Financial Analysis: Back of the Envelope

Often bankers, equity investors, traders, debt investors and business managers make quick, on-the-spot decisions about whether to pursue a new client or a new transaction, new trade, new loan, new investment. Decisions must be made quickly. Clients/borrowers/debt issuers want a bank response (yes or no) as early as yesterday.

In an event-filled year, 2020, decisions are tougher to make. Risks have increased in leaps and bound. But deals are getting done. Banks are extending loans to corporate borrowers large and small. Trades are being settled. Private-equity funds remain interested in finding the right investments. Fund providers are wrestling with risks and agonizing over the long-term impact of the pandemic on corporate performance.

Should we invest in the equity of a private company? Should we buy the stock of the mature business? Should we lead the syndication of a $1 billion loan? Should we protect ourselves by requiring collateral or imposing an array of financial restrictions (covenants)? Should sell the stock? Should we avoid exposure with the company? Should we not continue to provide working-capital funding?

How do we get comfortable quickly to determine whether the risk of an investment, trade, loan or debt offering is tolerable? 

How can we, therefore, perform "back of the envelope" analysis of a company when time presses? Or how can we perform a preliminary assessment of the company at least to determine whether it's worth  taking follow-up steps to investigate further?

What if you have just 30 minutes to understand the financial story of a company thoroughly (and get a sense of its future financial performance), based on access to a recent annual or interim report (10K, 10Q) or financial summaries prepared by Bloomberg or Yahoo Finance? 

What are the "go to" metrics that tell an essential story about historical performance and the company's ability to (a) manage debt obligations and (b) perhaps deliver shareholder value (in the form of promising future cash flow) to equity investors?

Performance Counts

First things first. Check historical performance: Earnings trends and patterns, ROE, NPAT, EBITDA.

Performance and trends dictate creditworthiness and prove insolvency, but they also influence management and board strategy (expansion, growth, downsize, sale of businesses, pursuit of acquisitions, willingness to be acquired, etc.). Is performance predictable? Is it erratic? Is it sustainable? 

What has the company done for investors, at least measured by returns on invested capital, if not measured by public stock prices, earnings per share, and price-earnings ratios (if it is indeed a public company)? 

The stock market rates a company everyday, although it is whimsical in how it absorbs bits and pieces of new information. The stock price, too, can be subject to exogenous factors (things not much related to the company, but to a macro-economy, industry or operating environment). 

ROE (or return on invested or deployed capital) can be calculated easily, swiftly. It shows whether it is meeting expectations of owners, shareholders, but it may also show how it is achieving the returns, if we check the components (ROE = ROS x ATO x ALEV). 

Effectively improvements in ROE are a result of (a) how the company manages costs, (b) how the company achieves productivity and revenue growth (given its current infrastructure), and (c) how the company adroitly uses the balance sheet and debt to achieve leverage returns. 

For analysis purposes, breaking ROE into components shows how the component is achieving returns or what strategy it is using to reach targets: Cost control? Revenue growth? Business efficiencies? Financial engineering (more leverage)? 

Many companies like to report (in financial presentations) returns on "invested capital"--which includes equity and long-term debt combined as "long-term capital." Some companies (typically financial institutions) will report and show trends in returns on "tangible capital" (by excluding intangible assets). 

A financial analyst can choose whatever returns ratio works. Sometimes that depends on the industry. The analyst can calculate ratios, of course, without company guidance. But when time is of the essence, choose the ratio that is appropriate to measure how well the company is using the capital long-term investors provide and whether the company is generating the returns they expect. 

Companies and bankers also examine the ratio to determine whether the company is achieving results that exceed the "cost of capital"--or cost of funding the balance sheet's long-term assets. 

Assessing the adequacy of investment returns (ROE) is important, too, because if targets are not met, management, boards of directors, and large-stake shareholders will consider taking action:  New management, new business strategies, spin-offs, business combinations, divestitures, mergers, etc. 

Back to the analysis. Dissecting returns on capital hints at the strategies companies have adopted to meet expectations. Is a company-wide cost-control campaign in place? Is the company pushing to increase revenues per facility, per warehouse, per branch, per square foot of retail space? 

Increasing leverage, too, can be a strategy. Company financial managers will consider increasing debt to take advantage of low interest rates. They certainly have done that in 2020--from March on. Rates are at historical lows. Is the company achieving favorable returns because of organic factors, because of management's concerted efforts to contain costs, or because of restructuring capital structure on the balance (by taking on more leverage). 

Now back to revenues and revenue productivity. 

Observe trends over the past five years. And if possible, observe the source of revenues (by product, by subsidiary, by geography, whatever information is immediately available). Are revenues flat, declining, surging, or volatile? Are the factors that explain the trends related to markets, competition, demand (weak or strong) for product, product obsolescence, product growth, pricing, pricing sensitivity or elasticity, or industry influences?

Understand the company's approach to cost control and expense management. Peek at profit margins and cost ratios. 

What is its strategy to use costs to help grow revenues and the business in the long term? Acknowledge for some young firms, some costs are necessary to gear up the business model or prepare for future years of revenue growth. 

The familiar cost ratios can be checked: EBITDA/Revenues, Operating income/Revenues, CGS/Revenues, Cost-of-sales/Revenues, R&D/Revenues, SGA/Revenues, etc. 

Observe trends in ratios, and watch carefully when these ratios increase or when these ratios fluctuate without reason. If they do, they suggest the company is permitting costs to unravel out of control or may not be engaged in an adequate hedging program to reduce costs of raw materials or pricing of commodity-like products.  

If time doesn't permit calculations of ratios (because this is, of course, "back of the envelope"), then at least examine Operating income or EBITDA profit margins. 

If profit margins are deteriorating, that might suggest the company will need to increase returns on capital in other ways (revenue growth, revenue productivity, and leverage). 

Any analysis of costs requires categorization of costs into fixed vs. variable.  In downturns such as we observe in 2020, companies with substantial high fixed costs are vulnerable. Revenues will turn downward in a recession, but profits disappear more quickly when fixed costs can't be eliminated. 

Throughout these observations and quick computations, begin to draw conclusions. You are letting the numbers and ratios tell the financial story. 

Those Precious Cash Flows

Investors and analysts ultimately must assess operating cash flow. That's what pays required interest on debt and shareholder dividends. That's how shareholders and markets achieve "value" (when cash flow increase better than expected) and that's how companies can plan for growth in products and markets.

While at it, use EBITDA (earnings before interest, taxes, depreciation and amortization) momentarily as a proxy for operating cash flows, and observe trends there, too. Accountants will have presented a statement of changes in cash flow, and their derivation of "cash flow from operations" is an even better metric of cash coming in from business activities. 

If possible, compute at EBITDA/CapEx and EBITDA/Interest expense. We'll now into the meat-and-potatoes segment of assessing solvency and ability to meet ongoing obligations without having to scramble to find other cash sources or without having to sell fixed assets to raise it. 

Can the company at least tend to debt obligations from operating cash? Can it at least handle debt interest and ongoing CapEx requirements smoothly--not to mention meet tax liabilities?  If these ratios are both less than 1.0, then there could be ensuing trouble. (Some prefer to look at (EBITDA-CapEX)/Interest expense.) 

Ratios less than 1.0 or declining ratios suggest a company needs to resort to secondary ways to handle basic debt and CapEx obligations. Hence, the company might have to take on more debt, borrow under revolving-credit facilities, or use up cash reserves.

After having reviewed these trends and metrics, the company's financial health is coming into focus. But we still haven't examined capital structure and must do so.

