Kartesia: European opportunistic credit is seeing a structural shift

This article is sponsored by Kartesia

What was your experience of covid-19? Were you able to find good deals amid the market volatility?

As the covid pandemic illustrated, opportunistic credit can sometimes be little more than an illusion. In the early months of 2020, a rash of dislocation funds were raised to take advantage of markets that had effectively frozen up.

The 2020 dislocation, though, was rather a short-lived one. At the moment it feels like a longer-lasting distressed opportunity is building. The challenging backdrop for companies is unlikely to abate any time soon – and, as the months and years go by, the pressure on corporate balance sheets will continue to grow. We need to get used to this new world.

The covid crisis was, of course, very brutal. It was totally unexpected. At the beginning of 2020, nobody knew how companies would adapt and it wasn’t clear what kind of support companies would receive from public authorities. Investors were forced to sell in the secondary market at deeply discounted pricing because very few people were happy to take the risk of the unknown.

But this was not a very long crisis. It probably lasted no more a few months. After that markets started to see a way out of it. Certain public authorities provided more support to the economy than others, but by the end of the year the liquidity crisis that everybody had been fearing was more or less under control. Markets rallied and prices went up, while interest rates stayed very low.

We managed to finance some very good transactions in 2020, but the available deals on offer were fairly limited from a financing point of view. As we pull away from the crisis, we have noticed a structural shift in markets, which is beginning to present new opportunities for private debt investment.

What are the main differences in the market vis-à-vis before covid?

The major difference is where interest rates are. This has totally changed the lending world.

Higher interest rates have a massive impact on interest coverage ratios and the amount of leverage people are prepared to put on. When we were living with very low or even negative base rates, leverage remained quite high in the mid to large market and was not really a key focus area.

Now, companies are increasingly facing issues with their interest coverage ratios, which can have a major impact on valuations. Leverage levels simply have to fall, especially since very few companies have hedged their interest rates over the last years. Many considered it too expensive to do so and didn’t really see the need. Now such companies are trapped by very high interest rates and existing portfolios will suffer because of this.

We have been encouraging companies to hedge their interest rate exposure. I would say that the vast majority of borrowers that we spoke to listened to us and understood that some form of interest rate hedging made sense. As a result, many of our portfolios are now shielded from interest rate rises. The same is not true of the global private debt markets, though, and firms continue to suffer a lot because of this.

As the markets adjust to this new world, what does it mean for companies looking to raise funds?

Fundraising is tougher than it was before the covid pandemic. The ongoing war in Europe, rising inflation and the denominator effect have led to a number of private debt funds pulling back from the market.

“As markets evolve, our LPs expect us to reprice our investments. We find that we can increase our pricing while maintaining same level of risk”

The rising likelihood of defaults is also a problem. This might not be immediately obvious, largely because a lack of covenants in mid-to-large cap transactions makes it hard to see what is really going on, but defaults will come. Funds that have not been disciplined when it comes to documentation, leverage and covenants will suffer the most.

This is making lenders extremely cautious about deploying capital, because they want to make sure they fund the right transaction. This hesitancy will lead to a massive increase in the imbalance between supply and demand, especially in the lower end of the market, where competition was already less acute.

On top of this, the retrenchment of banks, which has already been much talked about, continues, and may even accelerate as rising defaults make them even more wary of the market. Rising interest rates means that they can now generate decent profits from less risky business.

I’m not saying that banks don’t do any transactions, of course. They continue to support the customers that they know and like. But they’re now very cautious in terms of leverage and in executing new deals. They don’t want to take on any underwriting risk. This makes them much slower to embrace new business. In the current environment, they prefer to deal with current relationships.

Banks will stay fairly risk averse and concentrate on where they can make money without exposing themselves too much to the dangers of defaults.

You mentioned the ‘denominator effect’ as one of the key reasons many lenders have pulled back. How has such a portfolio imbalance contributed to market retrenchment – and why is there now such an imbalance?

In many cases the proportion of alternative assets within investors’ portfolios has increased beyond the limits that have been established under investment mandates. As public markets have decreased, the overall value of the portfolio has fallen as well. But this has mostly happened in the listed space and not for alternative investments. As a result, some funds are now hitting their limits for alternative investments.

Valuing public investments is very easy. You simply take the listed price of bonds or shares. Any correction is instantly reflected in the valuation. Valuing alternative investments, on the other hand, is somewhat trickier. These investments tend to be valued according to “FMV”, which is not a perfect science and usually involves a delay before changes in asset prices are fully reflected. This is what is causing the portfolio imbalance.

Let’s say, for example, that a fund was allowed to invest up to 10 percent of its portfolio in alternatives. As market valuations have shifted, this fund may now find itself with a 15 percent or 20 percent allocation instead.

Investors that are no longer within the limits of their mandate are likely to wait for six months or a year before committing to any new alternative investments.

What does this mean for opportunities within the credit markets?

As you can imagine, companies still need financing but now they have more of a limited choice as to where to go. This supply-and-demand imbalance will continue going forward.

In the primary market, reduced competition is being translated into reduced leverage and better pricing. As markets evolve, our LPs expect us to reprice our investments. We find that we can increase our pricing while maintaining the same level of risk.

“Given current refinancing uncertainty, many firms are keen to ask for an extension of the loan. Some lenders are tired of this. They just want to sell down the exposure and exit the credit. In such cases we are ready to step into the shoes”

In the secondary market, opportunities are also starting to emerge, especially in the more illiquid end, which is where we tend to focus.

However, we are still waiting for the full potential of this market to materialise. We have executed a few attractive transactions in the secondary market, in cases where we saw that the risk-return was adequate, but we expect much more activity to take place towards the end of the year. This is a key period for banks and forced sellers.

When we started Kartesia in 2013, the vast majority of our investments were in the secondary market, which was fairly dislocated at that time. However, we eventually shifted to the primary markets because secondary prices were not attractive enough.

Now, with the secondary market starting to come back, we will be trying to find some sort of balance between the primary and secondary transactions that we do.

Why is the secondary market starting to build momentum?

Many companies made use of state-backed loans during the covid-19 pandemic, and these loans will eventually have to be repaid. Given current refinancing uncertainty, many firms are keen to ask for an extension of the loan. Some lenders are tired of this. They just want to sell down the exposure and exit the credit. In such cases we are ready to step into the shoes. We can live with a maturity extension because we are new lenders. Sometimes a portion of this debt, especially the junior debt, has to be converted into equity. We can provide any necessary restructuring and extend maturities to three, four or five years.

We buy these loans at a discount, reflecting the fact that there are very few buyers in the illiquid secondary market for lower-to-mid-cap transactions. On top of this illiquidity premium, we are also able to attach other fees for agreeing to extend maturities.

How do you see opportunistic credit evolving over the next couple of years?

We expect the fundraising momentum to improve in the coming months for top performing funds and opportunities in the credit market to increase. We run an all-weather investment fund. We like complexity. We like volatility. The more volatile and the more complex markets are, the better off we are.

In the lower end of the mid-market, which is our core market, we have far less competition than in the mid to large market where 40 to 60 funds can be approached for one single deal. That’s why our performance was much better in terms of returns.

To succeed in this market you need to be local. You cannot simply operate from a central investment hub in London. It just doesn’t work. We have eight offices across Europe, with investment teams in each of these countries. This makes a huge difference.