markets and hedge it against the recurring money flows of EMI’s music catalogs. It also hoped to revive margins by cutting staff, outsourcing some activities, renegotiating artist contracts, rationalizing the property portfolio and reducing expense accounts. Terra Firma also had its eye on recent revenue streams – concert events, online services, merchandising and artist management – and sought to draw recent tech talent to implement digital transformation.
But despite multiple equity restructurings, EMI’s sole lender, Citi, took over the corporate in 2011 and rapidly sold it off piece by piece. It turned out that EMI was not a temporary disturbance but a everlasting disturbance. Due to online piracy, CD sales within the USA fell by two-fifths between 1999 and 2007. In the fiscal quarter prior to the acquisition, EMI’s CD sales were down 20%. Paying 18 times trailing EBITDA for such an organization proved unwise.
It was unwise to provide additional leverage to an organization facing such significant challenges. EMI’s net debt to EBITDA ratio remained above 8 throughout the LBO period. The turnaround strategy never sufficiently improved profitability to maintain pace with increasing debt obligations.
The risk pyramid
EMI’s experience shows that significant execution risk doesn’t mix well with leverage in a serious restructuring. Cost cutting, asset divestitures, contract renegotiations, refinancings, securitizations and other traditional strategic and operational tools are not any match for disruptive innovation.
Therefore, a dislocation can’t be confused with a disorder. The former is temporary and cyclical – it’s manageable, even when it occurs repeatedly by nature. In contrast, the disorder is everlasting and structural; For many corporations, it’s a deadly threat. While disruption requires adaptation and might be managed through incremental changes to an organization’s strategy, disruption requires reinvention. In this case, an organization has to revamp its processes. In such a fundamental scenario, extensive use of debt is a really bad idea.
The following risk pyramid illustrates this dilemma: Leverage ranks above many other risk categories. Companies have little room for financial risk – i.e. debt – when faced with market, operational and strategic headwinds. Under the burden of a lot uncertainty, additional debt can crush any business borrower.
Risks pyramid structure
The great flood
The unprecedented monetary stimulus following the worldwide financial crisis (GFC) and in the course of the pandemic is prone to provide fertile ground for emergency investments in the approaching years. Excess capital is commonly misallocated, resulting in wasteful and ill-advised investments. It can destroy returns.
Over-indebted takeovers and overcapitalized start-ups are plentiful, but due to capital accumulation – $12 trillion in assets, including $3 trillion in dry powder – private markets can take an extended time to regulate. After peaking in March 2000, the NASDAQ didn’t bottom until October 2002, and lots of dotcoms were still in crisis when the worldwide financial crisis broke out. Today’s shakeout within the private market could end in a similarly long wait. PE and enterprise capital (VC) firms would favor to carry on to impaired assets and proceed earning fees reasonably than acknowledge the true state of their portfolios. But given recent bank failures, the bridge funding that startups have to delay a round of downturns may dry up.
By assiduously using leverage, financial sponsors can still manage downside risks by negotiating looser credit agreements and massaging numbers. However, an excessive amount of debt can leave borrowers in a zombie state and make it harder for distressed investors to intervene. They can have to attend, as Citi did given the inevitable collapse of PMI within the wake of the worldwide financial crisis.
Dealing with market disruptions
The financialization of markets raises a bigger query: Does the growing debt overhang represent temporary turbulence or a more radical discontinuity of contemporary economies?
The costs of an overstretched balance sheet vary: corporations cut investments; Credit downgrades hurt stock returns; Company executives search for alternative employment; Workers turn out to be uncooperative; suppliers push for stricter payment terms; Customers switch to more reliable service providers; Lender increase the price of debt or cut off access to credit altogether.
Even if endemic over-indebtedness doesn’t result in widespread economic destruction, industries vulnerable to disruption could ultimately be more permanently affected. Today’s increased inflation, for instance, may very well be seen as only a minor hurdle for Ontex: When oil prices rose from lower than $0 a barrel in 2020 to over $120 two years later, the corporate’s EBITDA margins fell from 11 .2% in 2020 to five.5%. last 12 months. Leverage now exceeds six times profitslike in the times of the Candover LBO 20 years ago, when the EBITDA margin was 17%.
But the COVID-19 pandemic has created demographic instability that might have a much more serious impact on corporations like Ontex, which serves each the young and elderly by selling diapers and incontinence products. Excess mortality has occurred Europe and that United States. While this trend could also be short-lived, it follows declining life expectancy within the United States United StatesThe European UnionAnd England and Wales. The advantages of improved sanitation and public health could also be temporarily limited.
The pandemic also triggered further demographic developments. Instead of an expected COVID-19 baby boom, the lockdowns can have led to a “Baby bust.” During post-The economic stimulus from COVID-19 helped birth rates rise again Demographic challenges remain at pre-pandemic levels. In struggling economies reminiscent of Japan, SpainAnd Italy, declining birth rates have long been the norm. However, if changing birth rates and stagnant life expectancy turn out to be more entrenched, they’d represent not mere dislocations reminiscent of periodic oil price spikes, but more acute market disruptions that will impact long-term demand for hygiene products.
The impact would clearly extend far beyond a single company or sector. Therein lies the issue with investing. Markets are dynamic: macroeconomic turmoil and sociodemographic changes can turn value plays into distressed assets.
If you enjoyed this post, remember to subscribe.
Photo credit: ©Getty Images / SDI Productions
