Managing the Liquidity Crisis

by Mike Harmon and Victoria Ivashina

April 09, 2020

The coronavirus pandemic has left the corporate sector scrambling for cash. So far,
a relatively robust financial system has been able to provide short-term funding,
primarily through the revolving lines of bank credit available to most firms.
According to JPMorgan, as of the end of March, nearly $208 billion (77% of the
funds available in the facilities) had been borrowed by large companies through
revolver drawdowns, of which borrowings by below investment grade firms
accounted for about half.

But will revolving lines be enough to bridge companies through the crisis? Revolvers
are used to bridge temporary cash shortfalls — and once the limit of the line is
reached, no more cash is available, unless the lenders agree. If you can’t fund
ongoing obligations out of the money you have coming in, you are going to have to
get another form of financing or file for bankruptcy. So how are borrowers
positioned right now?

Corporate Balance Sheets Are Already Highly Leveraged

With the economic impact of the pandemic likely to last into the fourth quarter of
this year, it is very likely that companies will have to look beyond their bank credit
lines for additional liquidity. Unfortunately, the global corporate sector went into the
pandemic with unprecedented levels of financial leverage, largely because the low-
interest environment following the 2008 financial crisis made it easy for companies
to borrow. Global debt on non-financial corporations stood at $71 trillion by the end
of 2018, according to S&P, a rating agency. This is up 15% from 2008 and represents
93% of global GDP. Of this, we estimate that almost $6 trillion sits on the balance
sheets of companies that are highly leveraged.




The riskiness of this $6 trillion in debt has increased since the last downturn. A
decade of robust debt markets came hand-in-hand with looser creditor governance
terms and weaker covenants. Borrowers have been able to artificially inflate their
earnings for loan tests using liberal “EBITDA addbacks.” As a result, many weaker
highly leveraged firms have been able borrow more without restructuring their
balance sheets than they would otherwise have been able to. For the past several
years, these factors have raised red flags for economists, global leaders and
regulatory bodies. In December, before the virus emerged as a serious economic
threat, the Financial Stability Board (FSB) issued a warning regarding the
vulnerability of the leveraged loan markets to sudden economic shocks.

Typically, when companies are running out of cash and need a loan, they turn first
to their current lenders, who with their privileged access to company-specific
information, are best placed to make a decision quickly. In the current environment,
however, leveraged firms will struggle to obtain financing from their existing loan
creditors, for a variety of reasons.

Structural Limits on Lenders

Let’s start with the financing challenges facing larger companies. Leveraged loans
to these companies are funded primarily by non-bank institutional investors, with
the majority of cash raised by the issuers of collateralized loan obligations (CLOs).
Like the CMOs that were such a feature of the financial crisis of 2008, they are
structured credit vehicles that raise debt finance to invest in a specific class of assets,
which serve as collateral for the debt issued.
As their name suggests, CLOs use the funds received from the issuance of multiple
tranches of debt and equity to acquire a diversified portfolio of “leveraged” loans
(loans to companies that are relatively highly leveraged and consequently offer
higher interest rates to reflect the added risk). According to S&P (S&P Global
Market Intelligence, LCD’s Quarterly Leveraged Lending Review: 4Q
2019) between 2015 and 2019, 58.4% of the primary leveraged loan origination in
the U.S. was funded by CLOs (and 18.7 % by mutual funds specializing in investing
in high-yield loans).

Although CLO structures have evolved over the years, at their core, they are all
designed to protect investors at the senior end of their capital hierarchy: the global
pension funds and insurance companies that tend to buy the AAA-rated
collateralized notes issues by the CLOs. All CLO agreements contain a series of
protective covenants that place guardrails on the loans to companies made by the
CLO portfolio manager. The net effect of these provisions is to establish strong
disincentives for CLO managers to hold or invest in assets that are more likely to
default — as indicated by ratings of CCC+ or less.

