In line with expectations, the Bank of England once again raised interest rates on 23rd March. This is the 11^th successive increase with rates now at their highest level since 2008 at 4.25%.

The recent collapse of Silicon Valley Bank and the emergency purchase of its UK subsidiary by HSBC, not to mention the Credit Suisse turmoil, serve as a timely reminder that the impact of the rapid rise in interest rates globally has not yet been fully appreciated.

Resulting increases in cost of capital for businesses is driving higher cash burn and reduced financial flexibility to weather trading headwinds and/or invest in sustainable growth. This is naturally placing increased pressure on businesses at a time when they are already experiencing cash-flow pressures due to inflation.

As a result, we are seeing this combination of factors leading to some businesses breaching financial covenants, or covenant headroom coming under increased pressure. Auditor stress testing is also causing businesses covenant issues. Furthermore, “covenant-lite” structures are likely to lead to last-minute restructurings of firms with depleted asset bases.  As a result, creditor recoveries (and scheme recoveries for businesses with DB pension obligations) may be lower than in the past.

Many UK companies (and international groups, of which UK companies form part of and provide cross-guarantees in some cases) will be required to refinance significant debt and credit facilities in the near-term at significantly higher rates than when it was first issued, and when costs have grown materially. In fact, we are already seeing sponsors in our client base experiencing tricky refinancings, with lenders having the leverage in these situations.

The continued importance of covenant

Covenant remains the ultimate underpin for all scheme risks. As such, the evolving ability of the sponsor to support scheme risk over time needs to be clearly understood on an ongoing basis. In particular, given covenant strength, and ability to underwrite scheme risks, can change quickly.

While funding levels have generally improved recently, this shouldn’t be a reason for trustees to be complacent when it comes to employer covenant and corporate events.

In fact, trustees should be close to their covenant and be ready to take actions quickly in these situations as more challenging refinancings of debt could have material implications for covenant. For example, some refinancings are leading to the deferrals of contributions committed to DB pension schemes.

Such events could create the need to re-assess if a scheme’s journey plan remains appropriate as covenant risk dynamics are potentially materially altered. As a first step, it is important that trustees understand the impact of the gilts crisis on the scheme’s journey plan so they can then overlay the impact of a covenant event on the journey plan.

Understanding the scheme’s latest funding position and investment risk exposure, as well as the levels of debt of the sponsors (or at group level if the debt sits there and there is a group guarantee structure in place), the counter-parties of that debt and the timing of any refinancing would be helpful. This is important so that they can understand and prepare for the impact of any shocks and cash-flow issues that might be coming down the line.

Trustees would be wise to have contingency plans in place. This allows them to move quickly when decisions need to be made relating to a corporate event. As part of this, trustees should consider scenarios that could play out such as debt becoming secured, facilities being reduced, affordability materially reducing due to post-refinancing debt service costs, and understand the scheme’s routes to recovery and value flow within the business.

As ever, it is important that trustees continue to protect their scheme’s covenant and its ability to support the scheme when required and over the longer-term.

How can we help?

Our covenant experts are already working with their clients on these types of situations and, as always, are also ready to help you understand the impact of specific corporate events on the employer covenant, including linking this to the scheme’s journey plan.

Our corporate finance expertise means we understand the objectives of each stakeholder, which is key to delivering a successful outcome for trustees.

Our client teams are also able to leverage our regulatory and restructuring capabilities to ensure we can give the best advice to trustees on the practical implications of corporate activity. 

Please get in touch with us to discuss how we can help you.