The latest UK national lockdown represents a new kind of challenge for the Government: to articulate to Covid-weary households and businesses that things will soon get better, but first they will worsen. An ambitious national vaccination campaign is underway, raising hopes that the end of the pandemic is in sight. However, at the same time we are in the grip of the virus with rates of infection soaring, exacerbated by a virulent new strain. The latest lockdown aims to protect the NHS and save lives, but it will also increase business failures. Indeed, once Covid-19 is finally brought to heel, the next challenge will be the Covid corporate debt mountain, amassed by companies forced to accept additional leverage through government loan schemes to bolster their survival prospects.
In the first article in a new series, we will outline the broad themes facing businesses in 2021, as company boards grapple with the looming debt crisis that is certain to be a legacy of the pandemic. In subsequent articles, we will tackle some of these themes in greater detail.
Counting the Covid debt mountain
There are several ways to measure the size of this Covid corporate debt mountain. First, by the annual growth rate in SME borrowing from banks, which has risen sharply since last May. This borrowing reached 25.2% in November – the highest rise on record, according to the Bank of England. Of course, increased SME borrowing has been driven by the UK’s three government flagship loan schemes – the second indicator. By mid-December, the loan schemes aimed at SMEs had lent £63bn to more than 1.5 million businesses. The third national lockdown and the subsequent extension of all three loan schemes will further increase the final Covid debt mountain. The extension of these loan schemes just delays the inevitable reality – simply put, not all borrowers will repay them.
In an analysis by TheCityUK in September 2020, the trade body forecast unsustainable debt by private companies could reach up to £70bn by March 2021, of which around £23bn relates to the government lending schemes. The implied default rate for the Bounce Back Loan Scheme (BBLS), the most popular support scheme, was c.35–40%. In a separate analysis by the Office for Budget Responsibility (OBR), the default risk was estimated between 35% and 60% when loans become due from 4 May. As at mid-December, the BBLS has provided £43.5bn in loans to almost 1.9 million SMEs. These estimates will require further revisions, which will increase the total Covid debt mountain and, if the economic outlook is perceived to have worsened, possibly also the assumed default rates.
While necessary to protect swathes of UK SMEs pushed to the brink by the cliff-edge revenue collapse, which has undercut the ability to service debt, all these support measures have merely delayed inevitable loan defaults and business failures. It is also likely that the unintended consequence of some of these necessary policies will have been to create a second generation of ‘zombie companies’, which have survived only within the protective bubble of government handouts. When state support (including loosened insolvency laws) finally unwinds, loan defaults, Administrations, Creditor Voluntary Liquidations (CVL) and Company Voluntary Arrangements (CVAs) will rise, as will unemployment. In turn, this will trigger a spike in insolvencies, a new wave of non-performing loans (NPLs), and potentially some M&A (including Accelerated M&A) activity among resilient corporates and private equity funds. One legacy of the pandemic will surely be to widen the disparity between the weak and robust within and between sectors, with even notable ‘middling’ firms vulnerable. We will explore these themes in future articles.
SMEs that survive will be saddled with higher leverage, which will stifle the broader UK economic recovery at the national level. Higher debt and lower cash flow certainty will restrict business investment, rehiring and leave some vulnerable to earnings shocks and higher interest rates. All of which could have implications for future creditworthiness and cost of debt over the medium term, when refinancings are required. The tertiary refinance market will be set to grow, as SMEs move away from the big five banks.
This impact will percolate through all sectors, but will be felt most acutely among smaller companies and the Covid-vulnerable sectors (e.g., retail, hospitality, aviation, leisure and hotels, etc.). It is indicative of the consequential decision-making between bad options which governments have had at their disposal that the necessary economic measures in 2020 will morph into a new financial albatross in 2021/22.
If your company is affected by any of these issues discussed and you would like to discuss your corporate options, please contact one of our team today. Our team of specialists can provide advice on debt restructuring/raising, equity raising, business sales, transaction support, buy-side due diligence, options analysis and NPL management. We are here to help you make the best possible decisions in this fast-changing environment.