By: Christopher Weil
This article was originally published in the 6th issue of ThoughtLeaders4 FIRE magazine.
As the pandemic upended the global economy, creditors braced for an onslaught of insolvencies that never came.
Indeed, according to a March 2021 study by global trade credit insurance firm Atradius, global insolvencies actually declined by 14 percent in 2020.
However, this had less to do with the resiliency of businesses than it did with the effectiveness of fiscal support programs introduced to support corporations. In the United States, for example, the CARES Act included nearly $860 billion in business loans and guarantees. The United Kingdom guaranteed 80 percent of large businesses loans of up to £300 million. In Japan, affected companies could receive subordinated loans and rent subsidies. This story was repeated around the world—not just in major economies, but emerging markets as well: for example, Poland established a liquidity guarantee fund for medium and large companies.
While the Delta variant has injected some uncertainty into the pace of recovery, there is no question that the end to trillions of dollars of capital injections is on the horizon. For some debtors, the removal of this support will represent a significant and sudden erosion of their financial position, exposing weaknesses that support had kept hidden and calling into question their ongoing viability. Some of those exposed vulnerabilities may have been caused by the pandemic and some may have been long in the making, but when the inflection caused by the removal of support occurs, the insolvencies expected in 2020 will soon materialize in full force.
Along with a higher risk of insolvency, creditors should also be mindful of the increased risk of fraud.
The need for governments to respond quickly to the pandemic, and the limitations imposed by lockdowns, presented considerable challenges to providing relief programs with adequate due diligence. In addition to fraud relating to government programs, economic pressures following the end of those programs may well increase the incentive to commit fraud simply to keep the business in operation.
As we emerge from the pandemic and move into a less-forgiving financial environment with a greater risk of fraud, creditors should be more proactive in assessing their debtors’ business and fiscal health as they emerge from the pandemic. Rather than wait until insolvency seems likely, creditors should be closely examining any business that appears less than completely healthy. If it turns out that a debtor’s viability is questionable,the sooner the situation is out in the open, the more options both creditors and debtors will have to find solutions. Once a debtor declares bankruptcy— an increasingly common defensive strategy—the creditor’s position will be significantly weakened.
A rigorous assessment should be comprehensive and consider the debtor’s entire ecosystem—not just its business structure, assets, liquidity levels and access to funding, but the health of its customers, supply chain and inventory. The pandemic has brought a new appreciation of how a business can be crippled by a weakness in any of these dimensions. Even in less volatile times, investigations into debtor businesses have uncovered a range of wide issues, such as the use of revenue of a high-performing company to mask problems at a sibling company, increased vulnerability in supply chains due to interrelated vendors, and compromised liquidity due to the encumbrance of assets.
In each of the dimensions that creditors need to consider, the experience of the pandemic has introduced new factors and lowered the threshold prompting concern. For example, it is no longer sufficient to assess the viability of a debtor’s vendors; one must also examine the geographic diversification of those vendors and the strength and resiliency of those vendors’ own supply chains.
While the wisdom of proactively assessing debtors in this way may seem obvious, there are numerous reasons why creditors may neglect to do so. There is the natural reluctance to invest the time and resources necessary to address problems that are merely possible rather than actual.
The reality is, however, that in a post-pandemic economy, where sustained turbulence is likely and copious government aid absent, debtor problems may be more imminent than they appear at first glance.
In addition, creditors can also overestimate the thoroughness of their due diligence. Consider that transactions between creditors and debtors rarely happen in a vacuum but instead are often made in the context of overlapping relationship networks of attorneys, accountants, advisors and other investors and company executives. Because of this, even highly quantitative due diligence may include a subjective element that limits a deeper look below the surface numbers. This subjectivity is likely to be all the greater in the aftermath of the pandemic, when empathy from the experience of having survived a shared crisis will be high. But the volatile post-pandemic economy is exactly the time when creditors need the steelier, more objective perspective that a thorough examination of debtor positions provides.
One of the most difficult aspects of risk assessment is the accurate forecasting of adverse conditions that may cause previously healthy (or apparently healthy) assets to deteriorate. The removal of government supports is an event that will increase risk for creditors—and is one whose timing and extent is fairly well established. Creditors should arm themselves with this foreknowledge and prepare accordingly.