Last year presented a great many challenges, and much like 2008–2009, the impact was felt on a global basis. The last quarter of 2020 appeared to start with a sense of renewed optimism, with the end of pandemic-driven issues in sight. With known outcomes on matters such as Brexit and global elections, there was a sense of stability, and global markets reflected this. However, by the second week of December, talk of a new strain of COVID-19 and fresh lockdowns threatened to dampen such optimism. What then can we expect of Europe and 2021?
The Macroeconomic View
With a new US president, a settled position on Brexit and monolithic vaccine production in the offing, global equity markets ended 2020 and started 2021 in extremely bullish form, growing to pre-pandemic levels across some of the key indices. It seems that the risks of renewed lockdowns, logistical issues around vaccine distribution, the potential for fracturing of any political relationships following the inauguration of the new Biden administration and even the precipitant unwinding of government support measures were not enough to prevent an ebullient surge in global equity markets. In fact, the anticipated return to normality in the second half of 2021 seems to be driving renewed interest towards even those cyclical or “value” businesses vis-à-vis the technology and growth companies which will undoubtedly continue to perform.
However, while global wage subsidies and fiscal government support have ensured low delinquencies and corporate insolvencies, even compared to the pre-pandemic world, speculation continues that governments will soon start to trim the deficits around their debt spending through tax increases and reduced expenditure, particularly since the International Monetary Fund estimates that gross government debt within the G7 economies will rise by 23% of GDP in 2020. However, net interest expense is expected to be lower for all of these major economies, with Japan cutting the fine example of having estimated gross debt of over 250% of GDP, yet with net interest payments expected to be zero by 2023 with more than 60% of government debt having a negative yield. That is not to say that fiscal austerity and stringent monetary policy will not occur, just that they are less likely to be near-term eventualities.
In 2020, regulators in the United Kingdom seemed to first urge caution against overzealous action by market participants, the key driver being to protect companies (and jobs) and then a second message later in the year to encourage responsibility among those same participants, leading to thematic trepidation within the traditional banking industry. Even within 2021, the European Central Bank’s threat to require capital add-ons and potentially heightened scrutiny on leveraged lending makes the regulatory landscape for those banks even more difficult to predict, and the Prudential Regulation Authority publication on stress-testing shows that the most stringent standards will be applied to judge capital adequacy.
When one considers this landscape and then adds in the likely layer of protectionism afforded by M&A controls relating to national security, recent pan-European changes to insolvency laws and the regulatory unpredictability of Brexit, even following an orderly withdrawal, it is clear that those at the forefront of regulation will need to tread carefully, likely leading the way for other market participants and entrants to profit.
In keeping with the ongoing macro-trends, the uptick in public equities shows a clear return to grace of those business which might be described as “cyclical”, as post-COVID normalisation increases the likelihood of a renewed value for those businesses. With Sterling clearly affected by Brexit, the UK markets would appear to provide some of the best value globally as the hunt for yield continues, with the bounce-back in the United Kingdom predicted by many to be higher than most other key economies. Even if the Brexit deal drags growth rates down through barriers on trade, cyclical forces which drive GDP likely will dominate in the short-to-medium term.
We have seen some continued protectionist dynamics in recent months, ranging from the United Kingdom’s new national security legislation and Brexit, to US/China political relations remaining fraught, and Antipodean lockdowns restricting almost all foreign entry. Nevertheless, M&A markets remain buoyant in relative terms, with the most sought-after assets continuing to attract record multiples, especially in COVID-19-resilient sectors, and as more troubled sectors stay away from the M&A markets for as long as possible. In light of government aid and massive fiscal stimulus, there remains a continuing desire for market participants to transact, to seek yield and to drive return for the investor community.
The advent of market uncertainty from Q2 of 2020 saw regulated banks become increasingly mindful of tighter regulation and lending practices while being inundated with liquidity-based requests from corporate treasurers, as private lenders remained liquid and able to transact quickly. This trend accelerated the already-growing stature of private credit as a lynchpin of the leveraged lending markets.
