Coronavirus & the incredible shrinking asset value
June 7, 2020
All lenders and insolvency practitioners know what happens to the assets section of a company’s Balance Sheet when it goes into any formal insolvency process, even those designed as rescue procedures.
Valuation of assets in a business
The valuations placed on assets by directors in good faith or at least in compliance with reporting standards and then supported by external auditors somehow miraculously melt away, decimating the return to creditors in the process. Going concern valuations and insolvency reality make deeply uneasy bedfellows. It can be tough to explain that there is no objective price for an asset; it is simply worth what a distressed seller can persuade a properly-funded buyer to pay.
Now for the first time in decades, we are seeing a wholesale and savage reduction in asset values outside the insolvency process, as Covid-19 disruption tears through all commercial norms. Unfortunately, as some high profile examples are showing, the damage is not just to valuations but also to the funding capacity of the affected business.
Funding capacity of businesses
Early on in the pandemic, the iconic German flag carrier Lufthansa was confident that its rapid cash burn could be dealt with through the simple expediency of raising €10bn against some of its unencumbered aircraft, taking advantage of its long term policy of not leasing planes. Just weeks later, it was forced cap in hand to take €9bn in state aid to avoid a cash crisis, effectively admitting that the aircraft finance market now considered the planes to be worthless. The result is a major restructuring, of which the forced sale of other assets is a major part along with mass job reductions.
Elsewhere, the major oil production company Seadrill revealed a £1.2bn impairment charge against certain of its oil rigs following the collapse of the oil price as worldwide demand fell because of the economic shutdown. This has triggered a full scale restructuring exercise as bankers and lawyers were hired at short notice to evaluate ways to deal with the impact of this write down on the attitude of the lenders providing the company’s $7.4bn debt pile.
Whoever said that the safest investment was in bricks and mortar had obviously not anticipated the effect of the virus shutdown on the collection of rent by retail and hospitality landlords in the UK and elsewhere. Nor had they realised the direct link between rental income and property valuations, nor the nervousness of retail property lenders as loan covenants breaches started to be triggered all round the market. One major landlord has recently predicted that the crisis will reduce its rental income this year by 37%, which could trigger a broadly equivalent fall in the value of its property portfolio. The same landlord had already taken a £2bn hit to its portfolio value the previous year because of deteriorating retail conditions. The latest issues suggest that the portfolio has halved in value in just two years.
These are examples of individual asset diminution woes, some also worsened by fundamental industry sector issues, which existed before the virus put large parts of the global economy into suspended animation. The even greater concern for entrepreneurs and borrowers is that the pandemic will trigger the wholesale withdrawal of funding capacity from the worst affected sectors. This could mean that otherwise viable businesses with effective management, solid balance sheets and good post-virus profit recovery prospects could be derailed by this sort of blanket loss of financial faith.
One of the most striking examples of what insolvency can do to asset valuations was the collapse of the department store chain, House of Fraser in August 2018. Its last published accounts made up to December 2016 reported total assets of an apparently healthy £1.3bn. This final financial reckoning included some unlikely bits of accounting, including £23m for the alleged benefit of paying below market rent for some stores. This was dwarfed by a heady £424m of fantasy goodwill created in the restructuring through which it had been acquired by new owners two years previously. In the end, the wreckage of the chain was acquired by Sports Direct for a paltry £90m, a figure which probably owed more to the amount needed to cover the costs of the insolvency than any lingering worth in the assets themselves.
Current asset valuations
The problem with the current shock to asset valuations caused by the crisis is that the splurge of red ink will not stop there. If it destabilises funding arrangements, insolvency could easily follow and then we will have repeats of the HoF disappearing asset trick all over the UK economy and well beyond.
Then good insolvency practitioners really will earn their corn. In a recession as deep as this one, the reality is that nobody knows what anything is worth; there are too few buyers and too many of them are those connoisseurs of commercial carrion, the vulture funds who only pay the rock bottom price.