Director, Global Restructuring Advisory Duff & Phelps
Columnist
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An equity solution for the UK debt burden

4th Jan 2021
Director, Global Restructuring Advisory Duff & Phelps
Columnist
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The UK government’s solution to tackle the economic challenge created by Covid-19 has been to laden the economy with debt. Martin Gray thinks there is another way.

The government’s debt-based approach to supporting businesses and individuals through the pandemic has provided a much-needed respite while the country seeks to understand the short, medium and long-term impacts of Covid-19 and the appropriate response.

The strategy has supported the survival - at least in the short term - of a number of corporates across the UK, and with that the continued employment for many people.

But the future economic landscape remains unclear for the surviving organisations. UK government borrowing to support loan schemes and VAT deferrals added more than £80bn of additional debt to its own balance sheet and the quantum of debt on corporate balance sheets is likely to increase too.

A large proportion of the UK corporate population is currently facing a significant increase in redeemable debt and will need to consider how this will be repaid. The inevitable worsening of gearing ratios will increase anxiety. Depleting cash reserves, working capital constraints and unpredictable changes in supply and demand due to  Covid-19 will make it more difficult for corporates to manage their day-to-day operations effectively.

Subject to general economic performance, we may witness an increase in loan defaults. This could result in corporate failures, which in turn would negatively impact shareholders, employees, suppliers, lenders and the UK government directly.

The worsening economic outlook may make it increasingly difficult for corporates to obtain additional funding to support future growth at the market rates seen in recent years.

Equity or debt?

Given the likely increased levels of gearing, borrowers will struggle to find refinance to address loan defaults and/or looming cash flow pressures as the market contracts and lenders lose their appetite, potentially where there is insufficient security.

The wider economic changes following the  Covid-19 crisis will present opportunities for distressed debt providers, which is likely to lead to an increase in debt service costs for corporates and, in some circumstances, potentially result in formal restructuring processes to enable value extraction.

The most appropriate response to this situation may be to turn to shareholders and seek equity investment to recapitalise the balance sheet. While this may be possible for large corporates, it is increasingly difficult for small and medium-sized enterprises that don’t have sufficient funds to support such a request.

Aligning stakeholder interests

External investment is sometimes seen as a last resort for many small and mid-market businesses. However, in the current climate Duff & Phelps considers it as an active option that could provide corporates with the potential to increase market share, access new markets and benefit from sector expertise.

Perhaps the most important consideration between a debt or equity solution is the relationship which it creates. Debt is often a short-term relationship with a lender on specific terms, where equity is more akin to a marriage, where partnerships and common purpose need to be aligned.

If structured correctly, such investment could connect corporates to stakeholders with a financial commitment to the company’s goals and long-term strategy, as opposed to the uncertainty surrounding lender who may take a more short-term view on a company’s trading difficulties to protect its own interests.

When raising either debt or equity, the business fundamentals need to be in the best possible shape to attract inward investment.

From a macro-economic perspective, we must avoid lasting damage to the UK economy and global competitiveness. We must seek to harness the entrepreneurial power and innovation that is at the heart of our economy while ensuring that companies with sound prospects are given the time to bounce back from the pandemic and thrive, rather than simply survive.

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