Bridgepoint Credit: Versatility is critical to success in special sits

This article is sponsored by Bridgepoint Credit

Can you describe the state of the special situations market today?

With so much uncertainty now out there, the constantly evolving landscape for special situations/credit opportunities investing is particularly compelling. Macro risks were mounting even before Russia’s invasion of Ukraine; massive supply chain issues globally, labour shortages, inflation rising fast and central banks pre-empting further price rises with rate increases. The combined picture led to the re-emergence of volatility in markets.

When you add in what is happening in Ukraine, much of Europe has a pressing need to divert its energy imports away from Russia and that has significant implications globally, with a strong likelihood that high energy prices are here to stay.

In our credit opportunities strategy, rewinding the clock back to the first half of 2020 when covid hit, the best risk-return was definitely in the secondary market. Senior secured term loans were trading in the seventies and eighties (as a percentage of par), so we took advantage of those opportunities before the markets rebounded.

Then in 2021 and coming into 2022, the best relative value moved into the primary/direct origination market where we’ve been able to effectively move our focus. We are fortunate to be able to draw upon our direct lending and syndicated debt teams at Bridgepoint Credit and leverage the entire platform to access a large number of sponsor relationships and attractive investment opportunities. Even in relatively benign markets, there is a need for capital that can be priced or structured more creatively.

Now the pendulum is swinging back again, and it looks likely there will be more opportunity in the secondary market later this year. Whenever economic growth slows, all markets are impacted: equity markets, loan markets and bond markets. It presents us with a big opportunity.

The macro situation is changing fast. How flexible do special sits strategies need to be?

The special situations strategy broadly defined has evolved over the years. For many players, it used to be mostly distressed but the arbitrage of buying debt below par, taking over the equity and getting the risk premium to capture value through a restructuring has gone away. Frankly, the companies trading in distressed territory these days are troubled, often with uncompetitive business models or operating in industries in secular decline. That is not our focus.

Today, only 2 percent of loans in Europe are trading below 80, and that was less than 1 percent a few months ago. It has therefore been difficult to find attractive investments in the secondary market over the last 18 months. Instead, we have primarily focused on working with sponsors and entrepreneurs to provide them with the creative capital solutions they require to grow or acquire high-quality businesses.

Bridgepoint takes a thematic approach to investing, and our credit division focuses on  three primary sectors: software; tech-enabled services; and healthcare and medtech, where we have strong due diligence angles through our industrial adviser network, internal sector teams and accumulated deal knowledge across our business lines. For example, we recently looked at a software company that is going through a transition from a license and maintenance fee model to a SaaS model.

While the transition will lead to strong growth and resilience in the medium-term, in the interim it puts pressure on EBITDA and cashflows. We designed a flexible capital structure to navigate that, with a revenue covenant instead of an EBITDA-based covenant, and the ability to pay cash or payment-in-kind (PIK) interest to facilitate the transition while retaining appropriate protection for our capital.

We have strong sponsor relationships across our business, giving us access to those deals. You need the flexibility to access the best relative value at any point in the market, including the ability to pivot seamlessly to the secondary market when the opportunity is there.

Special situation funds typically target at least 10 percent net returns, which means low- to mid-teen gross returns. When secondary markets are strong, we focus on the primary space, where there is a premium for complexity, structure, and illiquidity. That’s where we have been focused over the last 18 months. Primary transactions encompass a range of investment opportunities from senior debt through to preferred, convertible, and common equity.

If you don’t have access to the primary market, the other way to generate those returns is by taking greater risk – either industry risk or operating turnaround risk in the underlying investments – and that’s something that we just don’t do.

We have learned over the years that good companies are usually better than we expect and bad companies are usually worse, with hidden risks surprising to the downside. We focus on well-positioned companies with a strong reason to exist and where we have real insight and a strong due diligence angle that gives us conviction. Once we find those companies, flexibility is key to our approach and what we can offer the sponsors we work with.

How about sectors – where is the optimal special sits environment today?

For us, it’s really important to invest where we have an edge in our knowledge base and understanding. This is software, tech-enabled services and healthcare and medtech. We will also invest in industrial companies, where there’s a value-add linked to technological advances, but there is a time and place for investing in industrials, particularly if they have a bit of cyclicality to them. It’s not that time yet.

Generally, our sectors remain the same even as the weighting between them ebbs and flows, and that’s because we have built that strong understanding of them, and we have an industrial adviser network and strong sector teams who can share knowledge and best practice.

How did covid change the game for special sits investors?

The speed of the sell-off and the speed of the snap-back really came as a surprise to many investors. During the global financial crisis, it took 18 months to go from peak to trough levels. In 2020, it took about four weeks to go from par down to the mid-eighties.

If you were slow, you missed that opportunity, so being prepared and knowing your target credits well ahead of time is key to being able to move swiftly. We have deployed capital consistently over the last few years and that trend continued in 2020 but shifted into the secondary market rather than primary.

It was only the players that had a good understanding of the market ahead of time – with a shopping list and know-how on prices – that were well positioned and ready to go. People always talk about there being so much cash on the sidelines. It is true but it’s funny how that dries up when there is real volatility.

Certain players, including Bridgepoint, carried on investing throughout the downturn, while others waited for either lower prices or more clarity, and to my mind missed out on the opportunity. We are not anywhere near that point in the secondary market now, with average loan prices in Europe trading at around 97, but I expect lower prices in the months ahead.

Covid was a really unusual recession because we went into an unprecedented global lockdown that created a huge shock to the system. Then the scale of both fiscal and monetary response was also unheard of, so we saw that rapid snap-back across the economy and the markets.

This time around, with inflation where it is, governments are not going to be able to stimulate their way out of the crisis in the same way, and if anything there is pressure to actually raise interest rates to control inflation. That makes the landscape particularly interesting and suggests to me that a resulting slowdown could last longer this time round.

What are LPs looking for from their special sits allocations today?

It’s a difficult world to make money in, whether you’re a retail investor, institutional investor, pension fund or sovereign wealth fund. You can’t keep your money in cash because interest rates are still very low and inflation will erode it away, you can’t just put it all into public equities because those markets are at or near to all-time highs, and you can’t put it into government bonds because returns are still very low. That means you must have some allocation to alternatives.

Within the alternatives space, credit opportunities funds offer low- to mid-teen net returns with steady cash yield. We are an absolute return fund and this is a counter-cyclical model that provides our investors the option to significantly outperform in times of volatility and dislocation. When times are good, we can find attractive risk-adjusted returns putting money to work on the primary side. Then when there is volatility in secondary markets, we are very quickly able to pounce and take advantage to drive even greater IRRs.

Stephen Escudier is a partner with Bridgepoint Credit and co-head of its credit opportunities strategy

What does the rest of 2022 have in store for special sits?

Credit opportunities is really becoming a conversation piece again as LPs see how quickly the markets move. It’s becoming very thematic and front and centre in terms of how LPs are thinking, so I’m optimistic that there will continue to be a healthy environment for credit opportunities fundraising for the rest of this year and into next year. This is an exciting time because the stars are aligning, with slower growth and more market volatility, creating a healthy opportunity for special sits funds and particularly those with a flexibility of approach.