This article is sponsored by RBC BlueBay
Markets have climbed a wall of worry over the past few quarters. Increasingly, forecasters are confident that major developed market economies will avoid hard landings, with consumers and corporates having shrugged off the impact of higher policy rates to date. At the same time, major inflation indicators have started to decline.
However, in our view, significant challenges remain. With inflation still at elevated levels and showing stickiness in various quarters, we expect policy rates to remain higher for longer and that rates at the long end will also stay higher, reflecting a return to the conditions that prevailed before the global financial crisis. Furthermore, as monetary policy operates with a lag, we expect to see more negative data in the months ahead.
At the global level, other challenges are clear in the shape of economic weakness in China and the ongoing geopolitical strains of the war in Ukraine. Commodity prices remain at elevated levels and are vulnerable to further disruption.
These factors, in combination, represent a significant headwind to European corporates which in some cases have yet to recover from the impacts of the covid-19 pandemic. With consumers facing a cost-of-living crisis, pressure on corporate revenue and higher input costs equate to lower profitability and weaker debt-to-EBITDA ratios.
The impact is exacerbated by reduced commercial bank lending since the mini-banking crises earlier this year. It is particularly acute in Europe, where mid-market companies rely more on the banking system than public credit markets.
A rich opportunity set in Europe
This backdrop is leading to a rich opportunity set for special situations credit investors, and we have observed a significant increase in potential investment opportunities. Unlike other periods of economic weakness during our careers, these opportunities come from a particularly broad range of sectors and jurisdictions. Indeed, it is hard to think of a sector not impacted one way or another.
In the months ahead we anticipate deploying capital into a variety of sectors to help companies navigate the tricky macroeconomics and return to profitability with right-sized balance sheets. In some cases, business models that work in a low-rate environment, such as commercial real estate, will struggle to adapt to higher financing costs.
We believe that European mid-market companies, in particular, represent an exceptional opportunity for experienced distressed investors. Moody’s project that default rates will rise in the months ahead and, although we believe it is unlikely that defaults will reach the levels seen during the global financial crisis, we highlight that European high yield and loan markets have grown significantly over the past decades.
More specifically, if we multiply Moody’s moderate projections for European defaults by the size of the high yield and leveraged loan markets, this leads to some €60 billion notional, and the severe pessimistic scenario would amount to almost €90 billion. These are large numbers and dwarf the amount of capital we estimate to be managed by dedicated specialist managers.
The competitive landscape
Although investors are increasingly looking at special situations and distressed strategies, the bulk of the capital has been raised in successor vintages from large US-focused managers. The managers of these larger funds are forced to look only at larger capital structures, and in most cases, they focus primarily on North America.
With our European focus, we welcome this competitive dynamic where the demand for capital exceeds supply. In addition, we stress the importance of local knowledge and a local presence given the patchwork of bankruptcy codes, which we regard as a significant barrier to entry. Chapter 11 in the US is well understood and extremely efficient. Whereas, in Europe, the rules of the game continue to evolve and represent an additional source of alpha for experienced local specialists who understand the local culture and have local professional networks.
The biggest opportunities need active involvement
Some of the biggest opportunities will require active involvement from such specialists. For instance, in distressed situations where companies with unsustainable capital structures need a financial and/or operational restructuring, we seek to be actively involved in the restructuring process, either through involvement in bank steering committees, ad hoc bond committees, or advising the restructuring process with companies on a bilateral basis.
In such cases, the company’s debt instruments will commonly be converted into new debt and equity instruments through a debt-for-equity swap. We aim to be actively involved in turning around the company’s fortunes and may look to take a board seat or observer rights at the back end of the restructuring process.
In other situations, there will be opportunities to provide new capital to stressed companies that cannot access local banking or other financial markets. Even before 2023, many European mid-market companies with idiosyncratic problems or wider industry or secular issues were finding it difficult to access domestic banking markets, and this has been compounded by tighter lending conditions after the mini-banking crises in the US and Switzerland. We aim to lend at the top of the capital structure with real asset security and advantageous lending terms. Sourcing and structuring such investments successfully are resource-intensive and require highly experienced hands.
In certain other cases, companies will have no alternative to liquidation. Insolvencies across Europe fell dramatically in 2020, but insolvency moratoria and fiscal support measures have subsequently been phased out. Given the ongoing economic weakness, we expect that there will be a significant increase in company liquidations across Europe. Investments in liquidations entail acquiring debt instruments and trade claims in liquidating companies at large discounts to par. As specialist investors, we look to work closely with liquidators in an advisory capacity to recover value through liquidating company assets.
Given this steady flow of opportunities, we are excited about the outlook for the strategy and its return potential: headwinds for global economies and markets should translate into tailwinds for special situation investors. By buying at significant discounts to par and adding value through specialist, hands-on management, the asymmetry is to the upside. We are confident in the strategy’s potential for high returns while remaining senior in the capital structure.
James Rous is a BlueBay institutional portfolio manager specialising in special situations investing