Liquidity and All That Debt

Before leaping into a more thorough examination of debt burden and capital structure, take a peek at liquidity: Is there sufficient cash resources to manage through the next 3-6 months? 

Of course, check recent trends in familiar liquidity ratios:  CA/CL, Cash/CL, and (Cash + AR)/CL. But observe recent trends in cash reserves on the balance sheet. Are reserves generally the same? Are they disappearing and withering? Are they stockpiling? Is cash at low levels and dwindling because the company is paying dividends at high payout rates?

Look for signs and red flags of liquidity risks. A company's long-term prospects may be bright, but is cash on the table or on the way to the treasury to manage a whole host of short-term obligations--those on the horizon within the next quarter?

Now after the liquidity evaluation, proceed to long-term debt analysis.  

The initial assessment of ROE and ALEV (asset leverage = asset/equity) gave some indication of how much the company is relying on debt to achieve higher returns and support the funding of long-term assets (infrastructure, capital expenditures, equipment, investments, etc.). On paper, higher leverage implies higher returns on capital. That explains the leveraged finance and leveraged-buy-out industry. Investors can achieve returns beyond 40% just by rearranging an old balance sheet. 

Debt is also alluring when interest rates are low. Let's tap into the market now, CFOs will argue, while the going is good, while interest rates (as they are in 2020) are ranging at record lows, and while investors are willing to lend. 

But debt must be serviced and paid back. Debt means there must be cash flow to pay those quarterly interest obligations. 

Rapid analysis requires us to resort to familiar debt metrics to get a sense of whether, despite performance and cash flows, debt levels are too high, unreasonable or at perilous levels. 

In the absence of doing projections (to compute maximum debt capacity) and debt-service coverage (all part of a detailed analysis for a more comprehensive review of the company), check the familiar ratios: Debt/Equity, Debt/Ebitda, Net-debt/Ebitda, Debt/(Ebidta-CapEx). 

For complex transactions, analysts, bankers and investors perform in-depth due diligence. They project operating cash flows (from now into perpetuity perhaps), they review all major business sectors in depth, they determine how cash flow will be deployed, they assess how much capital expenditure is necessary to support revenue growth, and they determine how debt will be managed (paid off or refinanced)?

But in the 30-minute window of making a rapid assessment, it's back to familiar debt ratios. 

If Debt/Equity is rising quickly (>4?) even as the company is generating earnings, check for stock repurchases and buybacks and question such a buyback strategy. 

 If Debt/Ebitda is rising quickly (>5?), check for recent borrowings and try to determine the purpose of the borrowings. Check these ratios to see from year to year whether they fluctuate greatly or appear to be stable. Check Debt/Operating cash flow, if time permits.

Compare debt metrics with what is known to be normal for companies in a certain industry or companies in the early or late stages of revenue growth. 

If debt is increasing, what is the purpose of the debt? What is it actually funding? Examine cash flows and balance sheets to get quick clues.  Is debt funding new investments, fixed assets, or infrastructure?

Is it being used--as it certainly has been in 2020--to build cash reserves to prepare for a tough operating environment? Is it ultimately being used to reward equity investors--stock buy-backs, increases in dividends, e.g.?

And are we comfortable with how the debt has been used or how new debt will be used? 

Now it's time to step back and develop themes about what has happened at the company and what will likely happen going forward? Just as important, what could happen if the current downturn scenario worsens? 

We can actually draw some conclusions about how swiftly cash reserves can evaporate, what might be the high-probability amount of cash generated from operations, when will the company need to suspend dividends, whether it may need to forestall planned capital expenditures, or whether it will struggle to meet interest payments over the next two quarters?

And we might be able to answer among ourselves:

 
Is the company still piling on debt while losing money? 

Is the company generating reasonable earnings, but altering its capital structure to increase returns on capital?

 
Is the company doing well and has tolerable levels of debt, but is vulnerable in liquidity (because of asset-conversion cycle or its redeploying cash into new ventures)? 

This, of course, is not be the comprehensive, exhaustive analysis of a company. Bank risk managers, bank regulators, investment committees, SEC regulators, and fund investors will want to see that and will demand more. 

But preliminary perspectives lead to the more focused, purposeful analysis later and permit analysts to zoom in on what requires further investigation, more answers or more risk-reducing strategies for companies.

And often, the preliminary assessment leads decision-makers to decide up front whether a deal, loan, trade, or investment is a no-go. Or is it something do-able, but requiring tight structure (covenants, guarantees, management discussion, collateral, principal amortization, etc.)?

Tracy Williams

See also:

CFN: Financial models and tools, 2014

CFN:  Mastering technical skills, 2010

CFN: New financial technology, 2014

CFN:  Banking 101: Corporate borrowers, 2020

CFN: Financial metrics and ratios, 2015

CFN:  The finance resume' and recruiters, 2014

Banking, Finance: 7 Months into CoVid

In a banner year for trading, Goldman Sachs could generate over $12 billion from trading net revenues

Global finance is treading water while managing a global pandemic. Surviving better than expected. After an initial period of shocking disbelief, banks and businesses are now operating in markets, doing business, selling product, issuing debt, and engaging in trading in capital markets. It's as if we have entered a phase of a "CoVid-normal"--a scenario described by players assuming the threat of CoVid-19 will be here for at least another 18 months. 

Economic and government statistics lament increases in unemployment and decline in GDP. (In the U.S., unemployment hovers about 8-10% and GDP is expected to decline 5% in 2020.) But business activity, banking transactions and trading markets hum along. There has been financial carnage everywhere--bankruptcies, shutdowns, and massive restructuring. But most participants, while struggling and recovering, have adapted. 

Banks Are Surviving Well

Banks across the U.S. have survived well after initial speculation of massive loan defaults, operating losses and severe capital erosion. Most medium- to large-size banks have managed through this crisis, where in that last crisis, financial institutions were pummeled. 

Banks had to boost loan-loss reserves to prepare for the long-term impact of the pandemic. They also had to increase loan-loss reserves to respond to new accounting rules--"CECL"--that require them to project loan losses far more conservatively. 

CECL--"Current Expected Credit Loss" increased loan-loss reserves in the first quarter for publicly traded U.S. banks. At the same time, banks were forced to add to reserves to deal with CoVid-related deteriorating quality in their loan portfolios. Wells Fargo, through June, increased its loss reserves from $9-19 billion in the first half, 2020. Citi increased its reserves from $12-21 billion. 

In 2020, banks are anchored by stronger balance sheets, less leverage, and tiers and tiers of additional capital. U.S. Dodd-Frank and Basel III requirements boosted the capital cushion they all needed to get through this unexpected scenario. 

No one anywhere envisioned a pandemic in 2020 (at least on the massive, global scale we've endured). Hence, banks have been able to build reserves while still maintaining excess capital (and still paying dividends). Increases in reserves subtract from earnings and capital. But large capital cushions (because of regulation) help banks to absorb these modest hits.

Bank stock prices plummeted and have been volatile all year, even as banks have proven to be strong enough to endure 2020. Bank supervisors are less worried about share values, because they assess a bank's "book capital" more closely than "market values." Investors may dislike the fact that U.S. regulators have prohibited bank moves they normally enjoy in good years:  stock buybacks and dividend growth.  Early in 2020, U.S. bank regulators stopped buyback programs and prohibited increases in dividend payouts. 

The Federal Reserve rolled out the results of its stress test in June, the exercise applied to the top 34 bank entities operating in the U.S.  That stress test was based on a "severely adverse" scenario, quite similar to the scenario we are living through in 2020. But its stress test presumes what we are enduring now will continue for about two years more. 