Typically, a CLO is limited to investing only 7.5% of the whole portfolio in CCC
loans. If existing holdings are downgraded, placing them in the CCC category, then
the CLO manager is essentially obliged to direct future lending towards higher-grade
borrowers. What’s more, excess holdings of CCC are marked to market to test that
the value of the CLO collateral (the loans extended) exceeds the value of the debt
the CLO has issued by a certain margin. Thus, drops in the prices of lower-grade
loans, which are inevitable in the current crisis, will further require CLOs to skew
future lending towards safer borrowers, in order to maintain the collateral levels
mandated in the debt issued by the CLO.
CLO managers have entered the pandemic crisis with portfolios over-weighted with
loans that are most likely to be downgraded to the undesired CCC category.
Although single-B rated loans comprise 56% of the U.S. leveraged loan market, they
comprise 70% of syndicated CLO portfolios. Single-B minus loans comprise
approximately 29% of these loans (S&P Global Market Intelligence, LCD’s
Quarterly Leveraged Lending Review: 4Q 2019). Already to date, as a result of
downgrades, CCC assets have increased to 9% across CLO deals on average, putting
many CLOs in violation of the 7.5% threshold (Creditflux, 04/06/2020, “S&P puts
48 triple C-heavy CLOs on negative watch”). Moreover, as of March 31, the average
bid for U.S. leveraged loans was 83 cents on the dollar and 63% of the market was
bid below 90 cents (S&P Global Market Intelligence, SP-LSTA LLI Liquid
Composites).

This is a crisis hiding around the corner. Given the covenant constraints and current
market conditions, it is pretty clear that CLOs will be unable or at least unwilling to
extend any additional capital to the most leveraged borrowers. It is worth noting that
in two recent debt restructurings — Deluxe Entertainment and Acosta — CLOs
declined to participate proportionately.

Small and mid-cap enterprises (SMEs) are not immune to the leverage problem, but
they are less visible due to the private nature of the bulk of this market. CLOs are
not a major player in this segment, but over the past decade, a desire to reach for
yield has attracted other providers of risky debt capital to the balance sheet of SMEs.
By the end of 2019, business development companies (BDCs) — publicly quoted
investment funds specializing in loans to SMEs — were holding about $110 billion
in SME debt (S&P Global Market Intelligence, U.S. Middle Market Research). An
even larger amount – $600 billion by some informal estimates — is held by a wide
variety of private investment funds.

Although it is difficult to obtain data on SME balance sheets, we would expect a

proportion of these companies to be reasonably highly leveraged, given the
environment and the availability of credit. It is also unclear whether existing
creditors have the funds and flexibility to inject additional capital. Given the
inevitable downturn in the value of their existing loans to SMEs following the
pandemic at least some of these investment funds will be facing some pressure. In
any event, many SMEs will have little available collateral to offer lenders and face
more uncertain commercial futures than their larger competitors, who benefit from
relatively large and stable market shares and can access more efficient capital
markets.

Where Does This Leave Us?

Given that their bank credit lines are already full, the effective closure of the main
sources of liquidity for lower-rated companies leaves only one plausible private-
sector source for these companies: private capital investors, specifically distressed
debt funds, private equity, private debt funds, and hedge funds. These investors have
plenty of money available — about $1 trillion in cash waiting to be invested. But in
the current circumstances, with the debt of many highly leveraged companies trading
well below par, investment by these players will likely entail some form of capital
restructuring. This can be a complex process, requiring extensive due diligence and
involving negotiation among many parties. As a result, investors may not be able to
provide liquidity quickly enough to meet the timing of many borrowers’ needs.
The bottom line is that without a meaningful government intervention, a very large
number of highly leveraged companies will almost certainly be forced into free-fall
bankruptcy as a direct result of the pandemic, even though there is plenty of cash in
the financial system that could tide them over. But clearly any such interventions
should be structured so as to channel that $1 trillion to where it is needed rather than
simply substitute for it. Let’s look at what the government is putting on the table.

