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Leveraged companies need help too

Bank of England
By Owen Sanderson
24 Mar 2020

Extraordinary support measures from central banks across the world include an element of corporate lending, but all the schemes announced so far target SMEs, and companies rated BBB- and above. That leaves a gaping hole in the rescue net, which the authorities must fill.

With the corporate crisis caused by coronavirus deepening, the central banks are stepping up.

The Federal Reserve announced it would buy corporate bonds in primary and secondary markets on Monday. The European Central Bank announced last Wednesday it would step up its long-standing corporate bond buying, and loop in short-dated commercial paper as well, while the Bank of England announced its Coronavirus Corporate Funding Facility on Friday.

All the central banks in question are seeing strong demand for their services. The Fed’s decision may have reignited US bond markets; its purchases of bond exchange-traded funds have also damped the dislocations seen there. The Bank of England and its designated CP dealers are also seeing a flood of inbound enquiries, while corporate issuers in the eurozone have long benefitted from the ECB’s scheme.

But all of the central banks have limited their purchases to investment grade companies.

That’s an understandable stipulation. Central banks, recent activities notwithstanding, are rarely keen to take much credit risk, and need a fast, easy way to avoid doing so. They cleave to part of the original Walter Bagehot maxim — lend freely against good collateral (though no longer, as the eminent Victorian suggested, at a penal rate).


Old fashioned view

It is premised, though, on an outdated view of the structure of corporate financing. Companies rated below investment grade are not necessarily speculative punts from private equity, or dying firms entering a spiral of disaster.

Plenty of respectable, economically vital companies run leveraged capital structures. Plenty of them are huge employers, suppliers of critical services, and household names. Good companies, which, because of their ownership or their business, or their expansionary ambitions, choose to run higher debt loads than their investment grade brethren.

Lots of these firms are owned by private equity funds, and that can stick in the craw. Funding support for a sponsor-owned firm amounts to rescuing the company from the private equity fund’s decision to load it up with debt. The fund may even have jacked up the debt load further to pay itself a dividend.

But it’s hard to find a principled objection to these practices that ought not to apply to investment grade companies too.

The end investors in private equity funds (and sometimes the co-investors) are basically the same pools of money as in the public markets — pension funds, sovereign wealth, the various pots which aggregate ordinary people’s savings. 

While the PE shops take a higher slice of fees for their activities, most investment grade firms have also paid out dividends, optimised their capital structures and sought to serve their shareholders. Some have even bought back their own stock.

Leveraged companies chose to optimise their capital structures to a higher debt load — but one which most of them can bear in good and bad markets alike. Many of the companies, cognisant of their less stable capital structures, locked in financing early this year and last which pushes maturities out to 2024 or beyond.

But no leveraged company, nor private equity firm, has managed to put away enough resources to see it through an indefinite shutdown of the economy and a global pandemic — but who can blame them? No other portion of the financial markets or the official sector was prepared either.

Outside the subset of sponsor-owned companies, there are also high growth tech firms, crucial but unprofitable to date, larger midmarket firms, family-owned businesses, and plenty more besides, which are too large to be rescued by 'SME' support from the UK, or the Fed’s 'Main Street' operation, but never made it to investment grade bond issuing status, and certainly can’t now.

“Moral hazard” will always be a concern where public money is used to rescue private companies, but the depths of an economic crisis is not the time for excess handwringing. The sudden stop in the economy is without precedent, and only government can provide the support needed to make sure companies can bounce back afterwards.

Credit concerns

The concerns about credit, though, are harder to dispose of. The aim of the sharp stop at the edge of investment grade was to make sure that the central banks were lending to companies whose business was viable before coronavirus.

The Bank of England makes this explicit, saying that the facility is “open to firms that can demonstrate they were in sound financial health prior to the shock, allowing us to look through temporary impacts on firms’ balance sheets and cashflows from the shock itself.”

It certainly shouldn’t be in the business of rescuing companies that were on the brink of collapse before the coronavirus crisis

But there’s a lot of room between, say, an airline like Flybe, which called for its own rescue in January, and Ba3/BB- Virgin Media, providing broadband to more than 3 million in the UK and with no credit issues in sight. It cannot be beyond the wit of the central bankers to figure out how to draw the line between the two.

The Bank of England’s facility also makes it clear the central bank expects some credit impairments. It is willing to look at credit ratings and financial metrics as of March 1 — before any coronavirus effects — and to offer commercial paper funding for 12 months.

Depending on the duration of the shutdown, this guarantees some credit issues will emerge. Without extra support for airlines, the solidly triple-B (on March 1) IAG, owner of British Airways, has somewhere between three and eight months of liquidity if it can’t fly, but is a perfect candidate for Bank of England funding.

There are tools, too, to mitigate the credit issues. Official sector support could come in at a senior level in the capital structure, for example — which would require bondholder and lender consent, at a price.

But with leveraged companies effectively locked out of capital markets now, the chance for a fundamentally sound company to have access to indefinite official sector liquidity might be worth some structural subordination. High yield bondholders are used to guarding against the risks of being “primed” by a credit fund, private debt or other leveraged lenders — but may regard a central bank as less of a threat to their position.

Whatever the mechanism, it must happen soon. In these market conditions, the safety net cannot have a hole this large.

By Owen Sanderson
24 Mar 2020