Pulling Liquidity Levers

Uncertainty around the depth and duration of COVID-19 has compelled companies to reassess contingency planning, with liquidity and cash flow preservation top of mind. As issuers navigate challenging markets, they will need to carefully analyze a decision to continue investing today versus preserving capital for tomorrow, and also must consider the impact these decisions might have on a company’s future competitive profile. For some, it may be prudent to reevaluate discretionary expenditures and shareholder distributions as part of financial policy planning. In the S&P 1500 year-to-date, more than 40 firms have decreased dividends, and more than 40 have suspended share repurchases as well.

Near-term financial flexibility is critical during times of market volatility; accordingly, issuers should consider a broad range of capital markets that can help to improve a company’s liquidity position. Traditional capital markets such as investment grade bonds and convertible debt have materially strengthened over the past few weeks, while the leverage loan and high yield markets have recently opened up for business. However, despite the improving capital markets conditions, management teams should not overlook alternative markets and monetization strategies, such as private capital markets (e.g., convertible preferred), the recently announced Federal Reserve facilities (e.g., Primary Market Corporate Credit Facility), and corporate real estate strategies.

Some Sectors See a Surge in Growth—But Will it Last?

The service industry has undergone a dramatic shift, with social distancing fundamentally altering consumer behavior and spending. As a result, companies across sectors are revising forecasts and assessing how best to manage costs and preserve liquidity. However, certain sectors are outperforming the broader market, including consumer staples, internet services, and online retail. Companies that provide essential goods, now the most important consumer priority, could benefit from strong capital markets reception. For example, issuers in this space with strong credit, such as CVS Health and Kimberly-Clark, easily accessed the debt market in the past week.

Many market participants expect COVID-19 to be a two-quarter event, with business normalization beginning in Q3. While surges in demand for certain products may be temporary, the change in spending patterns could be long-lasting. The rise in global urbanization, marked by extensive air travel, has not only exacerbated the ongoing COVID-19 pandemic, but could also lead to future pandemics, creating the potential for ongoing disruption to industry norms, particularly social interaction at work and home. For example, Moody’s has cited strength in software, cloud services, cybersecurity and digital transformation efforts as key drivers of a stable outlook for the Global Diversified Information Technology sector. It remains to be seen whether some companies will sustain a prolonged uplift from valuation re-rating.

M&A Spin-offs Continue as Scheduled

Aside from board approval, most spin-off transactions are subject to fewer market restrictions than nearly all other M&A transactions, and generally can proceed even in volatile equity capital-market conditions. There are a few examples of previously announced spin-off separations that continue to move forward, with Arconic beginning regular way trading on April 1 and Madison Square Garden Company (MSG) recently announcing that their spin-off date has been set for April 17.

While spin-off transactions tend to be less sensitive to market conditions than other M&A transactions, some situations require new financing which could present challenges for certain industries. For example, MSG will use an intercompany loan to provide a temporary financing alternative instead of a capital markets borrowing. This kind of agreement could provide further flexibility and optionality for firms seeking enhanced capital structure flexibility amid volatile market conditions.

Capital Structure Decisions are Presented with a Familiar Challenge

The ongoing pandemic has weighed heavily on both the leveraged loan (LL) and high yield (HY) bond markets. Less than 1% of overall leveraged loans are trading above the face value of the bond, and the average price of the JPM LL index is currently in the 80s. Average yields on HY bonds have increased significantly since late February, with the vast majority of leveraged loans and HY bonds trading below par, including a significant portion of each asset class trading at distressed levels.

Because many companies have debt that is trading below its face value, firms could soon look to restructure or refinance debt, either out of precaution or necessity. Under U.S. tax laws, borrowers modifying existing debt terms could incur a tax liability if the existing debt was trading at a discount. This tax liability arises from and is called Cancellation of Debt Income (CODI), and it can create a significant obstacle that prevents issuers from engaging in an otherwise beneficial debt restructuring.

During the 2008 Financial Crisis, Congress passed temporary relief for this tax liability to aid companies amending their capital structures. While Congress has been focused primarily on fiscal stimulus, worsening credit conditions could again bring such a proposal to the forefront. Relief would facilitate debt restructuring transactions and provide critical, timely relief to businesses that need to, or would like to, amend their capital structures.