The classic “distressed for control” strategy, aka vulture investing, may have largely gone the way of music’s compact discs, but the collapse of two tech lenders amid a looming recession brought on by a steep and rapid rise in interest rates, high leverage and low loan documentation, could well bring it back into vogue in the US.
As PDI pointed out last summer, although the fund designation “distressed” has lately been supplanted by such terms as opportunistic, special situations and capital solutions, the underlying principle of providing capital to companies experiencing some sort of stress, price dislocation, or situational need for financing, is alive and well – and some say could represent a $500 billion to more than $1 trillion opportunity over the next few years.
“With quantitative tightening continuing at a pace of $1 trillion of liquidity to be withdrawn from the system in 2023, and further Fed fund hikes ahead,” Silicon Valley Bank and Signature Bank, whose depositors are being bailed out by the US Federal Reserve, probably will not be the last of the liquidity and funding victims of 2023, wrote Charles Peabody, a partner at research firm Portales Partners, on the heels of SVB’s collapse in mid-March.
“The Goldilocks environment created by unending central bank intervention with no consequence for the past 15 years is one we will look back on as unique in history and not to be repeated,” says Ray Costa, a managing director of Benefit Street Partners. “We will have a recession,” Costa says. “The only question is how long and deep will it be.”
He likens the current period to the late 1990s leading up to the global financial crisis in 2008, when capital had a real cost and economic cycles evolved more naturally.
Others, like Adam Schneider, an independent banking consultant in New York, says the situation with the collapsed banks resembles that of the savings and loan crisis in the 1980s, although much faster. In both cases, banks put their deposits to work in assets that fell in value; in the savings and loan crisis, resolution took months or years to work out, but today, with “flash mob runs on the bank”, given both the speed of communications and the concentration of deposits over the FDIC insurance limit, any such problem can manifest at warp speed.
Some believe the liquidity crunch that is now unfolding will be a boon for vulture investors doing very aggressive deals. Indeed, even before the collapse of the two tech-focused banks, deep-pocketed lenders were picking up loan assets on the cheap. David Conrod, co-founder and chief executive of FocusPoint Private Capital Group, notes that a client he is raising capital for recently bought $150 million of debt for $4 million, or five cents on the dollar.
Already, the Fed’s relentless tightening regime has put enormous pressure on many portfolio companies. Conrod relates that someone from a $10 billion private equity firm told him at a Christmas party that interest expense across the firm’s portfolio had risen by a whopping $700 million.
“We will have a recession. The only question is how long and deep will it be”
Benefit Street Partners
More such scenarios are likely to come to light in April, when fund managers begin to report their audited fourth-quarter financials. Pain is already evident in deals that are currently being negotiated. For instance, Conrod is raising capital for a growth equity fund that is looking at buying the debt of a private equity-backed company for 60 cents on the dollar. The portfolio company, in which the PE firm invested $300 million, still trades at a lofty 14 times earnings. Although the PE firm is carrying the investment at cost, Conrod says it will be forced to mark its equity in the company to zero.
So much for the relatively muted period of defaults that some are predicting. Moreover, the economic backdrop will be quite different from the kind of brief shocks that have characterised the past 15 years since the global financial crisis – including the Greek debt and euro crisis of 2011, the commodity and China crisis of 2015, and the covid-induced swoon of 2020. Those jarring events likely will be followed by a more prolonged economic cycle that is expected to take several years to play out.
The market seems to be only starting to catch up to that view. “We’ve moved from the market saying ‘a hurricane is coming’ and ‘the sky is falling’, when the rate hike cycle started, to a ‘soft landing or no landing’ outlook,” says Jason Friedman, partner and global head of business development at Marathon Asset Management, whose bread-and-butter strategy is capital solutions to underperforming businesses. He notes that part of the reason for complacency is that the default rate has remained at historically low levels of 1-1.5 percent, which people have come to accept as the norm.
That is about to change, with Marathon looking for a more traditional default rate of 3 to 5 percent. Friedman notes that there is typically a lag of 12-18 months for contractionary rate policies to flow through the economy. Because many companies were able to lock in relatively low rates for most of last year, he expects that we will not begin to really see the effects of higher interest costs until the end of the second quarter.
Moody’s Investors Service said that fourth-quarter defaults doubled from the previous quarter, and that more than 70 percent of the defaulted debt was leveraged loans restructured out of bankruptcy. Moreover, nearly all the loan defaulters had a private equity sponsor, and the share of PE-backed companies with the weakest liquidity is more than double that of companies without a PE sponsor. In a January report, Moody’s was predicting that 12-month trailing defaults would approach nearly 6 percent by year end, above the long-term average of 4.7 percent from a still low 2 percent at the time.
Given that interest rates had only begun to tighten early last year, the picture could be vastly different this year.
“Despite the significant market volatility, the overall repricing of risk assets was fairly orderly in 2022 as the discount rate increased,” says John Pavelski, managing director and co-head of North America for Carlyle’s credit opportunities business. “Going forward, we think the opportunity set will increase further as, with high leverage and valuations, many balance sheets aren’t built for five percent base rates.”
Indeed, Pavelski points out that in September 2021 the two-year Treasury was trading at a mere 21 basis points. Today, it approximates 5 percent, and continues to exceed that of the 10-year Treasury. “The slope of the line has been dramatic, and I don’t think the impact of that has fully reverberated through the economy.”
Although Fitch is forecasting a default rate of 2.5-3 percent on loans broadly, “the default rate on middle-market loans could be higher”, says Lyle Margolis, head of private credit at Fitch. That is because the interest rate spike will hit that part of the market more, as loans are floating rate and often unhedged. “We could see a near doubling of interest expense for companies that are already operating at pretty thin free cashflow margins.”
Because the Fed had to resort to extraordinary measures of making uninsured depositors at SVB and Signature Bank whole to stem a panic, bank financing is likely to be further constricted, likely opening up more opportunities for deep-pocketed distressed lenders. Portales Partners’ Peabody expects that hundreds of community banks could fail during 2024 and 2025, which could present further opportunities for private lenders.
“This is really the continued evolution of the private debt market – the intersection of private credit and stressed investing,” says Carlyle’s Pavelski. “We can be a solutions provider in scale to companies who may not have access to ‘regular way’ capital markets.”