Capital Structure Solutions in a Disruptive Market
Unprecedented Period of Uncertainty
The COVID-19 crisis has presented a range of unprecedented challenges to the automotive supplier industry, most significantly in the form of OEM plant shut-downs and declining vehicle sales. For many suppliers, these conditions have resulted in an acute liquidity situation.
Revolver draw-downs, cost-cutting, and other measures have lengthened the runway for suppliers to survive while awaiting a restart of manufacturing operations – the timing of which is highly uncertain.
However, even after manufacturing operations start back up, capital constraints will continue as suppliers will need to rebuild their inventory levels, well in advance of receiving payments from customers. Concerns about the health of the supply base have been widely reported – especially the lower tier suppliers that were already working with a relatively thin capital cushion.
While the immediate focus of most industry participants is protecting and maximizing liquidity, suppliers will soon begin to evaluate their available strategic alternatives in order to emerge stronger from this crisis period.
U.S. Automotive Sales, Seasonally Adjusted Annual Rate
Source: Federal Reserve Bank of St. Louis, Federal Research Economic Data (webpage accessed on April 8, 2020)
Consideration of Strategic Alternatives
The range of strategic alternatives considered by companies facing declining revenues and tight liquidity typically includes raising additional capital, exploring M&A, and balance sheet restructuring.
Raising Additional Capital
If fresh capital is needed to address balance sheet pressures, companies often turn to their incumbent lenders for support. However, if debt defaults begin to ramp up across the business landscape, such traditional capital sources may become more difficult to access.
In such circumstances, companies can turn to alternative sources of debt capital that are well suited to quickly analyze and fund companies in financial distress. While more expensive than “traditional lenders”, alternative capital sources typically provide more favorable lending terms and greater covenant flexibility that allow businesses to navigate choppy markets. Credit products sourced from alternative lenders can range from unitranche loans (combining a senior and junior loan), second lien loans, or mezzanine loans.
In addition to, or perhaps as an alternative to, taking on additional debt, there is a growing population of structured equity providers interested in partnering with companies facing a liquidity challenge. Structured equity can take many forms, but effectively serves a minority or non-control infusion of equity capital. This could be of interest to a business owner that would benefit from the resources of an equity partner, but is not interested in selling a majority stake during this market environment. Historically, structured equity has been a specialist financing product, but a wider range of traditional private equity firms are now willing to explore taking a minority stake during this period of time where M&A transactions may be fewer and farther between.
As part of a liquidity maximization strategy, companies may consider the sale of non-core assets or business divisions. This approach can have the dual benefit of generating liquid resources and reducing the level of management oversight – allowing attention to be focused on the core, more valuable segments of the business.
In a disruptive market, the greatest challenge to an M&A process may be the typical timeline, which can stretch from 6 to 9 months, especially if strategic buyers are involved. As a result, sellers often consider an accelerated M&A process in distressed situations, which can significantly shorten the timeline to as little as 1 – 3 months.
An accelerated M&A process can be complemented by the introduction of “special situation” investors, comprised of financial investors who are well-equipped to react quickly, perform diligence, and close transactions on an expedited basis. If the situation is highly stressed or complicated by debt defaults, sellers can utilize the protections offered under Chapter 11 of the US bankruptcy code which stays creditor actions while a sale transaction is concluded.
Traditional process: 6 – 9 months
Accelerated process: 1 – 3 months
|Going Concern||Under Pressure||Highly Stressed|
Balance Sheet Restructuring
Capital raising and M&A strategies can go a long way to help address liquidity issues in a distressed situation. However, it is sometimes necessary to address the capital structure itself, especially if the outstanding debt no longer fits the revised operational outlook for the business.
The first sign of financial distress is often an impending or actual breach of a financial covenant in a borrower’s credit facility. In this market environment, lenders will be closely monitoring the performance of their borrowers, and covenant defaults will be carefully evaluated. Lenders will assess the preparedness of borrowers to deal with any defaults, as well as what corrective actions borrowers might take.
Companies that have debt instruments trading in the secondary market, such as leveraged loans or bonds, may find that distressed investors have acquired a meaningful debt position, and seek to form an ad hoc steering committee to provide a forum for such investors to participate in the restructuring process. While this presents an additional workstream for management, it is important to engage proactively with such creditor groups, especially if a debt default, near-term maturity date, or other liquidity event is upcoming.
Communicating frequently and transparently with lenders can go a long way to ease concerns and set the stage for a successful balance sheet restructuring – whether a resetting of financial covenants or realignment of outstanding debt to better fit the current state of operations.
No matter what strategic path is selected, the probability of achieving success can be enhanced by following certain well-established best practices.
Communicate openly with lenders, noteholders, landlords, customers, suppliers, and other parties in interest. In this environment people, generally don’t like surprises, and you will build credibility by communicating openly and frequently with your business partners.
Be proactive and develop a plan. You will be better off having thought through the available options, analyzed them in detail, and developed a logical rationale for the selected path forward.
Strengthen Your Team
Surround yourself with the resources to help you navigate uncharted waters – including operational, legal, and financial. Professional advisors have valuable experience dealing with crisis situations and can help you to evaluate options and chart the course forward.
The automotive industry has weathered many prior economic cycles and market downturns. While this crisis is unprecedented in many ways, we believe the industry will persevere and thrive. By considering their strategic alternatives and taking appropriate actions, many industry players will emerge even stronger on the other side
Automotive Industry M&A Synopsis.
- The global automotive industry recorded 73 M&A deals in the first quarter of 2020, a substantial 31% decline on a Q-o-Q basis and an 11% decline on a Y-o-Y basis
- The automotive parts and equipment segment also witnessed a similar trend, recording 55 M&A deals in Q1 2020, a 33% decline on a Q-o-Q basis
- The effects of the COVID-19 crisis on M&A activity are profound. While many transactions might have gone on hold in these turbulent times, the industry will likely witness greater and more accelerated consolidation going forward
- The financial and economic impact will create opportunities for automotive suppliers with a strong balance sheet to take over businesses struggling with liquidity in this harsh environment