What is the outlook for the restructuring industry?
Higher interest rates and economic uncertainty fueled a surge in restructurings in 2023 and are setting the stage for another potential increase in 2024.
While there are glimmers of hope in the economy, economic uncertainty hasn’t dissipated and significant rate relief is likely still months away. Cost cutting and new sources of cash helped some companies limp along in 2023. But those tactics are likely to run out of steam soon and macro improvements later this year may likely be too little, too late for some companies.
We can also expect to see more debt downgrades and fewer upgrades this year. Some distressed companies will find relief out of court through amend and extend and liability management transactions. Commercial real estate owners, particularly in the office space class, will continue to hand back the keys on underwater assets leaving more lenders taking these assets onto their balance sheets.
2023 in review
Last year saw a 68% jump in bankruptcies compared to the previous year according to Reorg. The increase, especially in the first half of the year, reflected a return to more normalized levels than what we have observed in recent years. Bankruptcies were lower than normal in 2021 and 2022, as companies that might have otherwise been forced into restructuring benefited from low interest rates and hundreds of billions of dollars in government stimulus.
Sector insights
Commercial real estate restructurings, as they have since 2021, made up nearly a third of all bankruptcies. Work-from-home trends, economic uncertainty and other factors continued to weigh on demand in some sectors and markets while higher interest rates squeezed cash flow.
Consumer goods companies had more filings in absolute terms — up from 64 in 2022 to 109 in 2023. But this higher number represents more of a return to historic norms — the sector averaged 109 restructurings annually from 2016-2020.
Healthcare providers faced more difficulties in 2023, with 76 filings — the highest in recent years. Government stimulus helped bolster healthcare balance sheets during the pandemic, however some of that stimulus came in the form of advance payments. That meant some providers had to repay these funds, squeezing cash flow and pushing some organizations into restructuring.
2024 outlook
Bankruptcies and other forms of restructuring are broadly driven by macroeconomic factors, including interest rates, inflation, overall economic growth and other forces. However, under pressure many companies will hold out as long as they can before turning to restructuring as a last resort. It typically takes 12-18 months to see the overall effect of the macro environment show up in restructuring trends.
Therefore, despite 2023’s high bankruptcy numbers, even higher numbers are likely in 2024. Many distressed companies will watch for rate cuts, a more positive economic outlook or positive geopolitical changes as they battle compressed margins. But we don’t expect significant positive overall change until the second half, at the earliest, and many borrowers may not have the runway to hang on long enough.
Here are the trends to watch in 2024.
- Default rates
- Interest rates
- Inflation
- M&A activity
- Liability management transactions
- Amend-and-extend transactions
Default rates
Excluding the unusual circumstances of the 2020 COVID-19 pandemic and the 2008 Great Recession, we’re now at one of the highest rates of issuer defaults in the past 20 years. The size of the loan market has increased significantly in that time, creating the potential for greater impacts on borrowers and investors.
Interest rates
Higher interest rates have made it more difficult for companies to maintain sufficient cash flow to pay debt service and to stay in compliance with loan covenants. Rates are likely to decline in 2024, but the pace of the decline will depend on the strength of the economy. A recession would likely push rates down faster while a soft landing might keep them higher for longer.
Inflation
Inflation moderated in the second half of 2023, but it was still above the long-term target. The Federal Reserve’s December 2023 Summary of Economic Projections had a median year-end personal consumption expenditures (PCE) rate of 2.8% — down from 3.3% three months earlier. In addition to its impact on the Fed’s interest rate actions, inflation increases consumer uncertainty, compresses margins and pressures cash flow and liquidity.
M&A activity
If transactions rise — more likely later in the year than earlier — stressed companies could find relief in an acquirer. Likewise, more M&A activity can lead to more successful bankruptcy proceedings, with a bigger pool of potential rescuers to draw on. For private equity firms, distressed debt could be a source of outsized returns, depending on how they select and structure those deals.
