Bankruptcy and Restructuring Year in review and 2019 outlook

January 2019

2 | Restructuring: Year in review and 2019 outlook

As predicted, the answer wasn’t 2018. The US economy over the past 12 months was characterized by stable and steady growth buoyed by tax cuts and historically low, al-beit rising, interest rates. In contrast, financial markets were anything but stable and steady in 2018, and most major asset classes finished the year in correction territory.

Now, as we look to 2019, we don’t see signs of fundamen-tal macroeconomic changes that alter our thinking. That said, weakening fundamentals don’t always precede a recession. Whether it’s an asset pricing bubble, mortgage crisis or simply the cumulative effect of deteriorating con-sumer sentiment, recession triggers are rarely obvious to those looking forward.

If forced to predict the next recession catalyst, one could select from a number of potential candidates, including global trade tensions, fallout from the Brexit saga, com-modity price volatility, rising inflation and constricting credit markets. The list goes on and on.

In terms of restructuring activity, we anticipate 2019 to remain subdued, consistent with the levels in recent years. But as we look beyond the next 12 months, we are mindful of where we sit relative to the length of historical economic cycles and expect that our outlook 12 months from now could be very different. When the economy does slow, we expect sectors that are already navigating challenges from technological disruption, competition and commodity price volatility will experience the most restructuring activity. Retail, healthcare, automotive suppliers and oil and gas are the sectors at the top of our watchlist.

In our outlook, we also consider what may be different about the next cycle of restructuring activity compared to previous cycles. Notably, leveraged credit markets have ex-perienced significant growth over the past 10 years, driven in large part by the emergence of non-bank direct lending firms. The magnitude of capital chasing deals in this sector has created a borrower-friendly environment which has led to fewer financial covenants and lender protections. This could change the restructuring dynamic of these loans in the next cycle and lead to lower recoveries for investors.

December 2018 marked the 115th month of the current economic cycle in the US, the second-longest expansion since the Great Depression and yet also the slowest pace of growth during that time. GDP has grown at an annualized rate of only 2.2% since 2009. As we approach the record of 120 months set by the 1990-1999 economic expansion, more and more people are asking “When will the music stop?”

Overview

-10%

-5%

0%

5%

10%

15%

20%

Annualized GDP Growth

1950–1959 1960–1969 1970–1979 1980–1989 1990–1999 2000–2009 2010–2018

120 months Longest

Expansionary Period

115 Months Current Expansion Period

Source: Bureau of Economic Analysis, PwC Analysis

US Expansionary Economic Cycles

Period of Recession

Restructuring: Year in review and 2019 outlook | 3

Top 10 Chapter 11 Filings1

Deal Sector Liabilities

iHeartMedia Inc. Media 20,329

Sears Holdings Corp. Retail/Consumer 11,339

HCR ManorCare Inc. Healthcare 7,118

FirstEnergy Solutions Corp. Energy 3,093

Southeastern Grocers LLC Retail/Consumer 2,625

American Tire Distributors Inc. Automotive 2,506

Claire’s Stores Inc. Retail/Consumer 2,414

Nine West Holdings Inc. Retail/Consumer 1,937

Bon-Ton Stores Inc. Retail/Consumer 1,743

Westmoreland Coal Co. Energy 1,432

Total Top 10 54,535

All Other 36,798

Total 91,333 Source: The Deal, PwC Analysis

2018 in review

Over the last 12 months, we continued to see the larg-est bankruptcies concentrated in the retail sector, which accounted for five of the 10 largest Chapter 11 filings. More iconic retail brands succumbed to the disruptive forces reshaping the industry. Last year, it was Toys R Us. This year, it’s Sears. As we look to 2019, we expect more large national retail brands will be seeking Chapter 11 protection, and some not for the first time.

Media claimed the second spot for restructuring activity in 2018 in terms of aggregate liabilities, although that is nearly entirely attributable to the largest Chapter 11 reorganization of the year, iHeartMedia.

As predicted, the energy and healthcare sectors were also among the most active in restructurings in 2018, claiming the third and fourth spots in terms of Chapter 11 filings during the year. The challenges facing these sectors show no signs of abating as we enter 2019, which makes us think they may also be near the top of next year’s list.

By the numbers, the level of restructuring activity in 2018 was one of the lowest we’ve seen in the past 10 years. Chapter 11 filings decreased by 6% to 166, while the liabili-ties addressed by those filings decreased by 22%.