The test and the Federal Reserve's models attempt to predict worst-case losses at banks and check whether they can continue to be "well-capitalized" by regulatory standards. Most banks passed this test adequately. Projected losses were computed to reach enormous levels--about $47 billion in loan losses at Wells Fargo, for example.  But large banks among the peer group that includes Wells Fargo each maintain equity capital near $200 billion.  

In this current crisis, JPMorgan Chase has now eclipsed $3 trillion in assets, almost $2 trillion in deposits. The atmosphere is far less gloomy among the top-tier ("too big too fail"?) banks than it had been in late 2008. 

The Federal Reserve gets the last word, as usual. In the midst of 2020 it altered capital-requirement rules by tying minimum-capital requirements, in part, to how banks fared in its test. (It has now implemented a new, incremental "capital stress-test" buffer.) Stumble in the stress test; then you are required to hold incrementally more capital. 

For banks, third-quarter numbers are about to be reported, and there aren't signs of trouble. If there have been notable increases in loan defaults and losses, they should have been be accounted for and projected in the first and second quarters during the re-calculations of loan-loss reserves.   

While this has been a year of caution for banks on the lending side, banks all over the country (and in all sizes) have had to manage responsibilities in booking loans under the under the U.S. Government's PPP and U.S. Cares Act programs. Some argue banks have encountered operational risks (processing and cybersecurity risks) in these programs, rather than funding and credit risks. 

Banks everywhere have whispered this has been a money-losing operation (low spreads, high operating costs), even as the program has had favorite impact and the Government accepts credit risk. Otherwise, banks are having a banner year for big banks on two fronts:  (a) deposit taking and (b) trading.  

Retail and corporate depositors are comfortable with the soundness of banks (along with FDIC insurance), have increased deposits substantially, and have permitted banks to accumulate cash that helped support PPP lending, corporate loan growth and increases in investment securities portfolios. (JPMorgan announced it had booked over $25 billion in U.S. Cares Act loans.)

All the activity, flurry of trading, and volatility in capital markets mean big trading banks have massive opportunities to make money with such volume. Trading at big banks is practically a function of volume and volatility. (The big banks engage in trading and rely significantly on trading to contribute to total net revenues. Beyond the top 10 banks, few banks engage in trading (market-making) across all risk classes.)

Markets move, investors want to switch out of and into other asset classes, and banks make money doing the trades. In the first half, 2020, JPMorgan generated $5.3 billion in trading gains; Goldman Sachs is on a pace to generate more than $12 billion in trading for the year.

As the Federal Reserve pushed down interest rates to near-record levels, the move encouraged bankers to nudge their corporate clients to issue long-term debt raise cash for uncertain business activity, of course, but also to take advantage of low funding costs. From quarter to quarter, some banks have racked up enormous feeds to help corporates issue record levels of bonds. 

Corporates: A Different Story

Among corporates, the story must be told in tiers, different chapters.  The big have gotten bigger and stronger. The vulnerable have disintegrated or disappeared.  The middle of the pack, while floundering, are managing to endure while hoping for better days if and when post-pandemic days arrive. 

Market observers everywhere have tried to explain the surprising performance of stock markets. In the year that everybody wants to forget, equity indices are up. 

But remember, stock indices reflect the outlook and current performance of large and mid-size corporates, not the thousands of smaller and middle-market businesses that have struggled or collapsed in the pandemic.  There certainly has been a large roll call of well-known, large bankruptcies, but almost all were names that were

(a) in industries that were about to disappear or were in transformation before 2020,

(b) were poorly managed or bet on dubious growth strategies, or 

(c) were simply too enormously highly leveraged after having been blinded by near-record low interest rates. 

After a first-half roll call featuring Hertz, Neimann Marcus, J.Crew, Brooks Brothers, and JCPenney, who's next? Is a Macy's filing just around the corner? There has seldom been a time when a bankruptcy filing was less of a stigma. 

Otherwise, the corporate story in 2020 is mostly an industry story:  Vulnerable industries, dying industries, thriving industries, industries exploiting the current environment, and industries that will do fine regardless of a pandemic's impact. 

Beyond the industry story, it becomes a story of balance sheets, cash on hand and capital structure. What companies are suffering for having too much debt, despite the low cost of debt? What companies prepared well for worst cases and stockpiled cash on the balance sheet and managed tolerable amounts amounts of debt? 

Beyond the balance-sheet story, it might be a management story: How are current business leaders adjusting, changing tunes, tweaking operations, and managing a workforce for the next 18 months? 

Just check stock markets, and we see how well the familiar tech names are doing or at least see the favorable impression investors have for them (Apple, Google/Alphabet, Amazon, Facebook, etc.). There are notable stories of companies reporting exploding revenues because of the pandemic (Zoom, Netflix, e.g.). But the corporate space is dotted with names that six months into the pandemic will see no bright horizons for a long time (airlines, travel and entertainment companies, hotels, etc.). 

A recent issue of the Economist identified another segment:  Zombies, non-investment-grade companies that have avoided bankruptcy, but are proceeding aimlessly, showing few signs of growth, but operating at bare bones just enough to remain solvent. 

The pandemic kick-started debt markets and spawned companies' renewed love affair with leverage. Banks saw companies with revolving-credit lines borrow almost to their limits. Everywhere, from General Motors to middle-market borrowers, companies that hardly used these lines in the past tapped them to prepare for the worst. Meanwhile, after the Federal Reserve clipped rates to near zero, many of the same companies decided to reduce some of the R/C loan outstandings by issuing new public debt at enticing near-zero rates.  Investment banks salivated at the opportunity to help them.

Bank lending appears to have leveled off since then, and third-quarter bank balance sheets might show a slight decline in loan totals. Bank loans at JPMorgan Chase topped $1 trillion in March-2020, but fell to $979 billion in the second quarter. Bank of America also touched $1 trillion in gross loans this year, but will likely report less than $990 billion in the third quarter. 

All in all, debt and equity investors appear to have combed through the markets and identified winners and losers. And perhaps hangers-on (Zombies). 

Beyond the periodic spikes in equity volatility for corporate names in public secondary markets, there is the new-issue market--IPOs. The IPO hasn't disappeared in 2020.  After a crash of equity indices in March and after a period of digesting what hit everybody in the first quarter, the IPO market re-emerged. New companies and their investment banks decided to march ahead and stay the course in plans to go public. 

The New York Times reported the third quarter, 2020, was the busiest IPO quarter in 20 years (81 new offerings). That includes a recent and closely watched Palantir Technologies deal. Bankers and executives Airbnb and DoorDash have queued and are preparing for the next wave of equity offerings. Major investment banks (the JPMorgans, the Citis, Morgan Stanleys and Goldmans) are enjoying exceptional years trading securities and derivatives, as well as issuing new debt and new equity. 

(A new trend, "direct listings," has surfaced, which could hurt banks' roles in IPO. This approach, popular in Silicon Valley, permits companies to go public without the underwriting roles (and the related enormous underwriting fees) of major investment banks.  For the past 15 years, tech-savvy companies have been exploring ways to circumvent the traditional IPO-underwriting process when going public. Banks still must assist in the early due-diligence and SEC registration process.)

In late 2019, this kind of confidence and flurry of banking activity would have been projected and highly expected. In late March, 2020, this confidence disappeared, but had re-emerged cautiously by September. 

