The UK is heading for levels of indebtedness many of us have not seen in our lifetimes. Business owners are borrowing to keep their companies alive and the Government is set to borrow more money this year than at any time since the Second World War.
Massive debt financing has been justified in the context of this crisis. The pandemic would have already caused thousands of business failures and millions of job losses were lending facilities not available.
But there comes a point where the growing mountain of public and private sector debt becomes unsustainable and we need to know when exactly that is.
At the encouragement of the Bank of England, financial industry body TheCityUK, has formed the Recapitalisation Group (RCG) with EY and other sector partners to tackle this issue.
The group’s interim report suggests UK indebtedness could rise to unsustainable levels by March 2021, with an estimated £100 billion of problem debt across the economy.
SMEs are expected to incur just over half of all unsustainable lending, amounting to between £50 and £56 billion.
Around a third comes from Government-backed schemes, raising the possibility of taxpayers having to cover £32 to £36 billion in unpaid debts.
The report also says more than half of unsustainable loans will be issued to businesses operating in the property, construction, accommodation and food and drink sectors.
Unsustainable is taken here to mean debt that will be impossible for a company to pay off or will require a company to take out more loans in order to continue trading.
The term “zombie company” comes to mind – a firm that requires constant financing to keep afloat and can only use revenues to service debts.
As we move into the recovery period, we have to grapple with the fact that debt financing, while being essential in the short-term, may risk getting out of control, compromising growth in the long-term.
Moreover, when you combine growing debt obligations with the weak trading conditions businesses will face for at least the rest of this year, we could have a situation where firms that might have failed this March when the pandemic struck end up failing next March instead.
We therefore need to find ways of recapitalising businesses, without increasing their indebtedness to unsustainable levels.
The RCG is looking at what the private sector can do in this regard, which is welcome given that Government support schemes will start to taper away as the economy gets back up and running.
Where the public sector has stepped in to support the economy in the crisis phase, it will be the private sector that must step up in the recovery phase.
The RCG has published a number of provisional recommendations, described as debt recapitalisation instruments, that it will take into consultation with trade associations over the next few weeks.
But before getting into the detail, it’s important to understand why new measures are needed.
First is the problem of access to finance. It is still true that many businesses across the UK struggle to raise private equity, particular early stage businesses and SMEs.
Secondly, most of the equity investment that is out there is typically growth capital, rather than capital for rescue or turnaround. That means those looking for equity investment to recapitalise their business will find investors that only want to talk about growth.
Third, any equity investment that is secured for recapitalisation will be funnelled to those that are deemed to be safe bets, which cuts out many SMEs and businesses operating outside of financial centres like London.
As such, the UK recapitalisation challenge is one that can only be met with new measures and more private sector engagement.
The RCG’s debt recapitalisation instruments are an important step.
They include things like introducing a Contingent Tax Liability (CTL) where debts would be paid out of company profits and collected through the tax system.
Forbearance could also be better deployed so that debts can be restructured and rescheduled, with debt forgiveness for those in extreme distress.
Additionally, if private equity cannot be raised, then converting existing loans to equity would at least alleviate cashflow pressures.
These kinds of measures would give struggling firms a fighting chance to become profitable and solvent again, limiting the number of zombie companies that we will no doubt see in the months ahead.
We have so far managed to prevent mass insolvencies in this crisis, but that’s taken the UK Government borrowing more money than ever before in peace time. We must now see the same level of commitment from the private sector.
The economy must be eased off life support gently, but with schemes in place to get businesses back to doing what they do best.