These are worrying times for the wider advisory complex. The lockdown has already taken its toll and the reaction has been swift and decisive. Accountancy firms like Grant Thornton have asked staff to take sizeable pay cuts, while other companies reliant on City fees have canned bonuses, furloughed staff and reassigned debt.
Government help may be at hand, but the Financial Conduct Authority (FCA) has ruled that UK government loans rolled out to financial advisory firms cannot be used to meet their capital adequacy requirements.
As if to make matters worse, the FCA has also proposed that firms with advisory arranger, dealing and broker permissions will need to increase their contribution to the regulator’s future running costs.
While all this is happening, advisory fees are drying up. There was hope that we would witness a post-Brexit increase in initial public offerings, but any theoretical backlog is likely to remain just that for the foreseeable future.
Desperate times call for desperate measures. At the behest of accountancy firms with large restructuring divisions, the UK government has introduced emergency legislation that will help indebted businesses to stay afloat during the crisis.
Nevertheless, figures from the London Gazette point to a surge in insolvency appointments in the month through to 9 April. Presumably, matters could only have deteriorated in the intervening period.
But while the phalanx of City auditors, corporate advisers and lawyers struggle with the disruption wrought by Covid-19, there are sub-branches within those industries that are well positioned to benefit from the ongoing economic turmoil.
Insolvency practitioners were already profiting from a 50 per cent increase in the value of the UK insolvency litigation market over the past five years. This has been largely driven by recourse to third-party funding, but high-profile collapses such as Carillion and Thomas Cook have brought the issue of corporate probity into the public consciousness.
So, even though investors need to steel themselves in the face of market volatility, it is worth remembering that specialist advisory services will be increasingly to the fore as companies restructure their capital bases, or are forced into liquidation.
Opportunities amid the carnage
Heading into 2020, UK companies were already strained by the protracted political and economic uncertainty surrounding our departure from the European Union. New company insolvencies surpassed 17,000 last year, although this is still some way off the 24,000 seen after the credit crunch in 2009. The Covid-19 pandemic has dealt another body blow.
Business recovery specialist Begbies Traynor (BEG) produces a quarterly ‘Red Flag Alert’, seen as a benchmark for the underlying health of UK businesses. It tracks corporate distress signals, such as county court judgements, which are early warning signs of potential insolvency. Its latest report indicates the number of UK companies in “significant distress” – those with court debt judgements of less than £5,000 filed against them – reached 509,000 at the end of March, largely comprised of smaller businesses. As the lockdown continues, Ric Traynor, Begbies’ executive chairman, describes this already record total as “the tip of the iceberg”.
While that makes for grim reading for most, the ‘corona-crunch’ spells good news for Begbies. With almost two-thirds of its revenue from counter-cyclical activities, economic downturns drive a rise in demand for its insolvency and advisory services. While the ‘Big Four’ auditors have a stranglehold on larger corporate insolvencies, Begbies focuses on small-and-medium-sized enterprises who are more likely to suffer from the Covid-19 fallout.
The group did well during the global financial crisis, with adjusted operating profit surging 35 per cent in the year ending 30 April 2009. It capitalised on rising levels of business distress by increasing capacity through both recruitment and acquisitions. This strategy should still hold true – the insolvency market remains fragmented, offering further consolidation opportunities. Its service offering is also now more diverse, with a property division handling distressed asset valuations and sales.
Begbies’ shares aren’t the only ones presenting a potential hedge against the coming recession. Publicly listed law firms such as Keystone Law (KEYS) and Knights (KGH) will also see higher demand for legal services, particularly as the Coronavirus Act has given way to ambiguity. Naomi Pryde, head of DWF’s (DWF) Scottish commercial litigation team, says the group has seen an influx of insolvency and restructuring instructions from clients “either pre-emptively because they are anticipating being in financial difficulty, or because they are actually in financial difficulty”.
Gateley’s (GTLY) restructuring team supports insolvency practitioner heavyweights including Deloitte and KPMG, and the group’s acquisition of The Vinden Partnership has beefed up its corporate advisory and dispute resolution capabilities for property and construction.
The overall impact for law firms is likely to be mixed as some practice areas suffer. A recent update from DWF indicated that resilience in litigation and insurance was being offset by a deterioration in corporate finance and real estate services. Revenue growth for the year ending 30 April is guided to fall short of management’s expectations. Meanwhile, Ince Group (INCE) – formerly Gordon Dadds – has warned of potential delays in collecting client fees. With a more tumultuous ride than its listed peers, its shares sit a little above 20p, versus its 140p initial public offering (IPO) price back in 2017.