On March 27, President Trump signed the CARES Act, a bill which includes, among
other measures, up to $849 billion to back loans and assistance to small and large
businesses. This seed capital from the Treasury will be further increased by
contributions from the Federal Reserve. Although several details of the program
have yet to be specified, we are concerned that their benefits for leveraged
companies may fall short on several fronts.

To begin with, the Federal Reserve has yet to define the collateral requirements for
loans to large and medium-sized businesses. If it requires — as it generally has done
in the past — that these loans be fully secured by collateral, the act will not help
those highly leveraged companies that do not have unpledged collateral, with very
few exceptions.

Moreover, the CARES Act also excludes from the small-business portion of the
package the small companies that are backed by private equity firms. As a result, the
act does little to protect many of the companies and jobs that are arguably most at
risk from the economic shock delivered by the coronavirus pandemic and penalizes
perfectly good small companies that happen to be owned by private equity investors.
What should the government do to fix or clarify the program? These three
amendments should be urgently considered:

• Remove the affiliate exclusion of small companies backed by private equity

from the small business assistance provisions of the act. These companies
are as much part of the fabric of the U.S. economy, employing people and
generating economic growth, as any other small companies. To ensure that
this assistance does not amount to a bailout of the private equity firms that
back them, and which elected to leverage the companies in the first place, the
exemption could require that loans extended under the program be matched
with an equal amount of fresh equity capital provided by the owners. To
further limit abuse of the assistance, repayment of the loans could be required,
rather than forgiven as with other SBA-provisioned loans. Defaults on
payment could result in a forced conversion into a majority of the equity of
the company.
• Relax the Fed’s collateralization requirements. For large and mid-sized
companies, we propose that the Fed be authorized to lend on a junior lien
basis, in order to better navigate the legal barriers associated with the rights
of existing secured creditors. Since the Fed is not in a position to make credit
assessments of corporate borrowers, especially in riskier positions, we suggest
that such funds would only be distributed on a matching basis with or by
providing a partial guarantee to banks and other private lenders. Involvement
of private lenders with the expertise to identify whether a company is only
suffering from short-term liquidity needs or whether there are also long-term
solvency issues is key to efficient allocation of capital. The debt should be
priced at market rates and possibly carry significant equity warrants or
 convertibility rights to make the equity holders share losses and compensate
the taxpayers (and matching investors) for the risk incurred.
• Permit the Fed to lend to companies in bankruptcy. Government does not tend
to lend to companies in bankruptcy proceedings. Nor should the taxpayer ever
be expected to lend to a bankrupt business. That said, companies often enter
Chapter 11 bankruptcy proceedings as part of a standard, pre-planned capital
restructuring, from which they can exit in as little as a month. Any loans made
to the company while it is in Chapter 11 can be structured as super senior debt,
taking precedence over all other company obligations. As an alternative to
subordinated lending, therefore, we would suggest that the Fed be permitted,
on a matching basis with other investors, to lend to companies that are entering
bankruptcy as part of an orderly capital restructuring. For this to be a feasible
source of liquidity financing, the act would need to enable streamlining of the
bankruptcy process so as to permit more “pre-packaged” bankruptcy
proceedings that could be entered into and confirmed quickly.
It could be argued that changes of the sort that we recommend could set a dangerous
precedent and run the risk of creating moral hazard, if companies and institutional
investors come to believe that the government will always pick up the tab when
things go wrong. This is an important point, but focusing solely on it is dangerous.
The pandemic is a rapid and severe external shock that affects nearly all players the
same way. Debt markets are complex and heavily segmented; relying on private
markets alone in the short-term will only put more companies out of business and
more people out of jobs. The interventions we advocate here, however, will leverage
the resources and skills available in the financial markets, speeding up what could
be described as a national Chapter 11 proceedings, from which the economy will
emerge less damaged as the shock subsides and markets return to normal.