Looking ahead, 2021 has the hallmarks of being an exceptional year for private capital. Private capital is well-situated to overcome the constraints around market liquidity and even a medium-term recession. Private capital has significant strengths and unique characteristics versus traditional bank-lending which have perpetuated the growth of the asset class as a whole over the last decade, and have positioned the asset class for future growth. Whilst European fundraising in 2020 declined to just over $23 billion from almost $35 billion in 2019, private credit funds are rumoured to be looking to raise more and larger funds in 2021 to make up for lost time. The ability for numerous funds to underwrite larger deals, either individually or on a clubbed basis, around the billion dollar range, further highlights that there are no areas of the leveraged markets that are solely reserved for regulated banks. The offering of private capital provides increased synergies to a private equity community which increasingly seeks deal certainty among a reduced stakeholder group, whose interests will remain aligned in the case of stress or distress. Private capital can therefore represent significant strategic alignment with borrowers, whether they are simply sitting tight, or using patient capital to take minority equity positions or “equity kickers”, something that banks today seek to avoid outside of a restructuring. If the exit from a COVID-19-driven world is a relatively quick one, the volume of liquidity and the speed with which private capital can deploy it will be key. Whether from a senior secured or special opportunities perspective, private capital will continue to provide a useful stopping point for leverage from a wide range of investors.
It is not unreasonable to expect the relationships curated by private creditors through difficult times to carry favour in increasing their market share of leveraged lending in future years.
Restructuring and Special Situations
As we can see, 2021 holds a lot of potential for optimism—the macro story and micro markets all seem to suggest significant positive expectation for 2021. Yet we must still ask what will happen to those businesses which were struggling even pre-pandemic, some of which may have been saved somewhat by government intervention. It is hard to imagine those businesses burgeoning again; many sit in the retail sector and have seen reducing footfall year-on-year without any obvious fix.
The post-Brexit restructuring framework is generally uncertain with the United Kingdom leaving the European Union, but creative UK advisors will definitely look to ways to maintain London as the main restructuring venue in Europe. Correspondingly, the Netherlands and Germany have introduced new pre-insolvency processes (for example, the Dutch Scheme) which are being touted as the basis to move restructurings away from London. This will put a premium on advisors that have both a London and European platform.
Whilst we saw some large household-name restructurings, much of the middle-market remained untouched and the number of UK corporate insolvencies throughout 2020 was a fraction of those in 2019, or even 2008, which seems both counterintuitive and unreflective of the economic reality for those corporates. There was also an increase to default rates, which more than doubled between December 2019 and December 2020. This likely only tells some of the story as there will be a large number of deals which did not default solely owing to covenant resets or amendments during 2020.
Two possible trends are therefore likely to permeate the short and medium term: greater special situations investing and increased volumes of more traditional financial restructuring, whether or not consensual.
On special situations investing, we saw a genuine absence versus what the market predicted during 2020. This was driven by various reasons. For example, the lack of meaningful qualitative and/or quantitative information coupled with the unpredictability of when the pandemic effects would run off meant that distressed investors were reluctant to plough into the markets. Even then, national and supra-national intervention meant that the window of reduced pricing across large-cap loans and bonds was very short-lived, and opportunities to capitalise on that window had all but expired by the end of July 2020.
On insolvencies, we simply must expect more corporate insolvencies throughout Europe, whether through a rationalisation of economic value through capital structures, through court-led processes in one of the many revamped European insolvency regimes, or through wholesale ownership changes. Restructurings are likely to be more contentious where value is sought not only through the traditional areas of realisation maximisation strategies but also with a view to litigation claims as a significant asset to enhance the estate for the benefit of creditors. The European Systemic Risk Board published its “ASC insight” earlier in January 2021 in preparation for a “post-pandemic rise in corporate insolvencies”, covering both the economic environment and the expected impact of COVID-19 on insolvencies. Not only is this a prudent information measure, but there also is a strong likelihood that there will be increased numbers of corporate insolvencies throughout 2021, even if the wider market is otherwise thriving. Perhaps one point which will remain open to assessment throughout 2021 and beyond is how private credit funds navigate credit issues—how strong will their initial analysis prove to be, and to what extent will such “patient capital” be able to weather a medium-term storm to ensure a smooth transition from distress to normality.
Whilst care must be taken not to overestimate the possibilities of 2021, the overarching sentiment seems to be one of positivity. In 2020, it was difficult to see an end for COVID-19, and there was a deep sense of political uncertainty around Brexit, the US elections and certain international relations. The financial markets in 2020 had a consternation which echoed that underlying anxiety, at least during parts of the year and certainly within certain sectors. In 2021, we look to have turned that corner. The end of 2020 and the start of 2021 have started busily across the financing, private equity and public markets, giving strong signals of optimism for the year to come.