Research by Grant Thornton and Retail Economics in our Cut Back Economy report shows that almost 9 in 10 UK consumers intend to cut back their spending due to the cost-of-living crisis. This is forecast to wipe out £24.9 billion of discretionary spending across the economy through to April 2023, with 41% of consumers expecting to cut back spending until at least the end of 2023. This reduction in top-line revenues, combined with rising input costs has significant implications for businesses in the retail and consumer sector – as well as the lenders who finance them.
The cutback in consumer spending combined with the macro-economic headwinds is already affecting lending to retail and consumer businesses.
Lenders are adopting a more discerning outlook – being more selective both with new lending opportunities as well as re-committing support in refinancings. If a company doesn't fit a lender's required criteria, or if the credit quality of an existing borrower has declined significantly, some lenders are increasingly declining the opportunity upfront.
In general, pricing has increased in certain pockets of the mid-market, particularly with non-bank lenders such as direct lenders. Given higher interest costs, both on the floating rate and the margin, leverage is also coming down on some new transactions so that the borrower is able to service what is more expensive debt.
Despite some lenders adopting a more discerning outlook, there is still considerable supply of debt capital in the market, including cash flow lending, ABL funding and special situations funding.
With cash flow lending, lenders need to understand what likely normalised earnings for a business are, taking into account consumers' changing spending habits over the pandemic and the effect of the cost-of-living cutbacks. Establishing what a business can be expected to generate from a cash flow or EBITDA perspective can be more challenging in the current environment, and lenders are more vigorously stress-testing management forecasts.
ABL has an important role to play right now as many consumer businesses have substantial assets such as receivables, inventory, commercial property and intellectual property. Lenders must be aware that the value of inventory is often linked to the value of the brand, which is ultimately tied to consumer sentiment. Commercial property valuations have also shown instability recently, where the theoretical valuation has been materially higher than the actual value realised.
A large pool of special situations capital is present which may increasingly be needed across the sector. Such capital can work with incumbent lenders or be used instead of existing lenders. An important feature will be management teams' ability to understand the pricing and terms and conditions of such capital, which can look very different to typical bank style loans that many borrowers have enjoyed during the previous period of record low interest rates.
Official figures showing corporate insolvencies rose 43% in August 2022 compared to the same month last year don't tell the whole picture. These figures include many firms that were struggling pre-pandemic only surviving until now due to government support.
The full effect of reduced consumer spending hasn't yet played out in full. Activity in the market has primarily centred around restructuring with a small ‘r’ as management teams look for guidance on how to address challenges they anticipate materialising over the next 12 to 18 months. This includes how to build headroom into the current capital structure, covenant issues, cost reduction programmes, working capital optimisation, cash flow support, stress testing forecasts and so on.
We expect these challenges to come together, causing financial pressure for firms over Q4 and into 2023 as the full effect of rising input costs, higher interest rates and weaker consumer demand plays out.
Lenders must ensure they fully understand their borrower’s business proposition in order to assess how likely they are to weather the current market disruption.
With so much uncertainty and the likelihood for a recession, lenders must be proactive and stay close to their borrowers – as when headwinds start to impact, their financial position can deteriorate rapidly.
To discuss this topic further, contact Christopher Mclean or Kevin Coates.
