Why ‘distress’ does not always equal ‘risk’

This article is sponsored by Kartesia Capital

Distressed debt and special situations include a variety of deal types. How do you define these?

Our fund is set up to cover the whole economic cycle. We tend to look at distressed and special situations as a way of offering solutions to good businesses where the seller is distressed or stressed, or where there are “tired” creditors. There are points in the cycle where you see solid companies that are facing difficulties because of economic or industry issues and where their existing lenders may be also be facing difficulties or they simply need liquidity. That might include non-core loan sales by banks or CLOs. We’re not an aggressive loan-to-own investor. Rather, we see ourselves as offering assistance to companies to get them through the credit cycle into better times – that’s about 50 percent of what we do.

What do you mean by “tired” creditors?

These are classic special situations. Here, you’d have a business that isn’t performing to its original business plan perhaps because the industry is going through a tough point in the cycle. The business may have required covenant resets from lenders and had to renegotiate with sponsors, but they are not basket cases. Often, these companies can sit on lenders’ balance sheets for years not really going anywhere, even though they have solid potential for growth. That’s often because the business has been subject to increasing constraints through the request for waivers, etc. We can offer these companies and their lenders a way out through new debt structures.

Where are you seeing most opportunity in these spaces?

When we started out, we saw these across the board. In 2009 to 2012, there was a lot of opportunity buying from lenders that needed to exit certain geographies. From 2013 to 2017, most of the deals we saw were in France and Spain and, to a lesser extent, Germany.

However, over the past year, we’ve seen a lot of opportunity emerge in the UK and it’s now a clear focus for us. We’ve seen a change in the cycle following the extended recovery from the financial crisis. UK businesses have been subject to increases in tax, rates and salaries, many have been hit by the weakening of sterling and many companies have high leverage. Brexit has exacerbated and amplified many of these factors, with some sectors affected more than others. You now have a base of lenders with a big exposure to the UK and are looking to reduce that as they realise the market is going through an inflexion point. We’re looking to provide them with liquidity and offer support to the businesses concerned.

If you’re looking for solid businesses, does that mean there are parts of the economy that you actively avoid?

There are certain sectors of the UK economy that have suffered more than most – retail and dining chains are among these. They attracted high amounts of capital over the past decade or so, which means they became highly competitive and so haven’t been able to weather the increased rates, higher staff costs and effects of Brexit well.

This has been compounded by – in retail in particular – the impact of technology. It’s uncertain how the shift to online shopping will play out. They also have high fixed cost structures and so tend to perform poorly in challenging consumer conditions. They present binary risk and that’s not something we are looking to get into.

How do you view and mitigate risk in distressed and special situations?

We don’t see these deals as inherently riskier. We see them as an opportunity to improve returns without increasing risk. After all, these tend to be deals completed away from highly competitive segments of the market – areas I’d argue are pretty risky. We have the ability to complete primary and secondary deals across European markets so that we can construct deals with low risk but high upside potential.

Are these opportunities always sponsored, or is there scope for non-sponsored deals too?

We can do both and it really depends on the market structure as to which type of deal is predominant. In the UK, for example, there is an abundance of sponsored special situations because the market has seen a lot of private equity activity. In France, it’s about 50-50 sponsored to non-sponsored, while in Spain, deals are mainly sponsorless – here, the economic downturn was so severe that corporate loans were still emerging as a good opportunity for us even seven years after the crisis. The sponsorless market is less competitive because it tends to be far more complex than sponsored special situations. Sponsored deals tend to carry a far lower degree of complexity, they are more transparent and easier to execute. There are advantages and disadvantages to both.

How can these deals be originated?

It takes a lot of legwork, particularly at the outset. So, you have to get to know the secondary trading desks at banks, cold-call sponsors and CLO managers. That’s what we did in the early days to get the word out that we were looking to offer them liquidity. So, you have to address the lending market, but you also have to get to know the intermediaries because, even if you approach a lender directly, they’ll often run a process using advisers to ensure they are getting the best price. Companies themselves also use the intermediaries for financial advice. Small independent advisors tend to be a good source of dealflow for us.

Distressed and special situations are largely seen a cyclical strategy. To what extent are you expecting an uptick in this type of dealflow in the short to medium term?

The availability of these opportunities is inherently cyclical, although that doesn’t mean there aren’t deals to be done in less challenging times. There are always businesses that underperform because of industry shifts or as a result of specific conditions within the business and there are always lenders looking for liquidity.

Currently, we’re seeing a more challenging outlook across Europe. There are certain headwinds as economic growth has slowed and you have developments such as the rise of populism. Until recently, there were tailwinds in Europe stemming from the catch-up following the financial crisis, but these have now diminished in major economies, including Germany. We’re getting to a stage where we’ll see more distressed and special situations – probably over the next three years. I don’t think the downturn will be as deep as that of 2008 to 2011, but we will still feel it.

The UK’s economy may be uniquely affected by Brexit, but it is an early indicator of more challenging times in continental Europe. Germany is seeing slower growth and France continues to offer opportunities – the overall economy has only grown at around 1 percent for some time.

Do you think we’ll see more distressed credit funds raised in that case?

We may do, but the issue for LPs is that they can’t really time the markets if they wait for evidence in the change of the cycle. There has been a lot of capital directed at pure direct lending strategies because the M&A markets have been very attractive. Yet when the cycle changes, there may well be an element of shock – LPs may not want to deploy capital for some time and then when they decide to resume commitments, perhaps into distressed strategies, it may be too late. Funds raised may not be invested until a year or more after close, by which time, many of the attractive opportunities will have been snapped up.

That’s why our strategy is designed to take advantage of highs and lows in the credit cycle. It’s also why we have the direct lending and restructuring people in the same teams. Clearly, you need restructuring and structuring expertise across the different European jurisdictions, but you also need teams that understand how to restructure – you need to ensure your people are trained throughout the cycle – so that you are ready and well equipped when these opportunities emerge.