Don't Forget CLO Markets

One market niche shouldn't be forgotten: CLOs, or Collateralized Loan Obligations, securitized structures backed by portfolios of non-investment-grade corporate loans.

Contemplate what those loans could be. When structured, they include B+-rated secured loans under the premise that these corporate borrowers, while generating uncertain cash flows from operations, can still meet debt-servicing requirements. Investors like the high credit spreads on the loans and the fact the loans are senior and secured.  They take risks, but the risk-taking is "tranched," because CLOs issue securities rated from AAA to B. 

As long as these non-investment-grade names names are surviving and as long as the collateral is evident and valued (and legally perfected), investors in CLO tranches and securities can enjoy reasonable returns, sometimes slightly better than if they invested in AAA-to-B bonds elsewhere.  

But in 2020, non-investment-grade names, almost by definition, have struggled.  Some slipped quickly into default and bankruptcy. Others are similarly vulnerable. 

Could there be increasing levels of risks for the investors, traders, and risk-takers who have bought these bonds? A CLO portfolio with 100-percent in B-rated corporate loans in September, 2020, might have 10% in C-rated loans or a sprinkling of defaulted loans in the portfolio. CLOs, remember, are structured such that investors who take risks are tiered ("tranched"). Lower-tranched, equity-residual investors or BBB-rated tranches will absorb losses on the portfolio sooner than the AAA-tranched investors.)

Yet a portfolio of CLO loans will certainly not be performing as strongly as the same portfolio a year ago. What do the data say?

In normal years, the default rates of a portfolio of CLO loans might average about 3%. That won't be the case in 2020, where default rates, in some deals, could top 10%, if they haven't already.  Before the pandemic, industry analysts indicated about 11% of CLO portfolios included loans classified as "negative watch" by regulators.  That, too, has increased substantially as 2020 runs its course.  

Industry analysts focus on the percentage of the portfolio rated CCC+ or below. When the CLO is initially structured, the portfolio might include a small amount of CCC loans (about 5-6% when first structured)  Over the life of the CLO, investors, traders and analysts track trends in CCC and below.  Debt rated CCC or below, of course, will have significantly higher default probabilities, which will have impact on pricing and desirability of  CLO securities. 

CLO investors are protected, too, by diversity in the portfolio. A typical U.S. CLO may have as many as 250 loans in the basket, helping to reduce concentration by names, but not necessarily by industry. There is also the risk of "correlation"--that independent loans in the portfolio may be subject to default correlation. (They default unfortunately all at the same time.) Because so many different names and industries are vulnerable to the pandemic, correlation risks are real. 

Three Months to Go

The year is not over. And the impact of 2020 apparently will carry over into 2021. Expect markets to continue to be volatile. Expect interest rates to continue to remain low. Expect banks to remain in solid shape, notwithstanding their disappointing share prices and the quarterly upward blips in loan-loss reserves. Expect another round of announced bankruptcies of household names. Expect the expected.

Tracy Williams

See also:

CFN: Corporate Bankruptcy Season, 2020

CFN: Are Corporate Borrowers Prepared? 2020

CFN:  Stress Tests and Stressful Times for Banks, 2020

CFN: Anticipating the New Year 2020, 2019

Corporate Bankruptcy Season

(In late May, 2020 and with over $20 billion in debt, Hertz resorted to Chapter 11 bankruptcy to reorganize its business, improve its capital structure and buy time during the pandemic.)

Start the roll call. As we roll deeper into the CoViD-blamed recession, every other day a familiar corporate name announces it has filed for bankruptcy.

In May, J.C. Penney Company and Hertz Global filed. Others in 2020 include Neimann Marcus and J.C. Crew.  Market watchers and bond investors try to project who's next by providing drive-by analysis or injecting opinion into capital markets (via rising yields in corporate bonds and increases in "credit spreads" in credit derivatives). Airlines LatAm and Avianca have filed.

Bloomberg reports at least 98 global companies with debt of at least $50 million have filed for bankruptcy in the first five months of 2020. Other familiar American filings include Dean & Deluca, Borden Dairy, Modell's, Pier 1, and Gold's Gym. There can no longer be a stigma of failure when a company submits papers for Chapter 11.

Some bankrupt names are victims of the pandemic. Their business models are based on social contact and constant interaction among humans. They might have been thriving businesses until revenues evaporated suddenly after February.  Other bankrupt names (Pier 1, Modell's, e.g.) were vulnerable all along, barely surviving businesses that had been candidates for insolvency for a long time. A coronavirus scenarios merely thrust it off the cliff.

Take the rental-car agency Hertz. CoViD-19 has ravaged its business, because people aren't traveling on business or for pleasure. In mid-May, it missed a payment on debt due and requested extensions from its banks and a restructuring of the loan, an extension in some way. By late May after having asked its CEO to resign, it resorted to a formal Chapter 11 filing.

For others, it wasn't about CoViD-19; it was about changing tides within the industry. Either companies were evolving or they had begun a slow crawl toward the end of existence. Before March, a long list of names in the retail and consumer products industry were candidates for bankruptcy. They include the familiar department-store names, brick-and-mortar businesses that hadn't quite embraced Internet shopping. This industry has been embattled for a long time. Some companies casually glanced at the explosive surge of online shopping in the past decade without bothering to embrace it or compete.

Its woes are blamed, too, on their reluctance to embrace a different way for consumers to purchase goods. Some in the industry tried to transition into online sales, but did so too late.  Even Sears had embarked upon an online strategy, but its early hesitance led to the downfall of a company deeply embedded in American business history. That company filed for bankruptcy two years ago.

Other retail-industry companies were able to survive as barely break-even enterprises, scrounging for ways to come up with a miracle that might boost annual sales at least by 5-10 percent annually.  They might been able to squeeze a year or two of solvency or sell themselves to an optimistic private-equity firm--until CoViD appeared.

Rating agencies have tried to project default rates among non-investment grades after the beginning of the pandemic.  Default rates reported range from 8-14%, depending on the industry or country. That doesn't imply14% of corporates rated BB+ or lower will end up in bankruptcy.  But they become candidates.  Defaults initially lead to efforts by both parties to restructure or extend debt due. Many lenders and investors seek to resolve an initial problem before bankruptcy becomes a final resort.

Watch closely, too, WeWork.  Its near collapse in 2019 after it had prepared for a celebrated IPO was well chronicled.  A faulty business structure and fragile balance sheet put it on the precipice of insolvency.  It will continue to struggle throughout 2020-21.

JC Penney's Woes

JC Penney was certainly one of those names.  Others like Macy's or The Gap might be candidates further along.

JCPenney  is a name that could have managed survival before CoViD-19, despite its stumbles in updating business models and strategies the past decade. Unlike other retail companies, for the past eight years, it has managed to hang onto sales at $11-12 billion annually.  Business wasn't growing, but it wasn't disappearing in sharp down-steps. (By comparison, annual revenues at Sears fell by 60% in the last five years before its filing for bankruptcy.)

JCPenney suffered accounting losses, but when a company is struggling to survive, it's less about GAAP income and more about actual cash inflow. (Many companies, as we've observed the past decade, present GAAP results, but switch quickly to non-GAAP presentations of performance to show cash flows and often to show the best of themselves in whatever manner possible.  Accountants permit these non-GAAP reports of performance, as long as the company explicitly states the adjusted earnings don't meet conventional standards.)

For the past five years, the company consistently generated operating cash over $400 million each year. Much of that cash each year was deployed to fund capital expenditures, often cash outlays to maintain or upgrade old stores.  It sold other investments to gain cash to pay down some debt.  But debt still totaled over $3.5 billion at the start of this year.

