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Coronavirus loans: to default or recapitalise?

Uk Economy

The devastating impact of Covid-19 on UK businesses companies continues to unfold. As the economy slowly starts to reopen, attention has inevitably turned to the fate of the state-guaranteed coronavirus loans. If the economy recovers swiftly, the outlook for the serviceability of the Bounce Back Loan Scheme (BBLS) and the Coronavirus Business Interruption Loan Scheme (CBILS) loans would be positive. However, most expect a slower, longer and protracted recovery which will leave many businesses unable to service the second layer of corporate debt. What does that mean for CBILS and BBLS loans?

While the government is the ultimate lender exposed to the risk, the accredited lenders who facilitated the loans will be responsible for recouping the debt. In the scenario described above, where businesses are unable to service the loans, the question is how should arising defaulted debt be managed? The options are another example of a choice between bad options: (i) write off the debt, (ii) convert the debt into equity, (iii) pre-pack administrations, (iv) complete recapitalisation.

In the first scenario it is highly unlikely that the government will opt to support the economy’s revival through unilateral debt forgiveness, where the banks, as loan facilitators, have already been asked to robustly manage risk regardless of the government guarantees for CBILS and BBLS. The banks will already be exposed to risks among their existing loan books if the economic revival stagnates. Also, it is in broad mutual interest to protect the banks against huge losses so that they can continue to provide liquidity to the economy as we emerge from lockdown. A new wave of NPLs across the clearing banks would severely limit the role banks will be relied upon to provide in the months and year ahead. Furthermore, the ‘extend and pretend’ model, common during the 2008 global financial crisis, is likely to be resisted principally because the problem of these loans is in serviceability, not a looming maturity profile. Much of the market discussion has centred on the implications of debt for equity conversions. Equity conversion for businesses which default on CBILS and BBLS loans appear to split opinions.

On the one hand there are debt-for-equity swaps in which the government or an arm’s length government-controlled entity becomes an equity stakeholder in struggling businesses in order to help such firms to survive. Under the rubric of equity conversion is the public-private fund to manage CBILS and BBLS loans. In this regard, institutions are sounding out investors about managing a portfolio of equity stakes in UK businesses that in turn are expected to struggle to repay coronavirus loans. Crucially, the banks – as CBILS and BBLS loan facilitators – might be motivated to assist in the process as they are highly likely to want to avoid further ‘zombie’ borrowers on their books where loan interest rates are not simply reset to a level that just provides headroom to enable loan serviceability. Following the 2008 financial crisis, such bespoke interest rate resets led to the ‘zombification’ of borrowers, after which debt servicing there were no cash flows left to invest in businesses to stimulate future growth. In order to avoid a repeat of what happened in 2008, market commentators believe the answer for long-term recovery is an equity, not a debt-based solution.

However, for owner-manager businesses, ceding hard-earned equity to the government would be a bitter pill to swallow. It is unpalatable to suggest that small businesses that were forced into accepting emergency loans to stave off a liquidity crisis through no fault of their own, must now accept equity dilution to stave off a solvency crisis because they are unable to service the emergency loans due to pandemic-induced collapsed demand. Most owner-manager businesses would, understandably, likely resist strongly carte blanche equity conversions.

This limited choice between difficult options is expected to steer companies towards a combination of pre-pack administrations and wholesale debt recapitalisations. In the baseline economic scenario of a slow and protracted economic UK recovery, in which businesses are unable to service CBILS and BBLS loans and thus default, a mixture of these outcomes is probable. This is because some owner-manager businesses will resist equity dilution with everything they have got, while some will be more sanguine. Recapitalisation with alternative lenders will be for those businesses which prioritise quick access to higher leverage levels and are willing to weather the higher debt costs to prevent ceding equity. Pre-pack administrations will be for those businesses who want to write off certain debts, but the consequences for the ongoing businesses can be significant, not least in securing fresh financing, landlord negotiations and supplier credit agreements.

No decisions have perfect outcomes for UK businesses. If your business, or portfolio company is directly impacted by any of the challenges discussed above and you would like to talk through your strategic options, please do get in touch. The experts in our advisory and restructuring teams can assist, and offer an initial free consultation.

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