With inflation at 30-year highs, interest rates rising, widespread supply chain disruption and the conflict in Ukraine, credit investors are lining up to capitalise on an economic slowdown putting corporate balance sheets under pressure.
But gone are the days of distressed credit funds simply buying up debt below par, taking over the equity and capturing value through a restructuring. With interest rates so low and government interventions forthcoming, the past decade has created few openings for traditional distressed strategies. What we see now is a new generation of opportunistic credit managers pursuing both public and private investments across geographies, sectors and asset classes.
A significant amount of investor capital has flowed into such strategies over the past three years, with Oaktree’s 11th opportunities fund the largest private debt fund ever raised when it closed at $16 billion in November 2021. Distressed private debt fundraising reached $45 billion in 2021 as the average fund size of distressed debt vehicles hit a 14-year high of $1.6 billion. The top five distressed debt funds in the market today are all looking to achieve fund sizes in excess of $4 billion, as they line up to target businesses hit by the current challenges.
Raphael Schorr, deputy chief investment officer and partner at HighVista Strategies, a global opportunistic credit investor pursuing a range of niche strategies, including distressed and special situations, says: “We generally expect deployment to distressed and special situations to closely mirror capital raising activity. With substantial capital having been raised for distressed and special situations, we expect to see significant capital deployment. This raises the question of how high-quality the deployment will be.”
Large buckets of capital
Distressed managers, bereft of failing companies in need of lucrative rescue financing, are now sitting on large buckets of capital that need to be put to work.
“In terms of recent geopolitical turbulence, we are able to position ourselves to take advantage of any shake-outs or distress that may emanate from the current conflict,” says Schorr.
“Although it remains too early to identify specific opportunities today, there could be a good number of situational distress and special situations opportunities in Europe given the current geopolitical disorder, uncertain outlook for energy supply, and limited ability for some of the sovereigns to provide the necessary liquidity and financing to struggling businesses and assets.”
Fabian Chrobog is the founder and chief investment officer at North Wall Capital, a provider of private capital to Western European special situations. He says: “This is the first crisis in a long time that is primarily a European crisis. The Ukraine conflict has led to a dislocation that will be most strongly felt in European markets, directly because of the security situation and more broadly because of the knock-on high energy prices, and the impact on consumer confidence.
“We are bound to see more distress in European businesses and increasing requirement for illiquid private capital to solve problems. Institutional investors in the US are going to look at Europe and attempt to figure out how best to participate and potentially benefit from the dislocation. This is one of these very rare environments where all eyes turn to this side of the Atlantic.”
Chrobog says that his firm is currently looking at opportunities in countries like Finland, where well-performing companies are experiencing “first-order dislocation events” simply because of their proximity to Russia. Likewise, he adds that there are many Western European companies with small exposure to Russia that have suffered disproportionately.
“It is also just more difficult for companies to raise capital full-stop,” he says. “And for small companies that don’t have access to capital markets we see an opportunity to step in.”
An agile approach
Many funds targeting special situations have learned the value of an agile approach over the past two years. At Tikehau Capital, the tactical strategies team is currently investing in the firm’s second special opportunities fund, which focuses on capital solutions rather than distressed mandates. Leveraging the expertise of the firm’s holistic platform, including its capital markets infrastructure, the team pivots between liquid and private markets and invests across the entire capital structure into performing and non-performing loans.
“That agility has proved key,” says Maxime Laurent-Bellue, head of tactical strategies at Tikehau Capital. “In 2020, the market window and opportunity set in the liquid distressed secondaries space was much shorter than anticipated and we needed to be quick to deploy capital. When that closed, we pivoted into a more private strategy doing more flexible capital solutions.”
Stephen Escudier, partner and co-head of credit opportunities at Bridgepoint Credit in New York, says: “Back in the first half of 2020, when covid hit, the best risk return opportunity was definitely in the secondary market. We could buy senior secured term loans in the seventies and eighties, so we took those opportunities before the markets returned to par very quickly. Now the pendulum is swinging again and it looks likely there will be more opportunity in the secondary market later this year.”
His team focuses on creative capital and premium direct origination of good quality companies that have a reason to exist and where they can add value. “If you’re a special sits fund, your target returns are probably low to mid-teens. You can’t find that in the secondary market all the time, so then you look to the primary space, where you can still get a premium for complexity, for structure, and for illiquidity,” says Escudier. “That’s where we are focused and there is no secret to it. Maybe you take a little bit more leverage, or accept a higher loan-to-value, or take strips of equity.”
What comes next?
What will happen next as the current macroeconomic and geopolitical tensions play out is the big question for opportunistic credit players. Victor Khosla, founder and chief investment officer at SVPGlobal, says: “There was a strong cycle created in 2020 with covid. Generally, these cycles are two to four years long, and this cycle and the opportunities created were starting to wind down. Now, with inflation and central banks’ reaction, as well as the war in Ukraine, the cycle has been extended.
“We do not believe this creates a recession in the US. Neither do we think there is one in the EU, although Europe is much more vulnerable. We do not expect a brand-new cycle but expect there will be more volatility and more opportunities.”
All of the top 10 distressed funds raised in the last three years have been headquartered in the US, while only two of the biggest funds currently in the market are run by European managers. UK-based LCM Partners is currently targeting $4.4 billion for LCM Credit Opportunities 4, while Kildare Partners is looking to raise $2 billion for Kildare European Partners III.
Nicolas Motelay, managing partner at placement agent New End Associates and a former managing director with Oaktree Capital, says: “Distressed and special situations has long been viewed by European investors as a US asset class. Most of the European players have tended to be sector or country specific because the variety of legal systems throughout Europe has made that an expensive strategy to run. There is a natural market for special sits and distressed in the US versus any other place in the world.”
The latest crisis will put Europe in the spotlight and, as managers increasingly broaden their approach away from distressed and into more agile opportunistic credit strategies, the window may open for more players.
North Wall has raised €1 billion since inception in 2017, and is preparing to start deploying capital from the second vintage of its European Opportunities strategy.
Chrobog says: “A lot of the distressed money that was raised during and after covid requires distress to take place within big capital structures to enable deployment of big tickets. We are not seeing that yet. Our view is that the secondary distressed market is a market opportunity, not an asset class, so those investors will have to continue to wait. We focus on complex investments in the mid-market and we are optimistic about both the investment climate for what we do and the fundraising environment. We have never been busier than we are today.”
The distressed debt opportunity may have got more nuanced, but there are plenty on the side lines ready with flexible strategies to capitalise on a market upset.
Is current dislocation just the beginning?
Raphael Schorr of HighVista Strategies argues that the current dislocation may just be the beginning.
“A sharp factor that clearly stands apart from prior cycles is the quantum of capital and the breadth of capital that has been raised for distressed investing. We have seen a lot of capital being targeted to traditional areas, including US corporate distress, but we have also seen capital flowing into other areas such as distressed Chinese property,” he says.
HighVista Strategies is finding opportunities in “idiosyncratically stressed” areas, driven by micro rather than macroeconomics, such as foreign medical school loans, which trade at wide discounts to US medical school loans but have a similar credit risk.
“From a geographic perspective, the US remains a primary focus for our strategy, with an opportunistic focus on Europe,” says Schorr. “The US has been competitive but with shifts in the inflation and interest rate paradigm, the opportunity set may open up. Europe has been consistently fertile and appears to be becoming more so given geopolitical tensions.”