The company had little room for error and held onto an embarrassingly low amount of cash reserves for a company operating across the country (less than $400 million). With a small amount of cash on hand, CoViD-19 was the misfortune it couldn't afford to encounter. Its $12 billion-revenue business probably won't top $6 billion in 2020, while fixed store costs will remain the same until they can sell properties that will be shut down. The $400 million in operating cash flow of last year will more likely become $400 million in cash deficit in 2020.

While the evaporation of business activity in March-April, 2020, will be the blame for many insolvencies, highly leveraged balance sheets will have been the symptom that pushed them into the courtroom.  JCPenney might have been able to conserve about $100 million in cash annually if it had about half the amount of debt it had by the end of 2019.

Bankruptcy (the Chapter 11 version) is about devising a plan for how it will proceed (and how it will generate cash flow to appease creditors).  Because revenues won't grow anytime soon, the company will shut down stores to reduce fixed costs and consider selling related assets. It had done so in the past, but not in the aggressive way it must do so now.

In May, it announced it will sell 30% of its stores over the next two years.  Selling stores reduces fixed costs, but it subtracts off substantial amounts in revenues. It also wants to present a polished plan to emphasize online sales, activity that had heretofore contributed modest amounts to total revenues.  Sears, nonetheless, in its waning years before bankruptcy had tried a similar path and made similar promises.

How to Remain Solvent?

The retail industry won't be the only industry to get pummeled in these times.  Businesses in such industries as hospitality, entertainment, travel and airlines are similarly vulnerable.  In the first wave, companies that were already struggling with low cash flow or tenuous business models will seek bankruptcy protection.

A second wave could follow for companies that had been sturdy and relatively strong before the crisis. Because they had sufficient cash reserves and manageable debt levels, they can survive a short-term downturn.  Eventually cash runs out more quickly than revenues recover to pre-crisis levels.

Companies that exhibit the following will have the best chance of remaining solvent and staying away from bankruptcy:

a) Cash on hand and operating leverage.  Companies with adequate cash reserves to manage operating expenses with negative growth in revenues over a 6-12-month period put themselves on good footing.  Many large companies have stockpiles of cash, although they may have been earmarked for other activities. Unencumbered cash is always a short-term solution at least until an economy starts to rebound. (In early 2020, Tesla entered the crisis with over $6 billion in unencumbered cash. Goodyear Tire has about $4 billion if the availability under a committed revolving-credit facility is included. Netflix has over $5 billion.)

With the cash on hand, they can meet operating expenses comfortably if they have manageable levels of fixed and variable costs and relatively low cost structures. Companies are in better shape if fixed costs are relatively low (vs. total costs) and if variable costs can disappear as rapidly as declining revenues.

b) Low leverage.  Companies with insignificant amounts of debt can avoid insolvency.  Bankruptcy is technically a way for borrowers to manage the demands of creditors. Low leverage reduces the amount of cash payouts to creditors and the likelihood creditors will push for default resolution.  Leverage is measured in so many ways:  Debt/Ebitda, Debt/Equity, Debt/Operating-Cash-Flow, Free-Cash-Flow/Current-Debt-Payments.

In early 2020, ratings agencies and investment analysts were reporting Debt/Ebitda ratios rising slightly, but below 6 for leveraged-finance transactions.

In 2019, by these ratio standards, JCPenney had high leverage: Debt/Ebitda > 6, Debt/Equity = 4, Debt/Operating-Cash-Flow = 8.  In 2020, those metrics were only going to worst and worst, as cash flow deteriorates.

c) Debt refinancing and debt tenors.  In good times, investment-grade companies expect to pay down expiring debt by refinancing the debt.  In good times, non-investment-grade companies also expect to refinance most debt. (Netflix, a non-investment-grade name, has $15 billion in debt and typically plans to roll it over when due and use operating cash flow to continue to finance its growth spurt.)

In bad tines, non-investment-grade companies must plan for expiring debt not to roll over and must show they can pay down what's due.

If the principal on the debt is due in more than two years to come, struggling companies can breathe more easily by paying interest and hoping for eventual revenue upturns. JCPenney, for example, always managed a way to pay annual interest of about $300 million in the last few years--before the pandemic.

The "refinancing wall," thus, determines the level of problems a highly leveraged company can have: What amount of long-term debt is due within the next 12-24 months? (Investment-grade name Merck has $22 billion in debt, about $8 billion due in the next three years.)

d) Revenue decline.  How quickly will revenues decrease--slowly, gradually, rapidly?  Airlines, hotels and certain entertainment companies observed their sales erase overnight--in large percentage chunks.

For companies in other industries, revenues are slipping away slowly as the impact of recession affects their customer bases. Customers with long-term sales contracts or operating in low-risk industries might not experience revenue implosion immediately. Some companies with diversified revenue sources may suffer a less dramatic drop-off in sales.

Other companies took a sharp turn in repurposed the business or product in the interim to meet pandemic-related demand for other services.  Uber has begun to focus on UberEats.  Some manufacturers reengineered product lines to become makers of hand sanitizer, protection equipment, etc.

Hertz Global Files for Chapter 11

Hertz's suffering was caused by a global lockdown on travel--whether for business or pleasure. Yet excessively high leverage shoved it into bankruptcy court. The company had increased its debt burden by 2019 to over $20 billion (including obligations on operating leases). Almost all of that debt funds its fleet of vehicles around the world. (Debt/Equity at March 30 computed to an overwhelming 13.7. Its Debt/Ebitda was not a meaningful ratio because of recent operating losses.)

Hertz's operating model is built around ensuring vehicles are in use frequently, rented out to customers for the maximum amount of time.  Utilization of vehicles before CoViD-19 had been above 70%; in late March, utilization was sliding to 60%. By May, utilization may have fallen below 50%. Even as the pandemic wanes and travel increases gradually, the company can't expect utilization to rise back above 70% in 2020 and early 2021.

(Hertz also operates via franchises, which too will have suffered similar decline in activity.)

Cash is also generated from selling an aged fleet of cars. Cash flow from that source (normally about $2 billion/quarter) will also deplete in the short term.

Before it filed, Hertz did what many large companies did to prepare for the onslaught of the coronavirus:  It drew down on bank-led revolving-credit facilities. That permitted Hertz to confront a CoViD-19 environment with other $1 billion in cash. But that amount can't offset the substantial operating deficits it expects in the coming months.

The company has some favorable factors: (a) It has a globally known brand, which provides in multiple ways, and (b) it has the ability to bounce back quickly when people are comfortable traveling again.  Hence, it is in a waiting game and hopes creditors can wait, too.  Can it keep costs to a minimum until revenues return perhaps to near 2019 levels? When will revenues return--2021, 2022? Can utilization approach 70% again? And when will that be?

Advisory Firms

In bankruptcy and insolvency scenarios, banks play many roles.  They are lenders and creditors who line up to stake their claims on the borrower's assets.  They are also fund-providers, providing debtor-in-possession financing (often working-capital funding), a short-term source as the company and court work through the process. Or as investment banks, they may be advisers, assisting the borrower in identifying cash sources and restructuring the business and the balance sheet.

Many advisers are boutique firms, not likely to have been lenders and counterparties to the borrower and able to act independently.  Some advisers are firms that specialize entirely in restructuring and bankruptcies (Alix Partners, Alvarez and Marsand, e.g.).

Other advisers are investment banks with reputable positions in mergers, acquisitions, and underwriting. In down times, they switch tunes to focus on restructuring by devoting more resources and pitching related services.