1 Includes Ch. 11 filings with $25m or greater of liabilities

All Other

Healthcare

Energy

Media Retail / Consumer

27%21%

13%

15%25%

2018 Notable Sectors

Source: The Deal, PwC Analysis

0

100

200

300

400

500

600

700

20182017201620152014201320122011201020092008

No. of Fillings

0

100

200

300

400

500

600

700

Aggregate Liabilities ($B)

Annual Chapter 11 Filings1

718

277

633

419

103

266

116

226

85

202

53

17914189

166

92

175137

176

116 91

166

Source: The Deal, PwC Analysis

4 | Restructuring: Year in review and 2019 outlook

In forming our 2019 outlook, we first turn attention to the trending of key macroeconomic fundamentals:

Interest rates Interest rates increased throughout 2018 in response to four rate increases by the Federal Reserve Board. Mar-kets watched carefully as the US yield curve flattened and approached inversion between the 2- and 10-year notes. Each of the seven previous US recessions was preceded by an inversion of the US treasury yield curve, and the 2- and 5-year note yields have already inverted. Recent comments from Fed Chairman Jerome Powell that interest rates were nearing “neutral for the economy” have signaled a more conservative posture towards future rate movements. At its December meeting, the board projected “further gradual increases” for 2019.

UnemploymentIn 2018, the jobless rate continued its trend of consistent declines, down from the 10% reached in October 2009 after the great recession. At the end of 2018, unemployment dropped to 3.7%, its lowest point in nearly 50 years, before increasing to 3.9% to end the year. For context, the last time unemployment reached the levels seen in Q4 2018, it was the year Neil Armstrong walked on the moon. In re-sponse to the tight labor market, wages increased steadily during the year but remain more or less flat when adjusted for inflation.

InflationInflation in the US has increased in each of the past four years. In 2017, we saw the rate reach 2.1%, topping the Fed target of 2% for the first time since March 2012. With inflation reaching 2.9% in 2018, the Fed is balancing an economic tightrope with a worsening global economic en-vironment on the one side and its goal of keeping inflation low on the other.

Macroeconomic indicators

1.50

1.75

2.00

2.25

2.50

2.75

3.00

%

%

%

%

%

%

%

DecNovOctSepAugJulJunMayAprilMarchFebJan

2018 Federal Funds Rate

Source: S&P Capital IQ

2.00 2.00

2.25 2.252.25

2.50 2.502.50

2.75 2.75

3.00

2.75

2.5

4.0

5.5

7.0

8.5

10.0

11.5

%

%

%

%

%

%

%

2017201320092005200119971993198919851981197719731969

Unemployment Rate

Source: US Bureau of Labor Statistics

3.5

10.8

3.9

10.0

3.7

-2.50

-1.50

-0.50

0.50

1.50

2.50

3.50

4.50

5.50

%

%

%

%

%

%

%

%

%

201820162014201220102008200620042000

Consumer Price Index

Source: S&P Capital IQ, IHS Economics

Restructuring: Year in review and 2019 outlook | 5

The type of participants, scale and structure of the debt capital markets have changed dra-matically since the last recession. In 2007, before the financial crisis, total leveraged credit outstanding was $1.3 trillion, roughly half the $2.6 trillion outstanding at the end of 2018.

In the post-financial crisis era the focus on capital require-ments and restrictions born out of Dodd Frank, Basel III and the Volcker rule have made it more difficult for regulated banks to deploy capital in the leveraged debt markets. These increased bank regulations have caused the lending arms of traditional banks to pull back from the leveraged lending market.

At the same time, central banks have pursued expansionary monetary policies that have flooded global markets with an unprecedented level of cheap capital, keeping interest rates and yields at historically low levels. Private investment firms seeking to deploy large amounts of capital in a low interest rate environment were drawn to the private credit markets, where they weren’t burdened by the same regulations as commercial banks. As a result, private credit fundraising nearly quadrupled from 2009 to 2017, and the number of new funds more than doubled.

This inflow of capital and competition among lenders for higher-yield investments has led to an increasingly borrow-er-friendly environment. As the primary capital provider of leveraged loans shifted from traditional banks to non-bank lenders, other structural changes also took hold. Notably, the notional amount of covenant light (or “Cov-lite”) loans outstanding increased tenfold from 2007 to 2018.

