Gordian Perspectives for November 2019

Each month members of Gordian Group team pick articles, posts or current news events that we found interesting and worth sharing with Gordian clients and our growing network . We provide some commentary and context and where applicable how Gordian Group can help.

Toxic Debt

Many municipal and quasi-municipal entities have long demonstrated poor economic stewardship.  Chicago, Detroit, Stockton, Puerto Rico and Pacific Gas & Electric (PG&E, California’s prominent whipping-boy utility) have merely been the most visible of late.  There may be no new news in this sad state of affairs, nor in the reality that fundamental problems facing America cannot be fixed simply by improved management and the occasional bailout.  But, like Topsy, the crisis continues to grow.

An article I read recently in The Atlantic entitled “The Toxic Bubble of Technical Debt Threatening America” underscores this point by calling attention to looming too-long-deferred infrastructure expenditures, which it refers to as the nation’s “technical debt” 

A kind of toxic debt is embedded in much of the infrastructure that America built during the 20th century.For decades, corporate executives, as well as city, county state and federal officials, not to mention voters, have decided against doing the routine maintenance and deeper upgrades to ensure that electrical systems, roads, bridges, dams and other infrastructure can function properly under a range of conditions.  Kicking that can down the road like this is often seen as the profit-maximizing or politically expedient option. But it’s really borrowing against the future, without putting that debt on the books.

The costs are mind-numbing.  The author cites estimates by the American Society of Civil Engineers that contemplate “$3.6 trillion to get Americans back to an acceptable level of technical debt in our infrastructure”.  Those numbers are right up there with Medicare for All, and may not be financeable without a massive societal commitment.

However, even with such a social desire, there will inevitably be losers.  Taxpayers, ratepayers, bondholders and stockholders are all in line to suffer when that day of reckoning arrives.  And before then, it is certainly foreseeable that public and private entities in “infrastructure holes” may see their credit ratings and access to capital shrivel – which may actually accelerate the onset of a crisis as liquidity pressures mount.

Given our experience with the various levels of government and regulators that deal with these sorts of things, we don’t think this will be an easy fix.  For our perspectives on how this crisis may unfold, please contact us.  Fasten your seat belt, it’s going to be a bumpy ride.

Commentary by Gordian Group CEO Henry Owsley

Retail Apocalypse

Is there a “Retail Apocalypse”, is it here to stay, and will the wave of problems sink other vessels?  I read “Navigating the Retail Apocalypse” in The New York Law Journal by Brad Sandler and Jonathan Kim of Pachulski Stang Ziehl & Jones LLP about this very issue, and it resonated with me.  Far too many retailers these days are liquidating in chapter 11, rather than reorganizing.  Brad identified some of the key drivers behind this trend, and put some statistics to it. His conclusion was that – while Retail is not a total zombie – its troubles are far from over.

The article made me think about the retailers’ partners and bedfellows, the landlords.  Even when the retailer re-organizes, the landlord may end up with rejected and/or re-negotiated leases.  In a liquidation, the landlord will get the stores back and keep the deposits. The prospect of re-letting these spaces may diminish with every successive retail failure.

In the “old days” (pre-internet), landlords could count on another retailer arising to take the failed retailer’s place.  The Retailing business was attractive to entrepreneurs and investors seeking a quick hit. With relatively low barriers to entry, ability to capitalize on a trendy concept and the premium placed on growth, capital flowed into this sector.  With the Retail industry disintermediation caused by e-tail, perhaps the old paradigm is broken.

If true, and particularly if the landlords recognize it to be true, then the model for Retail restructurings may need to be rethought a bit.  The landlords may not be achieving their best result by getting their stores back through a liquidation or contract rejection. And if the new competitive environment limits the number of viable new retail entrants, proactively lining up new tenants may no longer be a panacea for dealing with reclaimed store space.

Conceptually, the solution for landlords may lie in being proactive not only on the new lease side, but also in taking steps to grant lease concessions to troubled tenants in exchange for greater participation up and down the troubled company’s capital structure.  While such a remedy is a dramatic departure from business-as-usual for many landlords, the additional up-front effort may produce far better results than sitting on idle space down the road.

Commentary by Gordian Group CEO Henry Owsley

Canary in a Coal Mine

Retailers and energy producers clearly face industry-specific headwinds that will drive many into bankruptcy or worse.  But the across-the-board wave of defaults that some financial prognosticators have been predicting “any day now” has been elusive.

Perhaps by focusing largely on omens such as inverted yield curves and other bits of technical arcana and animal entrails, such prognosticators have been looking in the wrong places.  One of the long-lasting effects of the Fed’s Quantitative Easing program has been relatively cheap financing – and lots of it. As long as financially-stressed companies are able to refinance, there has been little need to restructure.  For this dynamic to change, credit spreads for such companies would need to widen considerably, reflecting significantly decreased investor appetite for such paper.

We have observed such a trend starting in the junk bond universe we follow.  I read the Wall Street Journal article “Investors Spurn Riskiest Corporate Bonds” [subscription required] the other day that echoed this reality.  The author reported that Bloomberg Barclays determined the CCC spread over Treasuries to be 10%.  If this pessimistic investor sentiment continues to permeate junk bonds, we think that more and more distressed companies will be forced to restructure, rather than refinance.

The canary may be finally falling off of its perch.  Bad for the canary. Good for the restructuring community.

Commentary by Gordian Group CEO Henry Owsley