Lazard has a prominent restructuring group. Fees from this activity will offset the expected decline in merger advisory and underwriting.  In its latest annual report, not anticipating the major downturn at that time, it described how it represents the borrower or the creditors. The practice is divided into before bankruptcy advisory work and after bankruptcy advisory.

In periods of distress and before filing, Lazard will determine current debt capacity of the company and then advise how best to restructure its balance sheet while working with bankers and investors.  In bankruptcy, Lazard advises the company on reorganization planning and strategy. That could include the issue and structure of new securities. The firm generated $1.1 billion in investment banking fees last year, but it doesn't disclose what portion of that is derived from the restructuring and bankruptcy business.

Other boutiques, such as Evercore and Moelis, also push the restructuring business to the front when companies scramble to keep businesses solvent before filing.  Moelis, in fact, will assist Hertz. It's not unusual that senior bankers who step into these roles are former bankruptcy attorneys.

Tracy Williams

CFN: Radio Shack Files for Bankruptcy, 2015
CFN: Yahoo Tosses in the Towel, 2016
CFN:  MF Global: Too Small to Save, 2011
CFN:  Are Corporate Borrowers Prepared for CoVID-19 Scenarios? 2020
CFN:  WeWork: What Happened and Why? 2019

M&A Amid COVID-2020

In a 2020 COVID-19 crisis, will corporate mergers and acquisitions be on hold for much of the year?

With an energetic push from investment bankers, when corporate entities at some point decide to meet business goals they must either

(a) buy and invest in other companies, 

(b) arrange mergers of equals with peers, 

(c) sell off significant-sized assets or subsidiaries,

(d) divest in selected business operations or divisions, or 

(e) allow themselves to be purchased by rivals. 

Into the picture march the Goldmans and Morgans to spark ideas about how to accomplish these tasks and, of course, how to value prospective transactions:  How much should Company A pay for Company B? How should it arrange funding the transaction (cash reserves, debt, equity stock, debt and equity)? 

Investment banks and their cohorts at the client companies spend much time analyzing the company's own "market value" before the transaction, the "intrinsic value" of the target company, and the "market value" after the transaction of the merged companies.  They develop strategy and make decisions about a merger, acquisition or divestiture. Do the merger.  Ignore the merger.  Find another way of structuring the combination.  Of course, they will have considered countless scenarios (funding options, interest rates, capital structures, economic trends, legal risks, political risks, timing).

M&A decisions are difficult; the analysis is complex and often imprecise, ever-changing. Ultimately all analysis should lead to CEOs and boards of directors into making the right decisions. 

Companies contemplating M&A start with several approaches. There is no one common, correct way. Often the approach revolves around overall business strategy (at least the strategy at that point in time).  They may take an "inside-out" approach, investigating internal operations and deciding what they need to complement current operations.  Or they may take an "outside-in" approach, exploring beyond current operations to decide ways to expand and grow (also known as "scope" approach). They may start from scratch:  What transaction can we do to boost shareholder or market value of the company?

Bankers, from the bulge-brackets to the boutiques, stand behind top corporate managers to assist in these new strategies. 

Unfortunately there exist long lists of M&A transactions that have failed and should have never happened in the first place. Some skeptic observers of a frenzy of mergers enjoy counting off the failed deals.  They typically blame an over-estimation of synergies in most failures. 

Remember long ago when General Electric decided to leap into financial services first by purchasing the reputable investment bank Kidder Peabody? The TimeWarner-AOL deal is one for the financial history books. In some industries, all it takes is one headline merger to spark a spree of mergers among others in the same industry. Airlines merge. Pharmaceuticals merge. Food companies merge. Financial institutions merge (Morgan Stanley agreed to acquire E*TRADE a few weeks ago.)

There are lists just as long that explain why M&A deals don't work they way bankers and boards intended for them (unexpected costs, unrealistic synergies, delays in approval or rejections in regulatory approvals, flight of talent, hidden risks, unexpected market downturns, cultural clashes, etc.). 

Yet year after year M&A activity persists. 

Before the current COVID-19 crisis, industry analysts summarized 2019 activity and attempted to project transactions for 2020 and beyond. But that was before today's volatile, uncertain scenario. Consulting firm Bain & Co. reported there were $4 trillion in deals in 2019 (flat from 2018, slightly down from a peak in 2015). The biggest deals included mergers involving pharmaceuticals (Bristol-Meyers and Celgene, e.g.) and energy (Occidental and Anadarko, e.g.). 

In 2019, Goldman Sachs reported its involvement in $1.4 trillion in transactions, a 16% increase from the previous year.  (It closed $1.3 trillion in deals.) It has generated at least $3 billion in related fees in each of the past three years. Bank of America reported $1.3 billion in fees, a 10% increase. 

JPMorgan Chase boasted of its leadership role in U.S. and global deals. Morgan Stanley, Citi, and Evercore follow closely behind. Other big players in M&A, based on 2019 performance, include Barclays, Evercore, RBC, Centerview, Lazard and Moelis.  

Just as in other financial-industry segments, the M&A industry expected there could be a recession on the horizon, but something for which the industry could prepare and brace. 

By March, 2020, the world changed. 

And that means merger strategies were altered abruptly. The backlog of anticipated transactions for the next 18 months will change, too. The nature and even tone of early-2020 discussions about possible combinations were upended.  

Companies contemplating acquisitions and expansion must now consider restructurings and divesting of assets to raise cash to prepare for a prolonged downturn.  Bankers advising in proposed deals must return to models to revise values of companies and purchase prices. In fact, some have proposed a rethinking of the concepts "shareholder value," "intrinsic value," and "market value."

In January, companies and bankers outlined deals on the horizon, suggesting another prominent year in M&A for banks.  Several weeks later, some of the same companies are looking for ways to postpone deals or get out of them all together. Boeing, the aircraft company that has faced a multitude of  issues the past few years for well-chronicled reasons, was still an ongoing operation by late 2019. It pursued to Brazil's Embraer, a commercial jets business.  

By mid-April, Boeing pursued ways to cancel the $4.2 billion planned acquisition.  Boeing decided it was better to keep the $4.2 billion in cash than to invest in another enterprise and spend years in regret. Boeing canceled this deal, mostly because airlines have canceled their business orders with Boeing. Not to mention a recalculation of the value of Embraer would not justify the target being worth anywhere near $4.2 billion.  Boeing's bankers, Evercore and Lazard (in restructuring roles), may have been the voices to urge Boeing to balk and helped it find the legal loopholes to withdraw from a proposal. 

New Concepts of Shareholder Value?

In a recent issue of the Economist, a former governor of the Bank of England recommended now might be the best time for analysts and investors (and traders) to redefine shareholder value in the wake of COVID-19 and "the new normal."

Business school books for decades defined shareholder value based primarily on a projection of future operating cash flows, cash available annually for shareholders. In recent years, finance professors and other business leaders have proposed adding community contributions, environmental and social impact and governance ("ESG") to the components of shareholder value.  The Economist observer proposed assessing "value" based on whether companies are prepared for crises now and in the future and on how companies responded to employees and their communities during this crisis. Hence, companies that behaved responsibly during this crisis and are prepared for future worst cases should earn a premium in value no matter what cash-flow projections suggest. 

For the second half of 2020, M&A departments at major investment banks won't die or disappear. They are known to be creative in how to approach CEOs with ideas for combinations and spin-offs (all while they are hyper-motivated by the lure of million-dollar fees).  Corporate leaders will still encounter issues and opportunities where the best option might be an acquisition or a marriage with a peer.  More often than not, in a downturn, they will contemplate spin-offs, restructurings, and asset sales.  They reframe business strategy and elect to withdraw from certain business lines or look more closely for operating efficiencies.  