Liability management transactions
Bankruptcy isn’t the only option for distressed borrowers. Some companies may be able to take advantage of older, more flexible debt agreements to address over-leveraged balance sheets or liquidity needs. We expect up-tier transactions, asset transfers and unrestricted subsidiaries raising new capital will continue to provide creative work-arounds in some situations.
Nonetheless, capital for distressed debt will likely remain scarce and expensive for the foreseeable future. Companies seeking these kinds of bankruptcy alternatives should make sure they understand their options and the nuances involved in these types of financing vehicles and the time necessary to execute these options.
Amend-and-extend transactions
Another option for companies trying to stay out of bankruptcy may be amend-and-extend transactions. These typically involve patient lenders and companies that can make a compelling, value-based argument for easier terms on existing debt. These transactions are not, however, an easy out for struggling firms. They often come with high fees, higher interest rates, more restrictive covenants and more reporting requirements.
Sectors to watch
The headwinds that we see impacting 2024 will stretch across all sectors, but commercial real estate and healthcare are facing additional secular challenges that warrant a watchful eye in 2024.
Distressed debt concentrated among issuers in certain sectors
Commercial real estate
As previously noted, commercial real estate has faced multiple headwinds in recent years. The pandemic disrupted occupancy and usage patterns across industry sectors and then 2023’s sharp interest rate increases put pressure on new deals and refinancing transactions. These difficulties will likely persist in 2024 and with the sector facing record debt maturities over the next three years we expect this sector to be over represented in distressed transactions for years to come.
While lower rates may provide some relief later in the year, borrowers also have to keep an eye on economic fundamentals, which vary considerably across markets and asset type. We believe we will likely see a challenging environment overall, with pockets of acute distress and but also opportunities for investors in some places.
The bankruptcy statistics in commercial real estate can be a bit deceiving. Unlike with other kinds of debt, real estate borrowers can often simply hand the keys to the owner — in effect defaulting without the expense and complexity of formal bankruptcy proceedings. That means that the overall real estate environment may be more challenging than it appears.
Too many defaults — in court or outside of court — could also pressure regional banks, which have large amounts of real estate debt on their balance sheets. Poor real estate fundamentals could lead to negative follow-on effects for those lenders.
With office occupancy rates unlikely to return to pre-pandemic highs any time soon, there are signs that owners and developers are exploring ways to make use of office assets for residential, wellness and digital infrastructure plays. These transitions are typically capital intensive and financing for these alternative uses will be tough as long as interest rates are high and the market remains skeptical of real estate investments. But if pressure on banks leads to fire sales, there may be opportunities for well-capitalized firms.
Healthcare
As the industry works through its COVID-19 recovery, high interest rates and regulatory pressures could make for a rocky road for healthcare providers. There’s also considerable pressure on the industry to reinvent business models and transform portfolios to match a changing care and payor environment.
Smaller and more rural providers will likely remain at the greatest risk of default and restructuring. The pandemic brought temporary lifelines in the form of state and federal provider relief programs, but many of those are now gone. Many rural providers still face the fundamental challenge of operating in sparsely populated markets with many residents covered by Medicaid or Medicare, which usually reimburse at lower rates than commercial insurance.
Heightened federal scrutiny over antitrust issues has scuttled M&A efforts among some bigger hospitals and provider networks. That can make at least one alternative to restructuring — sale to another organization with a stronger balance sheet — more difficult. Overall, we can expect 2024 to be a challenging year for providers unless there is a step change in reimbursement rates, or until interest rates drop significantly.
Looking ahead
Companies facing uncertainty or financial challenges should keep the following in mind:
Time is critical; the earlier companies act the more options they have available.
Companies should plan for the next 18 months to have the runway needed to deal with potential problems and to pull value creation levers.
Stress testing assumptions and considering downside scenarios is key. Companies should be prepared for the downside even as they plan for growth.
Distressed situations are complex and need to be examined holistically across a range of issues, functional areas and technical expertise.
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