Insolvency and debt overhang following the COVID-19 outbreak

INSOLVENCY AND DEBT OVERHANG FOLLOWING THE COVID-19 OUTBREAK: ASSESSMENT OF RISKS AND POLICY RESPONSES

Lilas Demmou, Sara Calligaris, Guido Franco, Dennis Dlugosch, Müge Adalet McGowan, Sahra Sakha

Motivation  A swift response of policy makers across OECD countries has helped businesses to bridge the short-term liquidity shortfalls due to the COVID-19 outbreak.  However, the shock caused by the COVID-19 is likely to translate into a wave of corporate insolvencies and a significant increase in leverage.  This in turn could depress investment and job creation for long, with consequent negative effects on the overall growth.  Policies can play a key role in preventing widespread insolvencies while avoiding elevated leverage across firms.

A threefold contribution 1. Calculate the extent to which firms may deplete their equity buffers and increase their leverage ratios during the crisis.

2. Estimate the potential impact of higher debt levels on investment during the recovery.

3. Outline a number of policy options to prevent widespread insolvencies while avoiding elevated leverage across firms.

EMPIRICAL STRATEGY

Empirical approach 1: a stylised accounting framework ďƒ˜ Simple accounting exercise in which the economic shock of the firm is modelled as: Sharp reversal in sales

Limited ability to fully adjust operating expenses

Decline in firms’ operating profits

ďƒ˜ In turn, the decline in profits is used to calculate: I.

the percentage of distressed firms (i.e., negative book value of equity), as well as the percentage of firms not covering interest expenses

II. the associated increase in leverage ratios

Empirical approach 1: a stylised accounting framework Three main ingredients: 1. Large firm-level dataset: Around 1 million firms (Orbis dataset) for the last available year (2018). Both manufacturing and non-financial market services for 14 well-covered countries.

• [BEL, DEU, DNK, ESP, FIN, FRA, GBR, HUN, IRL, ITA, POL, PRT, ROU, SWE]

2. Granular sector-specific demand and supply confinement shock (e.g., 3 to 4 digits).

3. Dynamic of the recovery in line with the OECD Economic Outlook. Two alternative scenarios:  Upside: sharp drop in activity lasting 2 months, followed by progressive but not complete recovery in the remaining part of the year.  Downside: overlapping the upside scenario for the first 7 months, but then embedding a second (smaller) outbreak from the month 8 onwards.

Empirical approach 2: regression analysis Model 1

Model 2

Historical relationship between firms’ financial leverage and investment

Relationship between firms’ financial leverage and investment during sharp downturns (GFC)

Insights on the potential impact of increased leverage on investment during the recovery following the COVID-19 outbreak.

MAIN RESULTS

A consistent portion of firms is predicted to become distressed and will find it hard to service debt

Note: The sample is restricted to viable firms in the 2018 benchmark year (i.e., firms displaying positive net worth and positive profits).

Source: OECD calculations on Orbis data.

However, these percentages are heterogeneous across sectors and type of firms.

Large heterogeneity across sectors

Note: The sample is restricted to viable firms in the 2018 benchmark year (i.e., firms displaying positive net worth and positive profits).

Source: OECD calculations on Orbis data.

Sectors such as “Accommodation and food service activities” and “Art and entertainment” are hardly hit, whereas “Information and communication” and “Professional services” much less.

Firms in more intangible-intensive sectors are better positioned to face the shock Why? (Demmou & Franco, 2020) ďƒ˜ Lower sales shock and decline in profits due to easier adoption of teleworking arrangements and thus compliance to social distancing norms ďƒ˜ Higher reliance on internal funds: lower leverage and larger cash and equity buffers.

Note: The sample is restricted to viable firms in the 2018 benchmark year (i.e., firms displaying positive net worth and positive profits).

Source: OECD calculations on Orbis data.

Still, the share of firms in these sectors facing financial difficulties remains sizeable.

Old and more productive firms are less impacted

Note: The sample is restricted to viable firms in the 2018 benchmark year (i.e., firms displaying positive net worth and positive profits).

Source: OECD calculations on Orbis data.

Moreover, large firms are better positioned to face the shock compared to their smaller counterparts.

Leverage ratios will increase, potentially acting as a drag on investment

Source: OECD calculations on Orbis data.

Debt overhang? A high level of debt combined with high risk of default could hamper investment and undermine recovery.

Insights from the global financial crisis  Negative relationship, on average.  Heterogeneity across firms when conditioning on initial debt levels.

– Firms that entered the GFC with a higher financial leverage ratio experienced a sharper decline in investment; – The relation can turn positive, and thus an increase in debt could foster investment, for firms with very low initial debt levels.

Note: The figure shows the predicted percentage growth in the (post- minus pre-GFC) change in the investment to fixed assets ratio following a one standard deviation increase in the (post- minus pre-GFC) change in financial leverage, at different pre-crisis indebtedness levels.