Private-equity funds will be on the prowl to find under-valued assets and will look to bankers for guidance.  Some of the same are still waiting to see if the bottom has been reached and continue to survey lists of survivors, thrivers, and corporate wreckage. Some will decide which companies should thrive, but are impeded by bad management, bad luck or fragile balance sheets. 

PEs, EVs in 2020

M&A analysts focus on price-earnings-related estimates and metrics.  How much is a target worth? How much should a company be sold? How much will potential acquirers be willing to pay for an operating subsidiary?

M&A analysts also value companies based on concepts of "enterprise value." EV encompasses value of the enterprise to both equity shareholders and long-term debt investors.  The enterprise generates operating cash flow that will be available for discretion, rewards or reinvestment for both debt and equity investors. They attempt to compute or assess "enterprise value." They use a convenient metric (a multiple) to assess the value operating cash flows: The EV/Ebitda multiple, closely watched from period to period and from industry to industry. 

EV/Ebitda for deals done in 2019 (from Bain & Co. and Mergermarket reports) ranged between 9-15 across multiple industries and averaged about 12.5 (down from 15.0 in 2015).  The 15-year average computes to 12.0. 

Acquiring companies or private-equity funds were willing to pay about 12.5-times cash flows for target companies last year.  The higher the prospects for growth, the more they are willing to pay for targets. The more certain the cash flows will be generated, the more they are willing to pay.  Thus, growth and certainty contribute to value. 

Expectations for high growth in technology industries explain EV/Ebitda multiples averaging 15.0 in deals from 2015-2019.  Expectations of low growth and uncertainty explain the average of 11.0 in consumer and retail industries over the same period. 

Now enters COVID-19.  Forbes reports M&A in the U.S. activity in 2020's first quarter fell 50%. Before March, Xerox had coveted HP and expressed its intentions broadly and publicly.  Since March, Xerox has backed off and focused on more pressing matters. 

Without a doubt because of widespread uncertainty, acquirers will not be willing to pay 12-15-times Ebitda for targets. For potential acquirers (especially for private-equity funds), even if there are "good buys" in the market at 9.0-10.0 multiples, too much uncertainty and risk may keep them on the sideline for several months. 

Bankers and acquirers, like just about most investors, may continue to observe and wait until uncertainty dissipates.  Uncertainty won't reduce the urge or the need to do transactions. Uncertainty may slow the steps to decide when to do a deal. Yet in the midst of such uncertainty, don't forget the motivation of bankers to generate fees. 

For years (or decades?), star bankers have been blamed for pushing companies to do mergers that shouldn't have been done, weren't properly rationalized, and ultimately failed. Investment banks have earnings incentives to get deals done and risk pushing for undesirable corporate match-ups to earn millions in fees, even if they have doubts about the success of a merger. 

Scale vs. Scope vs. Private-Equity

Merger data in recent years show 85% of global mergers involve corporations acquiring other businesses for the purpose of scale (to expand, grow, gain market share, or get bigger) or for scope (to evolve, diversify, or revise business strategies).  And most involve public companies (as buyers or sellers).  At 15% of the total, private-equity funds continue to be significant players. 

History suggests "scale" deals tend to involve more successful integration than "scope" deals.  But scale deals have additional hurdles:  Regulators must evaluate and approve for anti-trust implications. And often regulators take their time to decide, especially in technology and telecommunications industries. 

In the periods to come, corporates will focus on existing operating priorities ("return to work," employee force, reviving cash flow, improving balance sheets, ensuring ongoing funding, raising equity, issuing term debt). They may seek merger partners only after everything else has gone wrong. Under this scenario, they seek partners to reduce costs, improve operating efficiencies, or raise cash. 

Private-equity players, especially those undeployed cash and related commitments, will explore and hunt for bargains, looking for businesses slowed temporarily because of the crisis, but showing signs they can rebound rapidly once the worst of COVID-19 is behind us.

Banks see themselves as advisers, but also idea-generators or list-drawers with rosters of potential targets. If deal flow slows in mid-2020, they will huddle and hustle more aggressively than usual to prepare pitchbooks of candidates and valuations. No matter the good deals done or the mounting number of prior failures, M&A activity doesn't go away forever; it reappears when banks show up to present ways to solve corporate problems via corporate pairings. 

Irrational vs. Rational Mergers

The Bain 2020 report blamed bad or failed mergers on (a) bad due diligence by bankers and acquirers, (b) acquirers not understanding the business model of the target or leaping into businesses they hardly understand, (c) loss of management talent after the merger, and (d) unexpected departure of senior managers of the target. In a COVID-19 environment, merger partners will not likely want to take the risks of possible bad mergers. The costs and impact will be too much to bear. In good times, a top technology company can risk millions making a bad decision to acquire an unproven start-up. In bad times, the same firm might pass.

Bain highlighted the best deals are a result of 

(a) better due diligence and scrutiny of operations, 

(b) well-executed integration (because of planning), 

(c) stronger awareness of strategy and planning on both sides and 

(d) retention of talent on both sides. 

Before the onset of COVID-19 and the near shutdown of global economies, M&A analysts had begun to note some trends over the past few years. The market valuations of companies (public companies, for sure; private unicorns, in other cases) have soared the past decade. 

If two large companies merge, then valuations, market shares, and their combined impact on markets will be enormous--overwhelming enough such that regulators will examine prospective deals closely for anti-competition implications. Large-value deals attract close scrutiny and lead to longer timetables to approval. Cross-border transactions extend the timetable, because of the layers of overseas approvals and related issues.

Sometimes deals are done because of regulator orders. The regulatory authority may mandate the company sell a business operation (because of anti-trust implications). Or a company may agree to acquire a target, but approval is granted based on the acquiring company selling off certain divisions or assets. The same requirements still generate business activity for investment banks, who get to preside over the reorganizations. 

Outlook for 2020-21

Analysts have noted the continuing rise of public-to-private deals.  Large public companies, trends show, are electing to run their operations without the scrutiny and threat of activist public shareholders, without the pressures of having to manage the business to particular earnings-per-share from quarter to quarter.  They enjoy not having to rationalize recent results and project boundless optimism in quarterly calls. (Years ago Dell, the computer company, prominently decided to quit the public arena and go public for similar reasons.) 

In the COVID-19 scenario, there might be companies encouraged to "hide out" from public scrutiny during tough times and consider becoming private--if they can do so, if they can find buyers who see long-term prospects.

Divestitures to Raise Cash

Now more than ever, a prominent corporate theme in 2020 into 2021 will be corporates ensuring they have piles of cash reserves to offset the risks of near-zero or negative operating cash flow.  Cash reserves help companies in a downturn to offset operating expenses.  

After companies have exhausted all ways to raise funds from revolving credits and new debt issues, companies will consider raising cash from selling assets of divisions and operations they declare to be non-strategic (or too much to tolerate).  They hire bankers to help them find buyers among competing firms or companies looking to expand into other businesses.  The assets under sale, remember, will likely be assets that had not been performing well or will likely suffer substantially in a downturn.  The value they achieve from the sale will likely be less than value they could have generated just a few months ago. But cash generated is king. 

They achieve the objective of raising cash, building reserves, and strengthen a balance sheet that must weather tough periods.

