Default… What now?

Following the announcement by the Land and Agricultural Development Bank of South Africa (Land Bank) on 24 April 2020, that an event of default (EoD) occurred on its notes, there has been rising concern from investors around such events occurring on the debt obligations of other issuers in the market.

There are a number of specific events that could trigger an EoD on the debt obligations of a counterparty which often stem from an underlying cause such as weakening solvency or liquidity of a counterparty.

In the current economic environment, the revenue of counterparties is likely to have been materially impacted due to reduced trading on the back of the lockdown enforced to combat the outbreak of Coronavirus (COVID-19). Further, counterparties are unlikely to have sufficient scope to reduce costs to the same extent as the decline in revenue, therefore ultimately impacting the profitability and liquidity of counterparties. The results of this could see counterparties triggering EoD.

What is event of default?

As protection for lenders in the agreements which govern the advance of funding (the Debt Agreements), whether this is a loan agreement or note programme, there are pre-specified events, EoDs, that, if they occur, allow the lender or creditor to demand immediate and full repayment of a debt obligation. The most common events which could trigger an EoD include non-payment of principal or interest due, a breach of a financial covenant, insolvency, material adverse change (MAC) or cross default.

The debt agreements will often contain more circumstances that would permit the lender or creditor to call an EoD. These events would be tailored to the unique situation of the borrower or issuer.

What happens when a default occurs?

Upon the occurrence of an EoD, a lender or creditor has the right to demand immediate repayment of all outstanding amounts owing to it. In practice, lenders or creditors rarely enforce this right, as it could result in the triggering of a cross-default on other obligations of the counterparty and in such a case cause a material part of a counterparty’s debt obligations to become due and payable on demand. As a result, if all creditors exercise their rights to demand immediate settlement of their obligations, the counterparty is unlikely to have sufficient liquidity to honour all their claims. This in turn could result in the counterparty, whether voluntarily or through being compelled to do so, applying to be placed under business rescue, administration or curatorship and /or ultimately being liquidated.  

Prior experience indicates that recoveries for lenders and creditors may be significantly reduced in the event of the counterparty being liquidated. Therefore, lenders and creditors will most likely commence a formal debt restructuring process with the aim of placing the counterparty on a sure footing and in such a way enhance the likelihood of full recovery of debt.

Can an event of default and restructure be avoided?

Counterparties can avoid EoDs by actively monitoring performance relative to the default provisions in its debt agreements. Loan agreements typically contain more EoD provisions than note programmes, with financial covenants often being the first of the EoDs to be triggered. Practically, counterparties are often aware of potential financial covenant breaches before the relevant measurement dates. In such cases, counterparties will pre-emptively engage with the lenders in an attempt to secure a waiver for the potential EoD before it occurs or to reset the financial covenants to an appropriate level given the prevailing circumstances.

In the event that the counterparty can satisfy the specific lenders that the causes of the EoD are of such a nature that it has not impacted the long-term sustainability of the counterparty or that the credit risk on the debt obligation has not fundamentally changed from when it was entered into, it may well be able to secure the required waivers or amendments from the lenders before the EoD takes place.

Should this be achieved, no EoD will occur and the cross-default clauses on other debt obligations will not be triggered.
Under these circumstances, the extensive debt restructure as discussed in this paper will not be required.

However, in more severe cases of distress the required waivers may not be obtained within the required timeline to prevent an EoD taking place (as was the case with the Land Bank EoD). In such cases, cross default clauses will be triggered which in turn will result in the entire caucus of the counterparty’s lenders and creditors being involved in the discussion. This is likely to lead to a debt restructure process which is discussed below.

What takes place under a debt restructure?

The initial phase of a debt restructure is characterised by engagements between the counterparty and its debt funders.
During these engagements, the underlying causes leading to the EoD are examined so that the debt funders can better understand the level of distress being faced by the counterparty. If, based on the information received, it becomes apparent that the counterparty is experiencing solvency and /or liquidity issues that are not once-off in nature, the debt restructuring process will commence.

