66 Finance & economics The EconomistMarch 28th 2020
2Buttonwood Bridges to somewhere
T
ake yourselfback, if you can man-
age it, to a more tranquil time—
January, say. Imagine a smallish restau-
rant chain that had a bad Christmas. Its
owner borrowed heavily to expand only
to find its new outlets were slow to at-
tract customers. The chain cannot meet
its interest and other costs. A consultan-
cy says $10m is needed to tide the firm
over until its problems are fixed. The
bank says it will forgo interest payments
worth $5m, if the owner kicks in $5m of
equity capital. A deal is struck.
Fast-forward a few weeks and imag-
ine a similar chain that is temporarily
shut down because of the covid-19 virus.
The firm has no revenue, but it still has
fixed costs. The hypothetical January
deal is a template for dealing with the
problem. But in a broader crisis, things
are always trickier. The bank’s balance-
sheet is stretched to the limit. The stock-
market crash has taken a bite from the
owner’s wealth. And she is reluctant to
sell a stake in the business.
An alternative is to turn to specialist
private-credit funds. These are vehicles
backed by long-term investors, such as
insurance firms, sovereign-wealth funds
and university endowments, which lend
directly to companies, much as a bank
would. Some will have discrete dis-
tressed-lending or “special-situation”
arms. Many more are prepared to put up
capital when others won’t. And every-
thing is a special situation now. So the
mindset and methods of these special-
ists will need to be broadly applied.
What might they offer our hypotheti-
cal restaurant chain? One option is a
payment-in-kind (or pik) loan. This
affords the borrower flexibility. If the
shutdown is protracted, it can roll up
missed interest payments into the out-
standing debt (ie, pay them in kind).Once the business gets back to normal, it
can make interest payments in cash again.
A pikloan has two advantages, according
to Mark Attanasio and Jean-Marc Chapus
of Crescent Capital, a private-credit firm. It
gives immediate relief, and it leaves the
capital structure largely intact, so the
owner retains control. The lender, in
essence, says to the borrower “you take a
spring break on interest payments; we
believe in your recovery.”
Of course, the interest on any loan
granted in a distressed situation will be
steep. The opportunity cost to a lender is
the double-digit yields now on offer in the
high-yield bond market. A way to reduce
the risk to the lender, and thus the cost to
the borrower, is to secure a loan on fixed
assets. Last week United Airlines agreed a
one-year loan with banks backed by air-
craft and other collateral, according to
Bloomberg News. Part of the loan was then
sold on to Apollo, a leading private-capital
firm. More deals like this seem likely.
Not every business in need is a big
airline. A lot of medium-sized firms, like
our hypothetical restaurant chain, do nothave many tangible assets. Property and
equipment are leased. The firm’s worth is
in intangibles, such as its brand. There is
no value for a lender to recover if the
company is liquidated. And in complex
situations, such as this one, it is difficult
to estimate the severity of the short-term
damage and how quickly a business will
recover. The ideal solution is an injection
of equity capital. But shareholders are
reluctant to issue equity in recessions,
when stock values are depressed, as it
dilutes the value of their stake. Conver-
tible loans offer a way around this. These
carry a lower rate of interest than a con-
ventional loan, but give the lender the
possibility of converting it into equity
when things—revenues, profits, asset
values—return to normal.
In our ideal world, there is one lender
and one owner. The real world is messier.
Lenders to firms in distress expect to be
paid back before other creditors. But the
company may have covenants on its
existing debt that rule out a new lender
pushing to the front of the queue. A
unique situation calls for flexibility. “The
right paradigm is a natural disaster,” says
Jonathan Lavine of Bain Capital. “More
than ever, banks, shareholders and other
lenders will have to work together.”
The goal should be to keep healthy
firms intact. There are some specialists
that buy the debts of troubled companies
in the expectation they will be forced
into bankruptcy, wiping the share-
holders out and leaving the debt-holders
as owners. A change at the top is some-
times necessary. But in general, it makes
sense only if the management has
screwed up. That does not apply to the
vast majority of companies now in dis-
tress. It will need a lot of ingenuity and
capital to tide them over. It will also need
a fair bit of goodwill.A unique set of problems calls for solutions from the world of distressed lendingseems far less important, he argues, than
the pandemic’s historic destruction of oil
demand. Covid-19 is obliterating this at
such an astonishing rate that analysts can-
not adjust their models quickly enough.
Bernstein, a research firm, estimates that
demand in the first half of the year may be
10%, or even 20%, below what it was in- In the past 35 years demand has only
twice been lower than in the preceding
year—in 2008 and 2009.
Yet production has been slow to re-
spond. That is only in part because of the
price war. Once a shale well is drilled, there
are only marginal savings from stopping
production. Many oil companies are
hedged and continue pumping in the hope
prices will rise. Even when firms slash
spending, output may not drop quickly. On
March 24th Chevron, an American super-
major, said that it would cut capital spend-
ing by 20% this year, but that production in
2020 would roughly match that in 2019.
It looks possible that supply will not
just exceed demand for oil now but fill the
capacity to store it. Bernstein reckons that
there could be over 735m barrels of extra
crude this year, and only about 500m bar-rels of storage available in theoecd, a club
of mainly rich countries, and oil tankers.
In the face of such a demand shock, “a
production cut that takes a month or two to
implement won’t do much,” argues Da-
mien Courvalin of Goldman Sachs, a bank.
He contends that a production limit in Tex-
as would slow the consolidation that
America’s shale industry needs to be com-
petitive in the long term. Government
stimulus might help to boost demand. But
the essential fix to bring the market back
into balance, reckons Mr Luckock, is a
painful one: even lower oil prices. 7