Dylan Coke | Local capital markets in the time of coronavirus – Pt 1
If you’ve been observing the local markets for debt and equity over the last few years, you could be forgiven for comparing it to one of Kingston’s famous street dances. Both spaces were characterised by tremendous creativity, energy, and dynamism. From ‘plain vanilla’ private placements of debt to mega IPOs, there was a constant supply of exciting transactions and innovative securities, and, not surprisingly, the number of patrons (retail and institutional investors) ‘in the dance’ increased dramatically, with recent IPOs bringing thousands of new investors into the market.
Statistics from the Financial Services Commission (FSC) further illustrate the point. Between 2013 and 2018, Jamaican-dollar private placements (exempt distributions) increased in value from J$11.8 billion to a whopping J$129 billion. The Jamaica Stock Exchange has been named the best-performing stock exchange in the world more than once in the last five years and saw a steady flow of new listings on its Main and Junior exchanges, with the Junior Exchange recording more than 30 listings since its creation in 2009.
This performance has been facilitated by dramatic falls in interest rates that began after the Jamaica Debt Exchange in 2010 and the National Debt Exchange in 2013. Interest rates, having fallen to historic lows, have remained low, creating the space for borrowers to raise substantial amounts of capital at a lower cost. Lower rates also meant that equity securities, by comparison, became more and more attractive for yield-hungry investors, thereby fuelling stock market growth. As Jamaica’s economic outlook improved and the Government of Jamaica (GOJ) was able to pay out some of its maturing local bonds, additional liquidity was created, allowing for much larger transactions in both debt and equity. In recent times, for example, the National Water Commission, the Jamaica Public Service Company, and New Fortress Energy have all been able to raise in excess of J$10 billion in local markets.
Then, like the authorities arriving to ‘lock off the dance’ just as the proceedings were really getting started, the coronavirus pandemic came along and brought things to a sudden halt.
The immediate result of lockdowns, travel bans, and social distancing has been a precipitous decline in global economic activity. Our own macro-economist at JN Fund Managers has projected a five to seven per cent reduction in Jamaica’s gross domestic product for the fiscal year ending March 31, 2021. Locally, GOJ has responded with a J$25-billion stimulus package, but it’s clear that the fallout from a sharp decline in remittances, the closure of our tourism industry, and reduced economic activity will have a profound effect on our economy.
What does this slowdown mean for local capital markets? In many ways, we are in uncharted territory, but perhaps the best way to understand the implications of the slowdown is to look at it from the perspective of the main participants in the market while looking to the Great Recession of 2008-09 for insight and also studying how players in the international markets are responding.
INVESTORS (THE PEOPLE WITH MONEY)
This is likely to be a very stressful time for dance patrons (retail and institutional investors). Retail investors who hadn’t previously participated in the market but (driven by FOMO – fear of missing out) were preparing to buy a ticket to the ‘dance’ have now, probably, decided to wait outside for the time being. Persons who had already invested, on the other hand, may now be suffering a kind of paralysis, finding it easier to do nothing rather than to buy into a declining market or sell into a falling market and take losses. Still, others who failed to appreciate the extent of their downside risk and are now seeing sharp declines in asset prices are selling assets, fearing that things will only get worse. Of course, there will also be some intrepid souls who see the sell-off as a good time to pick up assets at attractive valuations. It’s impossible to say how asset prices will perform, but investors should be advised to proceed cautiously, buying assets only after they’ve done careful research and avoiding panic selling as markets have usually rebounded after past crises.
Institutional investors, including pension funds, unit trusts, and brokerage houses, seeing sharp declines in the values of the portfolios they manage, will be feeling some of the same urges as retail investors. However, they are typically more knowledgeable and sophisticated and have different investment objectives, timelines, and constraints. They also benefit from built-in ‘institutional discipline’, reinforced by investment policy documents, investment or credit committees, and boards of directors, all of which help to avoid the behavioural biases of individuals and prevent the making of rushed, sub-optimal decisions.