Potential investments in this space go beyond short-term opportunistic plays as insolvency activity tends to persist even once an economic recovery has begun. This could be compounded by the government’s insistence on delivering Brexit by the end of this year, with potential changes to supply chains and trade rules spurring more business upheaval.
Court in the storm
While the outlook for full-service law firms is cloudy, other listed professional services outfits offer a clearer one-way bet on rising adversarial activity. One example is Manolete Partners (MANO), which funds or acquires the rights to what often amount to procedural insolvency claims. This business model, honed over a decade before its 2018 IPO, has adapted to life under coronavirus without a hitch. Judging by a recent trading update, activity levels are also on the up.
In March, Manolete’s network of insolvency practitioners – which already provides a conveyer-belt-like run of new cases – helped the group to source and sign 15 new cases, above the 12-a-month average for the group’s latest financial year. Case completions are also trending higher, in part thanks to the group’s focus on reaching settlements rather than taking cases to trial – which has the added advantage of avoiding any delays in the court system caused by social distancing measures.
Given the likely acceleration in actionable insolvencies in the coming year, broker Peel Hunt expects the market for Manolete’s funding opportunities to grow, propping up an annual return on equity of at least 25 per cent for the foreseeable future.
Whether corporate disputes work will rise more generally is a moot point, in part because it is such a complicated economic activity to measure. Last month, litigation financier Burford Capital (BUR) told the market that, while new business is set to slow down, over the longer term, "economic disruption tends to generate litigation and thus potentially significant levels of new opportunities... especially given corporate liquidity constraints”.
Data from BTI Consulting, which tracks corporates’ legal spending, is inconclusive. Corporate legal spend dropped in 2009 (see chart), although this looks to have been partly down to in-house cost-cutting and lower levels of commercial and corporate work than a fall in demand for advice. Indeed, an increase in the proportion of money spent on outside counsel in 2009 might suggest that the global financial crisis gave rise to bet-the-company litigation. BTI’s latest report, published several months before the coronavirus hit, forecast a 5.5 per cent rise in litigation spending by large US companies in 2020, in a slowdown in the observed two-year growth rate.
Perhaps more importantly for Burford, recent news reports have pointed to law firms’ own capital bases coming under strain. Theoretically, this raises the prospect of disputes lawyers requiring third-party funding to support the running costs of new cases. Whether Burford is primed for an influx of new business is another matter. Analysts at Canaccord Genuity recently expressed doubt that the Aim-listed firm can make good on this year’s discretionary commitments without its own fresh financing, or running into liquidity issues.
The debt business
Some companies make liquidity issues and credit risk their business. Hedge funds, private equity groups and other so-called ‘vulture funds’ are some of the best-known acquirers of bonds or loans gone (or going) bad. Why anyone would want to take on the debts of companies, countries or individuals facing bankruptcy is simple: while they carry huge risks, they are often cheap, and offer above-average returns if the debts can be restructured or credit conditions improve.
Despite emergency fiscal and monetary policy measures – ranging from loan holidays to the Federal Reserve’s decision to underwrite high-yield junk bonds – the market for these assets is likely to grow. Alternative asset investors are primed for this – according to financial data group Preqin, more than a third plan to target distressed debt in 2020, as a result of the impact of Covid-19. The ‘smart money’ is as interested in credit gone bad as it is private healthcare.
Ordinary investors can get exposure to this trend, too. Arrow Global (ARW), which buys books of distressed debt – typically from mainstream European lenders and sometimes comprising thousands of individual loans – is one listed name in this field. Management points to a track record of converting non-performing loans into “beneficial cash-flowing assets”, a business line which is increasingly carried out on behalf of third-party investors and asset managers, thereby reducing the strain on Arrow’s balance sheet.
In March, chief executive Lee Rochford, told us the looming potential credit crunch facing companies and individuals across Europe is “exactly the kind of situation this company is geared to”. That bullishness might have felt more convincing had Arrow not subsequently cut its final dividend for 2019, although in sticking by its 377p target price – almost four times the current trading level – broker Numis believes “there will be substantial opportunities to acquire assets that will deliver exceptional returns for investors”.
Fund investors’ options are rather limited in this space. In part owing to the illiquid nature of the holdings, US-listed alternative asset manager Oaktree Capital Management (US:OAK-B) does not offer any Ucits or non-Ucits funds for its distressed debt strategies. Retail investors might have more luck with London-listed investment fund NB Distressed Debt (GG00BFZ5JM92), which provides exposure to “distressed, stressed and special situations investments, with a focus on senior debt backed by hard assets”. Unlike their dollar-quoted equivalents, sterling-denominated shares currently trade at a discount to their estimated net asset value.
