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How is the prospect of a downturn in 2020 impacting the special situations space across Europe?

Jaime Prieto
Jaime Prieto

Whether driven by coronavirus or some other event, we would have at a given point in 2020 or 2021 found that the weaker credits in the markets would have suddenly raised their hands in a search for liquidity. When that starts, it could quickly trickle down through the market and we could see prices in the secondary market drop significantly.

Coronavirus has been a trigger but, overall, we think the impact in the leveraged loan market will be moderate. We don’t expect this to be sustained over many years and there are good equity cushions in the market generally but there are certainly some sectors and some credits where even a moderate impact on liquidity will be an issue.

One of the interesting dynamics we’ve observed this time, compared to maybe eight years ago, is that companies do not appear on the radar as poor-performing credits until they need cash. When they do raise their hands in search of a solution, the typical actors around the table are not the ones that might have been there before. Funds will be a lot more relevant than they have been in the past.

The way we are trying to play that is by trying to get some exposure into the deals before they actually hit liquidity issues, maybe when the CLOs decide to sell at 85 cents in the dollar. When the companies really ask for liquidity, prices can drop to 60 or 70 cents, but you need to have some initial early preference so people around the table know you, then you can more effectively provide a solution. If we want to lead, we need to be a bit earlier into that game, even if it means paying a little more.

Where are the opportunities in special situations in Europe at the moment?

In the UK, we’re seeing a good number of these opportunities. The UK was the first market to recover from the crisis, together with Germany, and was the market that attracted the most competition. So, the UK is currently a good source of deals, because of course there has also been Brexit on top of that. Otherwise, there are some industries suffering more than others, including some of the cyclical industries that the German economy is exposed to. France has always been a good market for us, in good times and bad. In Spain, we continue to have good exposure because we were early entrants post-crisis; that has helped us build a solid reputation as a constructive problem solver, even when the economy is doing well.

It has been a really long cycle and for us that creates an opportunity. The issue from our point of view is more the industries that are cyclical but are also undergoing some kind of technological disruption. That can be a downturn from which they will not recover. An economic downturn may be something that we can help companies go through, but there are going to be some cases where we won’t be the solution and we need to make sure we avoid going into those circumstances.

Excluding coronavirus, the economies in Europe are not doing bad. In this kind of environment, companies with a lack of adequate management focus or very fast growth may find themselves in a difficult situation that can be solved. That can happen in any sector, industry or geography regardless of the macroeconomic environment, and is a consequence of years of easy liquidity.

What is the current level of investor interest in special situations as an asset class?

There has been increased interest in special situations for some time but on the back of quite a bit of frustration around the shortage of special situations or distressed opportunities. For a long time, investors have been told what’s going to happen because of weak credit documentation, but when they go into distressed funds there is an absence of really strong deal opportunities. This has led funds to either take too much risk or find themselves unable to deploy capital at the pace they had anticipated.

“Managers need a bit of a traders’ mentality in order to time the markets effectively”

In our case, we provide both special situations and distressed in the secondary market but also via the primary markets. We’ve been able to show we can invest in both good and bad times. We may not be generating 25-30 percent returns, but we are consistently generating returns in the mid-teens across the cycle, which investors appreciate. You can do this at the lower end of the mid-market, which is less competitive.

Today, there’s investor appetite for special situations, but you need to provide an investment thesis that allows you to invest even if the distressed cycle is not there. We will see what coronavirus does to the whole story, but it’s going to play into the hands of experienced investors that can take advantage of these situations and have the capabilities to support management teams, not only financially but also operationally.

There has already been a lot of fundraising for special situations. Is there a lot of competition now in Europe? How can managers stand out in the space?

There is competition, but it’s really concentrated on funds that are looking to be opportunistic in the secondaries space. Most of them are based out of London and many have direct lending or CLO management capabilities and are now marketing special situations funds.

If your ambition is to be opportunistic, that’s a good complementary strategy, but if you want to be leading solutions it may not be enough to have a couple of people to drive that. Having the ability to build a comprehensive solution requires the ability to source deals locally to avoid competition. Investors appreciate that and they are looking for funds with local sourcing capabilities, the ability to invest in both the primary and the secondary markets and a proven track record across the cycle.

Managers need a bit of a traders’ mentality in order to time the markets effectively. If you have a local sourcing network, you also need to be able to perform your due diligence to build the structure into deals that offers protection but also provides upside. You also need people on your team with experience of working out the tougher situations, whether by supporting management teams or driving financial restructuring. In many jurisdictions, that capability needs to have been tested in a number of crises.

How would you sum up the outlook for special situations in the next 12 months?

It is probably the most favourable market that we have seen over the last four to five years. The economy is going to be suffering a little, but from a technical point of the view the markets are going to result in special situations funds being part of the solution in many of these situations. We feel the conditions are there for special situations funds to be pretty optimistic about the year ahead.