Among the urgent decisions investors are being asked to make is whether or not to agree to requests from distressed borrowers to renegotiate or amend the terms of existing transactions on terms sometimes less favourable to investors than before. No investor wants to deal with covenant breaches, or worse, defaulted securities, and these factors may be a strong incentive to renegotiate terms. But it’s also fair to say that in previous crises, institutional investors have been fair-minded and accommodating in working with issuers to resolve problems. We hope this happens again as it promotes not only market stability but better long-run outcomes for investors.
That said, it’s likely that many institutional investors will remain in ‘risk off’ mode for the foreseeable future and will allocate more funds to what they see as safer investments.
ISSUERS (COMPANIES THAT ISSUE DEBT OR EQUITY)
In some respects, issuers are like the sound systems at a dance. They are the key attraction that pulls patrons (investors) in, but as the slowdown has taken hold, the attraction many issuers hold for nervous investors has weakened. Some issuers may, therefore, correctly conclude that debt that investors happily rolled or refinanced in the past may not so easily be rolled or refinanced again.
While they are considering this fact, companies with debt maturing in the next year or so will be closely monitoring their financial performance to see whether they will have difficulty making interest payments and repaying outstanding principal when it matures. Where they anticipate difficulties making interest payments, they will be speaking with their investment bankers to see whether the markets will facilitate amendment of debt terms, such as the postponement of interest payment dates where principal repayment is a challenge. They may seek to roll or refinance the debt or, if this is not possible, seek to postpone maturity dates.
In addition to assessing whether they can pay interest and principal, companies will be assessing how any decline in their financial performance may affect the financial covenants built into their debt (covenants are contractual promises borrowers agree to observe as a condition of obtaining funding from lenders). Covenants may include prescribed leverage, liquidity, and loan-to-value ratios, and lenders will want to review these with the help of their lawyers to ensure that they understand the requirements and have the ability to meet same.
If there’s any possibility of not being able to meet covenanted ratios, issuers should quickly inform lenders and advise of any remedial steps they intend to take. It is critical that lenders communicate frequently and effectively with lenders as this helps to maintain transparency and credibility. Issuers should be mindful that if a breach or default occurs, this triggers various internal reporting and accounting requirements for institutional investors. Keeping investors in the loop prevents them from being blindsided and allows them to prepare for this eventuality.
Where the possibility of a covenant breach becomes unavoidable, issuers should seek the help of investment bankers and attorneys in negotiating amended terms with lenders. Amended terms may include loosened or staggered financial ratios or requirements to provide additional collateral. Issuers should be proactive as once a breach occurs, loan documentation typically contains timelines for advising the trustee/registrar of the breach, for holding noteholders’ meetings, and for providing proposals to remedy the breach. If these timelines are missed, a default may be even more difficult to avoid.
As with all things, nothing is free, and issuers may need to consider what they will offer unhappy dance patrons (investors) in return for any accommodation.
If there is a material risk that the issuer will default, or even become insolvent, issuers may wish to go beyond negotiating amended terms and perhaps seek legal advice regarding the possibility of filing a stay under the Insolvency Act 2014, which would limit the actions creditors can take against them while they take steps to address their difficulties.
Companies planning ‘new’ offers of securities are likely to have been advised that, as mentioned earlier, investors are in ‘risk off’ mode and are postponing investment decisions and/or allocating money to ‘safe’ assets. To attract the liquidity to fund new offers, issuers may, therefore, need to offer better security and/or a better return, bearing in mind that institutional investors still have substantial funds to invest, but the terms on which they are willing to invest may have changed materially.
If an issuer is unwilling (or unable) to offer better debt terms, it may wish to explore issuing equity. This, of course, removes the need for restrictive debt terms, but investors will expect better returns from equity, and issuers will need to consider whether they can meet these expectations. As it stands, a number of planned initial public offerings have been put on hold while issuers and their financial advisers work out pricing and reassess market appetite.
Part Two will look at the role of investment bankers, lawyers, and regulators.
Dylan Coke is an attorney-at-law and deputy general manager, investment banking and sales, JN Fund Managers Ltd.