Deal Postponements and Cancelations

Like the Boeing deal above, other companies will, too, look for ways to back off on doing transactions that made sense in late 2019. They are nonsensical in May, 2020, or they certainly aren't worth the values acquisition models derived a few months ago. 

The ability to postpone or cancel deals will depend on the legal documentation in place before March, 2020.  Is the COVID-19 crisis a material-adverse event? Is it a force majeur? Can present conditions be interpreted or construed as "Acts of God" that permit a cancelation or a right to renege on a promise to buy or sell? 

After March, 2020, it will, of course, be all but certain that merger-related documentation will include defining statements to address responsibilities of buyer and seller in a COVID-19 environment. Lawyers on all sides will define such an environment with detailed measurements and define the timeline of the COVID-19 period. 

Mergers Involving Failing Businesses

Struggling companies reach a point where they are willing to take on partners.  Neiman Marcus has reached that point. That's not a surprise, given its place in the retail industry where cash flows are based on customers avoiding the convenience online shopping and appearing on site at a mall.  Companies like Neiman Marcus, JC Penney, Nordstrom and Macy's have suffered for years.  The same group may pursue marriages if they prefer to stay solvency and out of bankruptcy courts.   

Beyond the retail industry, other failing businesses might be struggling temporarily or have had sluggish performance blamed on bad strategy or incompetent management.  Those businesses could find buyers who might be confident a mere tweaking (after the worst of COVID-19) could turn them into stable cash cows.  

Restructured Organizations

Some of the best known investment banks in periods of decline change their caps and transform from merger bankers to restructuring experts.  Companies that once tapped Lazard for ideas to expand into Europe or Asia will seek out Lazard for advice on how to reorganize to manage a downturn and squeeze out cash to service debt.  Lazard, the firm, has run a restructuring unit that thrived in the Financial Crisis, 2008-10, and is well-staffed to help companies in 2020. 

Restructuring will involve a sale of assets, but could imply ways to raise funding in creative ways. It also might mean coaching companies wrestling with decisions to file for bankruptcy or in how to manage through bankruptcy.  Banks like Lazard, of course, provide these services for a fee. 

Impact on the Process

To say the least, COVID-19 will have impact on the process of getting deals done.  A successful M&A transaction results from dozens of people contributing to a months-long process that requires perhaps a hundred steps. Companies must be valued. Fees, pricing, and valuations must be negotiated.  Information must be verified and substantiated. Lawyers prepare and interpret language (especially anything that implies "commitment" or "guarantee" or "promise").  Documents must be prepared, reviewed and submitted.  Regulators must review and approve. Investors must be informed. Buyers must arrange funding. Boards of directors must convene.  Shareholders must be informed. And amidst rampart market volatility, valuations must be updated daily. 

The spread of the coronavirus slows the process down and extends timetables indefinitely. Fewer deals will be consummated over a similar timeframe.  

The hundreds of steps toward consummation will be modified significantly if only because 

(a) bankers, regulators, accountants and all other parties and stakeholders involved cannot meet in person, 

(b) some parties involved (regulators, sellers, etc.) may have other more pressing priorities,

(c) uncertainty prevails everywhere (the ability to arrange funding, the reluctance of bankers and buyers to commit or guarantee performance, the inability to value companies as precisely as bankers would prefer)

(d) new forms of legal documentation must be prepared

Due Diligence will mean much more going forward.  For experienced bankers (and the analysts and associates who perform much of this work), due diligence was a rote process, a necessary step to ensure the buyer understands and knows what it targets. 

In 2020, that process must include addressing many questions for which today there is no helpful answer: What impact will COVID-19 have on operating expenses, markets, legal responsibilities, products, and political risks? What impact will working from home have on productivity for business operations? What roles will information technology groups play as more business activity is conducted online and when most employees are working from home? 

Negotiations, for which in a routine M&A deal are numerous and continual, will be cumbersome and often haphazard.  U.S. regulators (the Department of Justice, the Federal Trade Commission) will be slower and more deliberate in approvals. 

Lawyers for all parties will redraft standard documentation to encompass the new environment: How can buyers be assured sellers are meeting conditions for closing and are representing accurately business activity, expenses, efficiencies and productivity? How strong will legal documentation be if it is negotiated and executed online?

Financing 

Buyers must finance an acquisition, as mentioned above.  They fund acquisitions from cash, new debt, new equity or combinations of the three. Before 2020, investment-grade companies, advised by the models from their respective banks, could comfortably choose how they preferred to raise funds.  Often the financing decision was based on the advantages of debt, interest rates, debt-equity ratios after the merger, cash reserves on the balance sheet, and the degree to which earnings-per-share after the merger would be reduced (diluted). Logistics, process, and the time to receive funding were also factors.  

After 2020, acquisitions funded by new debt and new equity may slow down because of market uncertainty, market volatility, lack of interest in equity markets and a dwindling risk appetite from debt investors and banks.  

Banks and debt markets will be more careful about providing acquisition financing. The "highly confident" letters and "financing commitments" some major banks happily provided for big-name mergers may disappear because of the difficulty to predict how markets will behave:

(a) Highly leveraged combinations will not be treated as favorably as before, 

(b) "Bridge funding" from banks could dwindle if bankers aren't sure debt markets will be open and liquid in months to come, and 

(c) Bank risk managers understand well how quickly investment-grade companies in certain industries (in a COVID-19 setting) can transform into struggling, risky borrowers in a few weeks. 

Post-Covid Planning

Although there is little way to project when this crisis will be pronounced "over," many companies behave as if this will come and go. They prepare for an upswing in the economy and a "the new normal."

Potential acquirers may look for company bargains in anticipation of a post-Covid scenario. Companies that can do this look for targets where market values have nearly plummeted, purchase them, and spend the crisis integrating them. Companies surviving well and thriving nowadays (because they have positive operating cash flow and ample cash reserves) set their eyes toward strategic moves.  That list might include Walmart, Amazon, Facebook, Alphabet, and big pharmaceuticals. According to one market analyst, some potential targets might include restaurant chains, Target, and Under Armour.

Public-to-Private 

Public-to-Private deals occur when a private group (a fund, a private company, a majority owner, a management group, etc.) decides to take a public company private because the parties decide there is an advantage to being a private company vs. public company.  There are joys and advantages in being a public company, most notably because of the ability to raise capital broadly and realize market values (especially on an upswing) daily.  There are troublesome factors, too:  shareholder expectations, the thorns and probes of activist shareholders, the requirements to distribute operating details to a broad universe each quarter, the agony of being valued everyday, etc.  Then there are joys and advantages in becoming private again.  

Private-equity buy-out funds will likely look for bargains where sluggish operations and performance could turn to promising profit margins post-Covid.  Some companies may entertain bids from private companies or management groups just to escape the scrutiny they encounter as public companies, something they may welcome if there are 12-18 months of economic nightmares and uncertain operating earnings.  The veil of being a private company may give those companies a chance to hide out of view and revamp strategies or change the scope of the business model without being subject to constant input from market investors.  

Public to private, however, doesn't happen unless there is some underlying value and there are potential buyers, most of whom often require ample debt funding. 

In sum, M&A in the U.S. and around the globe will pause or dip and will slow down. It will be deliberate and purposeful and even better-rationalized. The billions that big banks generate in related fees will tumble after late-2010s highs. But M&A won't disappear. 

Tracy Williams  

See also:

CFN: Merger Mania: Boom Times? 2013

CFN:  Today's Bulge Brackets, 2012

CFN:  Banking Boutiques:  Pros and Cons, 2009

CFN:  M&A Rankings and League Tables, 2017