POLICY DISCUSSION

Policy options to support the corporate sector ability to weather the crisis and recover fast Short-term policies addressing firms’ liquidity shortfalls

Medium-term policies addressing firms’ solvency and debt-overhang

Need for an urgent and widespread policy response: timing more relevant than targeting.

Hard to distinguish viable and non-viable firms now due to high uncertainty.

 Temporary support to wage payments.

Preservation still warrants priority at the moment. But, need of statecontingent and flexible policies.

 Loan guarantee programs.

Hence, multi-dimensional cascading approach:

 Postponement of debt repayment.

1. Recapitalise firms through equity and quasi-equity type of instruments.

 Tax deferrals.

See Demmou, Franco, Calligaris and Dlugosch (2021)

 Transitory shock. Keep otherwise viable companies alive.  Permanent shock. Accommodate necessary reallocations.

2. Timely debt restructuring.

3. Efficient liquidation procedures.

This presentation!

Recapitalise firms: flattening the curve of insolvency while reducing the debt overhang risk Increasing firms’ equity capital provides a way to support viable businesses without raising corporate debt Hybrid instruments as preferred stocks

 

Senior claims relative to common equity while junior compared to debt.

No voting rights (e.g. no dilution of control) and allow exit strategy definition (e.g. retractable).

Debt-equity swaps

 

Conversion outstanding debt that cannot be repaid into equity.

Hard to implement: definition of the exchange ratio (e.g. suited for intra-group swaps).

Specific arrangements for SMEs

 

Equity markets are thinner or lacking, making valuation difficult.

Repayment via future taxes linked to returns; turn government (crisis related) loans into grants

Allowance for corporate equity (ACE)

 Eliminate the tax benefits of using debt financing attractive.  Careful design: avoid tax planning and acceptable fiscal cost (e.g. only for new equity).

Development of equity markets

 Speed up implementation of the EU Capital Market Union.  Reduce costs and streamline listing requirements.  Financial literacy to boost stock market participation.

Encouraging timely debt restructuring Structural changes to features of insolvency regimes could remove barriers to restructuring and help to coordinate creditors’ claims in a manner that is consistent with preserving the viability of the firm.

Favouring new financing Continuity of firm operations requires access to bridge financing. 

New financing should be granted priority ahead of unsecured creditors.



More controversial: also ahead of secured creditors?

Establishing specific procedures for SMEs Due to high burden (e.g. costs and expertise) for restructuring, most distressed SMEs are liquidated rather than restructured.  Simplify formal procedures.  Encourage the use of informal proceedings.

Promoting pre-insolvency frameworks Efficient pre-insolvency framework critical to speed-up resolution.  Encourage out-of-court agreements.  Complementary policies such as tax incentives (e.g. tax exemption for creditors who forgive part of debt).

Systemic debt restructuring for large companies Case by case restructuring difficult in crisis time.  Centralised out-of-court approach, such as the “London Approach” and “Super Chapter 11”.  Combine court-supervised restructuring with out-of-court renegotiations.

Improving the efficiency of liquidation procedures Some firms will remain un-viable in the post-COVID world despite equity support and debt restructuring; an efficient liquidation system could unlock efficiently potentially productive resources Ensuring the highest possible recovery rate for creditors Overwhelmed courts may be less efficient and lead to firesales prices.  Speed-up in-court processes; add temporary judges and judges reallocation to busiest jurisdictions.

Public agencies, with their balance sheets exposed, not well placed to negotiate liquidation.  Ensuring that liquidation is established by an independent broker.

Reducing specific barriers to market exit for small firms The corporate vs personal distinction in assets and liabilities is often blurred for small firms, also leading to personal insolvency.  Allow a fresh start. Exemption of future earnings from obligations to repay past debt due to liquidation bankruptcy.  EU Directive on Insolvency and Second Chance. Expedite its adoption, in particular with respect to time to discharge reduced to 3 years.

Policy options: a multi-dimensional cascading approach to facilitate the recovery of the corporate sector 1

2

3

Flattening the curve of insolvency while reducing the debt overhang risk

Encouraging timely debt restructuring

Improving the efficiency of liquidation procedures

Contributing to recapitalise firms Ensuring that equity markets continue to develop Favouring new financing to financially distressed firms Ease pre-insolvency procedures and debt restructuring Ensuring the highest possible recovery rate for creditors Reducing specific barriers to market exit for small firms

Equity and quasi-equity type instruments (e.g. preferred stocks, debt-equity swaps) SMEs: state-contingent loan repayment via future taxes; conversion of government (crisis related) loans into grants Allowance for corporate equity (ACE) Increase financial literacy and streamline listing requirements to boost stock market participation

Granting higher priority to new investors Establishing specific procedures for SMEs (e.g., by promoting informal debt restructuring) Establishing specific out-of-court procedures for debt restructuring of large companies (e.g. when the number of creditors are limited) Speeding-up court process Ensuring that liquidation is established by an independent broker

Reforming personal insolvency regime

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CONTACTS: Lilas Demmou: lilas.demmou@oecd.org Sara Calligaris: sara.calligaris@oecd.org Guido Franco: guido.franco@oecd.org