As 2023 came to a close, Carl Marks Advisors assembled a roundtable of senior leaders – Managing Partners Keith Daniels, Evan Tomaskovic and Brian Williams – to look ahead to 2024 and give us their predictions of trends to watch. The wide-ranging conversation covered the state of middle market businesses, the continued evolution of the lending environment, projected restructuring activity, and market sectors that may warrant attention as the year progresses.
Let’s start by taking a bit of a look back at the year that just ended – was the restructuring environment in 2023 what you expected it to be?
I would call 2023 an uneven year for restructuring. We are still seeing patience from lenders with middle market borrowers, but we expect that to shift beginning in the first quarter of 2024 as pressure from the successive waves of interest rate increases kicks in.
I agree with Evan that 2023 was a bit up and down for restructuring. It started very busy, and the expectation was that, because of inflation and the interest rate environment, the same level of activity would continue through the remainder of the year. But we saw some slowdown over the summer months, followed by a rebound in the fall.
2023 saw the continuation and likely the culmination of COVID supply chain disruption-driven work. In the first part of the year, there was a lot of demand due to the lingering effects of COVID on supply chains, and too much inventory at the retail level. That is now largely gone, and what we are seeing now instead are interest rate-related issues where borrowing money costs three times what it formerly did.
How will higher interest rates impact businesses as we progress into 2024?
I’d say a reckoning is coming, especially for those companies that are having to negotiate terms in a higher rate environment. We will likely see lenders who may have just wanted a quick assessment of a middle market borrower six months ago requesting more operational and transactional assistance.
Interest rates have peaked and are presumably trending down, but we are likely to see higher levels persisting for the next year or two. I think interest rate-driven challenges will be real and critical for stakeholders to assess whether they have a bad company or a bad balance sheet.
Let’s talk about the lending landscape. How are banks and alternative lenders managing in this environment?
We also see this as an opportunity for advisors in 2024. Banks are seeing stress in their portfolios and want to accelerate the process of fixing balance sheets, but may have limited in-house capacity or expertise for restructuring, if the restructuring wave is as broad-based as we anticipate it will be.
Traditional lenders generally don’t want to “take the keys” of middle market borrowers and are not really equipped to do so. But non-traditional lenders, who are getting much more involved in the space, are more willing to jump in. I think we’ll see more of that “keys on the table” scenario as we move into 2024, whether it’s a hedge fund or another non-traditional lender that is willing to take on equity.
With borrowers, it’s going to be a question of how well they are managing their liquidity. A lot of companies have been highly levered up by their private equity sponsors and then gone through dividend recaps, etc. Now, the balance sheets can’t support it, and they’re spending significant amounts of their liquidity on servicing debt, which is unsustainable.
Banks are generally looking to shrink their book size. One of the fallouts of all the banking challenges and interest rate increases is that people have been fleeing smaller banks for the security of mega banks. I think that has led some of the smaller regionals to shrink their books and, as a result, they’ve become more assertive than others in wanting to exit lending relationships outright.
My only caveat is that we could see a continuation of the old “ostrich head in the sand” scenario, similar to what is happening at the moment in commercial real estate. Some banks may continue to be forgiving by, for example, offering to extend maturity by 12 months and seeing how things look at the end of the year.
Are there specific sectors that you see as ripe for restructuring in 2024?
We try not to predict or front chase specific sectors. It’s really any company that is highly levered, and we are seeing examples across multiple industries, including retail, consumer products and healthcare, just to name a few.
Healthcare is a very complex sector, with a number of areas experiencing stress. Skilled nursing facilities are struggling post-COVID, as Americans with elder care responsibilities have reconsidered their options and are hesitant to put loved ones in facilities that are either understaffed or need to pass on high operational costs to consumers.
What is hurting the consumer segment right now really is the inflationary environment. Obviously, there’s a lot of talk about how inflation is declining, but when consumers are out shopping and they still see things double digit percentages higher than they were two to three years ago, that’s hurting. The grocery segment has held up well in 2023. People need to buy food and fuel. But discretionary spending has seen some fall off. Consumers are also feeling the pinch and opting not to spend on discretionary items or trading to private label products, and it’s the higher cost products that have been impacted.
Healthcare has a number of unique challenges, including reimbursements, labor availability and the re-engineering of the healthcare business model. We’ll also continue to see an impact from the shakeout in consumer products companies.
In the current environment, what is going to take for companies to be successful in restructuring and set themselves up for long-term success?
Every situation is different, but there are steps lenders can take, such as putting in controls on the borrower and creating guide rails for them to optimize collateral recovery value, vetting projections, setting covenant levels, determining the veracity of turnaround plans and incenting cost cutting strategies. These are all areas where lenders have limited resources, so it’s an opportunity for firms like ours.
On the other side of the coin, do you anticipate more bankruptcies?
I don’t think we will see a massive uptick, but we may see an increasing number of bankruptcies. Everyone recognizes how expensive a bankruptcy is and all parties try to avoid that expense if they can. But there will still be strategic reasons why it might make sense to put a company through bankruptcy, such as offering a buyer an asset free and clear of liabilities.
I think bankruptcies will stay at the current pace. We saw higher levels of bankruptcy in 2023 compared to 2022. People appreciate how expensive and painful they are. And you really only want to be in front of a bankruptcy judge if you have to and can’t do it out of court.
Finally, how do you see the middle market M&A environment evolving in 2024?
M&A activity overall slowed in 2023, but there are still a lot of pockets of opportunity. Though higher leverage multiples we had been seeing will be harder to secure in 2024, we continue to see an influx of family-owned businesses seeking an exit. Because these companies tend to be governed by life-events less than market dynamics, there is still a healthy appetite for well-run middle market family-owned businesses, both among PE sponsors and strategic investors. In fact, our healthy M&A practice, which focuses on these family businesses, is experiencing an all-time high in deal flow. Buyers are desperate for quality assets, and with Baby Boomers retiring in greater and greater numbers, it’s a great time to monetize.