This article is sponsored by Cross Ocean Partners
How is Cross Ocean positioned within special situations credit?
Graham Goldsmith: Special situations is a broad theme: being more specific, we are a Western European and US credit firm focused on the top of the capital structure, more often than not senior secured. We place significant emphasis on capital preservation.
We have a multi-channel sourcing platform focused on the motivated non-economic seller. Eight out of 10 times we are looking at a syndicated bank loan which might be being sold by banks withdrawing from particular regions or industries, or where an asset has become inefficient from a capital charge perspective. We normally originate directly via the strong relationships that we have built with commercial banks, which often is less competitive than operating in traditional capital markets.
That said, when the 1,000-year flood happens, we are very comfortable pivoting towards the more liquid markets and believe that we did that successfully during covid. As a team, we have worked through a lot of credit cycles and can respond when the market goes upside down. We focus on stressed and performing credits in areas of dislocation where we can get attractive pricing.
How has covid driven the market opportunity?
GG: Covid was an interesting time for us. We were fortunate to have entered covid on the front foot with a solid portfolio that performed well through the pandemic and dry powder that allowed us to take advantage of the sell-off. Traditionally our focus is very much sourcing from banks, but when a market shock happens, banks typically freeze and don’t do anything – it takes them quarters and sometimes even years to react.
At the beginning of covid, over a two-week period, we saw one of the biggest drops in history in the leveraged loan markets. We aggressively took advantage of that. As we moved from the liquidity phase to the solvency phase, banks were prompt in reserving their loan portfolios due to the economic fallout.
The significant provisions they made means they can now afford to sell loans at a material discount to par. Whilst the liquid markets had that big move in March/April 2020, the more illiquid bank loan selling continues to have significant momentum two years after the event, and we are very focused on taking advantage of that.
What is your approach to the market and how do you think about downside protection?
GG: If you look at our senior investment team, we have all been around for more than 20 years and built up a lot of experience through different cycles. We are very focused on downside protection and rapid payback times on our invested capital.
We also focus on senior secured lending at the top of the capital structure. Through being secured, we have more control of the outcome and reduced volatility.
Finally, through a deep and well-established multi-channel sourcing platform, we aim to source transactions off the run, capturing an illiquidity discount. In general, we are trying to source less broadly syndicated instruments where pricing is intransparent and therefore less efficient. We believe that our track record of minimal losses across our portfolio underlines the benefit of our focus on senior secured credit and downside protection.
What have been the key themes and opportunities over the last 12 months?
Steve Zander: The motivated seller of risk has moved from being the liquid market, during the course of 2020, to the commercial banks in 2021. Our portfolio likewise pivoted away from more liquid and visible credits into more illiquid credit. In the second and third quarters of 2020, over half of our deployment was in more liquid credits, whereas through 2021 that accounted for only about 6 percent of our deployment. There has been a marked migration from visible, transparently priced credit to bilaterally sourced private transactions sold by the commercial banks.
Why were the commercial banks in a position to sell that risk?
SZ: Unlike in 2008/09, when many banks went into the global financial crisis undercapitalised, banks both in Europe and the US are now much better capitalised. In addition, banks were quick to provision due to regulatory changes, namely IFRS 9. In Europe, we estimate that the top 20 banks that we source from, on average, increased their provisioning levels by 300 percent. A combination of these two points means that banks are now able to sell assets at levels that are more realistic.
Generally, banks are slow to sell risk and backward looking. They are motivated currently as much by certainty of execution as by price, and reputational considerations have certainly become much more pertinent over the last two years. That has meant that bilateral transactions or transactions where there has been limited competition across our platform accounted for over 70 percent of deployment last year and that was a key shift for us in the last 12 months.
The second theme has been the ability to provide new money. Pre-covid our platform did very little primary or new money financing, but over the course of 2021 and into 2022 that has and will likely account for around 20-30 percent of our deployment. These transactions typically take the form of heavily structured, downside protected short-duration rescue finance deals or liquidity bridges and sometimes acquisition finance, in more complex, structurally challenged industries. The new money is more bridge-like in nature, an opportunity that has increased materially for our platform and for the market.
Can you talk about inflation and the impacts and opportunities that might create for the funds?
SZ: Before Russia’s invasion of Ukraine with its tragic consequences, there was significant inflationary pressure from supply chain disruption and that has been exacerbated by commodity inflation that we have experienced in the last couple of months. That extreme inflationary environment has led to increased interest rates and will likely lead to further rises over the short to medium term that could reduce economic activity.
The immediate impact is that financing costs are increasing for many companies and often those are companies that raised additional finance during covid to bridge liquidity gaps. So, they are going into this with pretty stretched balance sheets, which means that financing costs going up is likely to lead to increased default rates. Furthermore, those companies that don’t have pricing power are going to see margins squeezed.
Combining these points, we are going from a time of historically very low default rates of around 1-2 percent globally, into a period when default rates will likely rise to at least the high single digits.
From a portfolio perspective, we are generally well positioned for that environment because of our investment strategy. We generally buy into companies with significant hard asset value, recurring cashflow and/or pricing power, which is important in an inflationary environment.
The bulk of our portfolio is floating rate, so high interest rates should increase returns as long as companies can sustain margins, and most of our investment is at the top of the capital structure with low loans-to-value. That means we typically have a large margin of safety in terms of any financial underperformance, as evidenced during covid when we were able to be outward-focused because we didn’t have any significant problem assets in the portfolio. Our investment style proved highly durable.
The assets we focus on will more likely benefit from a high inflation environment, and if there is disruption or dislocation in the markets, we are very good at navigating those disrupted markets given our experience in the team.
How will the war in Ukraine and Russian sanctions impact the portfolio?
SZ: We have no direct exposure to the sad events unfolding in the region through the portfolio or through our investor base. We target the US and Western Europe and jurisdictions where both the legal and political regimes are ones that we can underwrite with certainty and have a high degree of confidence. That has led us not to be focused on emerging markets or countries with questionable legal frameworks and governance.
There are nevertheless many implications of the conflict, with the most obvious being the higher degree of uncertainty in markets. In an environment where investment banks have been aggressive underwriting leveraged finance products, that has created a more difficult backdrop for them to sell that risk down to the market. There is an opportunity to work with the banks to find solutions to those hung transactions and to provide capital solutions for companies finding it more difficult to access capital.
How do you integrate ESG into your strategy?
GG: ESG is something we have had as part of our investment process for some time. Over the course of 2021, we hired a dedicated ESG consultant to review our policy. We are a non-control debt investor, so we don’t have much influence on company decisions, but we evaluated our policy and put a renewed focus on how we make our investments and what we do within our platform.
In December, we became a signatory to the UN Principles for Responsible Investment and we are also certified as a carbon neutral plus organisation, which is important to us and our clients.
Often ESG is as much about the investments that we don’t do as the ones that we do. We will not invest where we think an industry doesn’t meet the principles that we are focused on and we put ESG considerations at the heart of our diligence processes.
For some time, we have incorporated ESG factors in our investment process. More recently, we have created an ESG committee, as well as a diversity and inclusion committee and a committee focused on charitable initiatives. Senior individuals are involved in both.