Companies can get ingrained in their long-term thinking and be unprepared to adapt their tool kit quickly when times change.
Two dramatic financial changes to internal models are already evident. The first one is that companies often run forward forecasts automatically, assuming debt will be refinanced on the same terms. Now, they must be much more pessimistic that they can even refinance it with the same lenders, let alone at the same price.
An assumption of volatility and underlying rates staying higher for longer is critical. The one-, three-, five-, and seven-year swap rates or government bond rates are as good a guide as any, plus a volatility sensitivity on top, which could be the difference in the spread of those same rates from one year ago to today.
The second aspect is the need to think a lot more about the cash flow credit metrics that lenders scrutinise. What do I mean by that? One example has been the trend to present ‘normalised EBITDA’, so adding back so-called one-time or non-recurring negative items to reported numbers, presenting an adjusted EBITDA number that gives the impression leverage is low but can significantly overstate the actual availability of cash to service debt.
The markets have suffered heavily because of that feature and companies should assume that lenders henceforward will be very focused on true net cash flow and require debt downsizing accordingly.
We continue to see short-term thinking based on an assumption that the market can’t be like this for much longer, a dangerous approach
In an easy-debt money environment, it’s also common for companies to lower their hurdle cost of capital, hence prioritising spending on growth projects rather than debt reduction. They should reappraise all their capital investment projects and assume both a much higher cost of debt and a volatility risk premium for refinancing on investments that do not fully repay debt within an appropriate lifespan, the consequence of which should be a significant reduction in capital expense.
The fundamental point, despite the change in the economic cycle, is we continue to see short-term thinking based on an assumption that the market can’t be like this for much longer; a dangerous approach. One consequence of this short-term approach is companies adopting temporary financing solutions, such as short-maturity debt, accepting covenanted debt, or giving away valuable security.
A year or two later, they discover they have handed over the ‘crown jewels’ to one lender that blocks them from dealing reasonably with other lenders in their credit stack. We urge companies generally to have a dynamic medium- to long-term finance strategy and not be hoodwinked into buying one product from an energetic lender on a particular day.
What does a medium- to long-term financing plan look like? It should stress test the business model for broader and more negative assumptions around lender reliability and behaviour. Weightings for outcomes should lean into downside protection and flexibility and move away from simply the lowest price or faith in relationships.
We have had discussions with company CFOs who have argued that they can accept financial covenants or shorter maturities on their business if it gives them finance at cheaper pricing, whereas we would say that assessment models should have fundamentally shifted and companies should be looking for greater assurance from their financings than may previously have applied. I would say for many companies, the primary issue is to stop thinking the old world is coming back and just forget it ever existed. If it does come back, that is an upside, not the base case.
Remediating cash credit metrics to the enhanced levels seen in the low interest rate environment we previously had will make financial planning considerably easier and more robust to external challenges
If we look back historically at different crises, we have seen liquidity dry up even from the most dependable sources. That is not where we are now or where we expect to be, but simply remediating cash credit metrics to the enhanced levels seen in the low interest rate environment we previously had will make financial planning considerably easier and more robust to external challenges.
We already see far-sighted companies implementing these strategies – for example, by way of de-leveraging asset sales, equity raises, or paying more for long-dated covenant-lite debt. Taking these steps now, before outsiders perceive an impending crunch, is one huge advantage that management teams have. They have the benefit of knowing what their business is really going to do in the future and can plan for it appropriately.
Incorporating self-help tactics in any refinancing plan is also accretive and immediately positions management teams as proactive and prudent – both long-term protectors of fundamental value.
What's the outlook for the refinance market, and has it changed irrevocably? I think there's plenty of finance available for assets unless there's something very badly wrong with the asset. That is not the challenge. The challenge is how to work out the right strategy for the business at the right debt level and then optimise the refinancing strategy rather than default to short-term solutions or incredibly expensive longer-term solutions.
There's a whole range of techniques, and it does require people to be incredibly pragmatic but also analytic and recognise what is a real risk that needs to be measured, appraised, and perhaps structured out and what is simply a distraction.
There are two critical challenges. The first is for companies and boards with all of their different constituencies – some with significant money invested and others with none, some with a paternal responsibility for employees and others without – to come to long-term conclusions as to when a financing is a good financing, when and which financiers should be approached, what can be conceded, and what should not be.
The second is to recognise the need to analyse these options in depth and not opt for the path of least resistance.
Anthony Forshaw is a managing director and head of Capital Markets Advisory, EMEA, at Houlihan Lokey