Cov-lite loans are characterized by little to no financial maintenance covenants. In contrast to the public bond market, loans in this market are less standardized and aren’t subject to the same level of broader market scrutiny. As a result, there’s more subjectivity and less transparency into financial adjustments and add backs that borrowers are permitted to make in their periodic financial reporting to lenders.

What implications do these changes have on restructurings in the next credit cycle? We expect that fewer maintenance covenants in the loan market will combine with reduced transparency into the financial condition of borrowers to result in companies restructuring later in the stages of dis-tress. When restructurings are delayed, companies typically have fewer strategic options and less financial flexibility to effectuate a successful turnaround plan, which usually results in lower recoveries for investors and other stake-holders.

Leveraged credit markets overview

Leveraged Credit Market ($B)

Source: S&P LCD, PwC Analysis

709

1,480

709907

84

473244

2007 2018

1,266

2,631

Total Leveraged Credit Outstanding

Other Leveraged Loan Cov-Lite Loans High Yield Bonds

Capital Raised ($B)

201720162015201420132012201120102009

Global Private Credit Fundraising

Source: Pitchbook

24

No. of Funds Closed

41 4463 72 74

100 97 1076784

96114

159149

170 163136

201820172016201520142013201220112010200920082007

Cov-Lite as a Percent of Total Leveraged Loans

Source: S&P LCD, PwC Analysis*as of October 2018

17% 15% 17% 17%24%

30%41%

55%61% 63%

74% 79%

*

6 | Restructuring: Year in review and 2019 outlook

RetailFacing perpetual digital disruption and competitive pres-sures, the retail sector once again remains at the top of our 2019 watchlist for restructuring activity. Despite a strong US economy and near-record levels of consumer sentient and employment, retailers continue to adapt to market pres-sures with varying degrees of success.

Throughout 2018, the retail sub-sectors of apparel and big-box stores continued to use the bankruptcy process in hopes of rationalizing their physical store footprint and re-ducing unsustainable debt levels. We expect these themes will roll into 2019, resulting in another turbulent year for these retailers.

While it’s expected that consumers will have spent ap-proximately 5% more this past holiday season than in 2017, retailers can’t rely on continuing strong discretion-ary spending levels and must focus on streamlining their costs and operations in anticipation of future periods of uncertainty and change. The implications of trade tensions with China, interest rate increases and any slowdown in economic growth could accelerate future restructurings of underperforming retailers and eventually trigger distress amongst otherwise well-performing retailers.

Healthcare Companies, particularly providers, are caught in a multi-front war, battling structural changes stemming from the Affordable Care Act, competition from new entrants and ongoing regulatory uncertainty.

We expect to continue seeing pockets of distress in health services sub-sectors as reimbursement and care transition to value-based models from traditional fee for service. As these forces play out and the site and type of care chang-es, we expect to see more winners and losers, as some companies are unable to keep pace with the changing landscape. We also expect more deal activity in the sector, as operators attempt to exit sub-scale markets and refocus on regional and super-regional areas of strength.

Senior living operators are also navigating a challenging market environment. Demographic trends are favorable for the sector, but population aging, particularly in the key 75 and older demographic, hasn’t kept pace with the increase in new unit construction over the past five years, resulting in a supply-and-demand imbalance that is pressuring occu-pancy and rates. So far, with the exception of HCR Manor-care, Inc., some of largest operators have been able to nav-igate these challenges through out-of-court restructurings that center on renegotiating MSAs with REIT landlords.

Automotive The auto industry is navigating a number of structural headwinds that are expected to reshape the sector in years to come, including expected production declines from ride-sharing and autonomous vehicles, trade tariff impacts to supply chains, changing consumer preferences, a shift to electric vehicles and other technological advances. Coming off a record 17.5 million units produced in 2016, US vehicle production volume has decreased modestly. This modest decrease coupled with trade tariffs has started to trigger some stress in the automotive supplier base where the disruption is likely to hit first.

In the midst of these challenges, there’s also a shift in US consumer preferences toward space and utility over fuel economy. While sedans still represent the majority of sales, crossover utility vehicles aren’t far behind and likely will be number one soon. For this reason, Ford intends to stop sell-ing most of its sedans in North America in the near future, and General Motors is discontinuing the production of six sedans.

Finally, there is a longer-term technological shift on the horizon with the move toward electric and autonomous vehicles. This disruption, much like Amazon’s impact on retailers, will have a profound impact on automakers and their suppliers. As production growth slows, some suppliers that are heavily leveraged will struggle to make investments and adapt to changing technologies and platforms. This combination of events could spell financial troubles for U.S. suppliers, particularly those slow to adapt.