It is not uncommon for debt funders to arrange themselves into working groups, based on the type of debt advanced to the counterparty and for each working group to appoint legal counsel, which assists with the flow of information between parties and also to establish the rights of different creditors under the reigning circumstances. Ultimately, each of the working groups will form the debt funder group that will be involved in the debt restructuring.

Notwithstanding that each of the funders in the debt funder group may have different considerations in relation to its exposure to the counterparty, the ultimate objective of this group is to assist the counterparty to return to sustainability and thereby to recover the capital due to them.

Following the initial engagements, the counterparty is likely to request certain waivers and concessions from debt funders which may include a waiver of the existing EoDs as well as the deferral of pending interest and principal payments due for a period of time in order facilitate discussions which are aimed at solving for the longer-term debt obligations of the counterparty and ensuring the debt funders can recover their capital. These waivers and concessions are commonly referred to as a ‘standstill’ in debt restructurings.

In exchange for providing the initial standstill to the counterparty, debt funders may look to strengthen their positions through, inter alia, negotiating additional security, increasing the interest rate on the debt obligations, requesting increased frequency and quantum of reporting to be received from the counterparty, as well as obtaining liquidity support from shareholders.

During the restructuring period, there are many actions that a counterparty can agree to in order to reach an agreement to restructure its debt obligations. These actions may include but are not limited to the cessation of dividends, deferral of
non-critical capital expenditure, cost reduction measures, disposal of assets, or an equity rights issue. These actions are all aimed at raising or conserving cash within the business which can be used to settle the debt obligations.

Either during the initial negotiations or shortly after the approval of the initial standstill, debt funders will look to appoint independent corporate financial advisors (advisors) who will assist with negotiating the terms of the longer-term restructure of the counterparty’s debt obligations.

The ultimate goal of the restructure process is for the counterparty to be returned to a position where it has a sustainable capital structure (solvent) and sufficient liquidity to continue operating and pay its debts when they become due. With the assistance of the advisors, debt funders will conduct a detailed assessment of the counterparty to identify the underlying causes of the EoD,
as well as the short-to-medium-term liquidity challenges being faced by the counterparty.

The above process will culminate in a debt reduction or turnaround proposal being agreed between debt funders and the counterparty. In exchange for concessions by the counterparty, debt funders may provide some relief to the counterparty in the form of a more lenient debt repayment profile, amended covenant levels with appropriate headroom for the counterparty to trade through its challenges and other appropriate concessions, but taking into account the agreed debt reduction profile of the counterparty.

Does a debt restructure work?

There is not a straightforward answer to this question and the outcome depends on a number of factors, which will include the severity of the distress the counterparty finds itself in as well as the willingness of the counterparty and debt funders to work together to find a workable solution. From experience, the debt funders in South Africa have approached debt restructuring in a responsible and measured manner in most cases and we believe this will continue to be the case during and post COVID-19.

It is also important to note that notwithstanding the senior ranking of debt funders over equity funders, there are also considerations such as security provided by the company to different debt funders which further stratify the counterparty’s capital structure and ultimately inform each debt funders ability to recover its capital.

Importantly, should an EoD occur, it does not immediately point to a material capital loss for debt funders. Ultimately, debt funders receive a lower, fixed return in exchange for providing debt capital which ranks ahead of more risky sources of capital which have access to higher but more volatile returns. It is this senior ranking in the capital structure which allows debt funders to negotiate restructures with the aim of achieving full capital recovery.

Conclusion

In the current environment we expect to see pressure on the earnings of corporates. The corporates which raised funding in the South African debt capital markets were generally well-capitalised with sufficient liquidity to trade through the initial stages of the COVID-19 lockdown. This does not however mean that all the borrowers or issuers will not seek relief from their funders to avoid potential EoDs, but many are likely to receive support from such funders given their standing heading into the COVID-19 lockdown.

Despite the above, there are still likely to be some issuers which may require a more protracted debt restructure process but as we have seen from past experiences this is not the end of road for these counterparties. In such cases, Ashburton Investments has a strong Credit Risk Management team which has deep experience in restructuring, and which is supported by an experienced Ashburton Investments Credit Committee. Through this combined capacity, Ashburton Investments will work extensively to protect the capital of its investors and ensure the most favourable outcome for all stakeholders.