Sector outlook for 2019

Restructuring: Year in review and 2019 outlook | 7

CoalContinued movement away from coal to cheaper, alterna-tive fuels is expected to drive distress in the coal sector in 2019 and beyond. The shale boom created a glut of cheap natural gas in America, and the costs to deploy wind and solar energy continue to plunge dramatically.

In 2018, 14 gigawatts of coal-fired power generating ca-pacity were expected to be retired by year end, according to the US Energy Information Administration (EIA), the sec-ond-highest year ever for coal plant retirements, and anoth-er 23.1 gigawatts of retirements is scheduled for 2019-2024, according to S&P Global Market Intelligence. As a result, US coal consumption in 2018 is projected to decline to its lowest level since 1979, according to the EIA, a staggering 44% below peak 2007 levels.

As a result of these dynamics, coal mining and coal-reliant power companies will continue to see degradation in their businesses. The fallout from declining demand and plant closures isn’t limited to topline reduction. These business typically have to address substantial employee, environ-mental cleanup and remediation liabilities associated with legacy coal operations that can require meaningful cash outlays. We expect these forces to drive restructurings as businesses exit or diversify from these operations.

Restaurants and food service Following market shifts to a more “dine out” environment, the restaurant segment has become increasingly saturated, with the aggressive expansion of chain brands and the rise of new entrants, particularly in the quick-service restaurant (QSR) and fast-casual space. This heightened competition has resulted in a significant number of recent restructurings for casual dining brands, including Bertucci’s, Papa Gino’s and Taco Bueno.

Regional QSR and casual-dining chains saw some of the largest declines in sales and stock prices in 2018. We expect that fewer maintenance covenants in the loan market and reduced transparency into the financial condi-tion of borrowers will likely result in companies restructur-ing later in the stages of distress. When restructurings are delayed, companies typically have fewer strategic options and less financial flexibility to effectuate a successful turnaround plan.

While national QSR and casual-dining brands remained relatively stable due to their strong brand association and de-risked franchise model, there have been signs of disputes and distress in franchisees, which saw Applebees’ second-largest franchisee filing for bankruptcy in 2018.

Should this trend continue and we see more franchisees seeking bankruptcy, it could have detrimental impacts to the future of these large national brands.

Oil and gas WTI crude prices increased steadily in the first three quar-ters of 2018 but fell by more than 30% in the fourth quarter, as oversupply concerns arose, driven by the acceleration of production in West Texas and OPEC nations.

OPEC and Russia jointly agreed to production cuts to begin 2019, but production growth in the Permian and Eagle Ford Basins continues to outpace implemented cuts and operational declines elsewhere. This production growth has outstripped available pipeline capacity, increasing pricing differentials and necessitating the use of less efficient transportation methods to get the oil to market. Additional pipeline capacity in the Permian is expected to come online near the end of 2019 and early 2020, which will narrow spreads for Permian producers but create pricing pressures in other basins. These forces are expected to continue driving price volatility into 2019.

Drilling activity in the US will continue to be highly correlat-ed with oil prices but is likely to remain primarily focused in the Permian and Eagle Ford Basins. Offshore activity is anticipated to be soft over the near term, resulting in contin-ued pressure on offshore service providers and increasing the likelihood of additional bankruptcies in this sector. Fur-thermore, gas-heavy producers will remain susceptible to liquidity and cash flow challenges as the supply of natural gas exceeds domestic demand, despite construction of new and converted gas-fired power plants, keeping natural gas prices depressed.

Pharmaceuticals and life sciencesThe theme of specialization in pharmaceuticals and life sciences is likely to continue into 2019, driving continued industry consolidation and deal activity. There is investor interest in this sector from financial and strategic buyers alike, but some sub-sectors remain challenged.

Specialty drug manufacturers are likely to face growing in-dustry headwinds more than other sub-sectors, as generic and biosimilar Food and Drug Administration approvals continue to increase. Companies in this sector that were financed through early stage IPOs are at an even higher risk of failure. Early-stage business plans can hinge on FDA approvals or other milestones that can cause drastic swings in enterprise value. Ultimately, if business plans aren’t achieved, the public equity is at risk of being delisted, which can trigger defaults under debt agreements.

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Steven J. FlemingUS Business Recovery Services LeaderPrincipal, PwC Deals+1 917 929 6199steven.fleming@pwc.com

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