Special situations are emerging as a key fund focus in the 2023 mid-market, as managers respond to growing signs of distress driven by macroeconomic conditions.
Ed Testerman, a partner at New York-based fund manager King Street Capital Management, says there are many mid-market businesses whose debt service costs have doubled or more than doubled in the last 12 months due to the movement in base rates. Some, he says, have experienced “pretty severe” margin pressure from inflation and the inability to push through price rises.
“Many of those businesses are burning cash, and at the same time in leveraged loans there are over $100 billion of maturities coming due over the next two years,” he says. “So, there are problems that a lot of companies now all of a sudden have to address that weren’t present 12 to 18 months ago.”
The result is signs of a distressed debt opportunity for lenders and therefore a special situations opportunity for funds that can help solve that problem with a flexible source of capital. Testerman says the trick is to fund good businesses whose problems are temporary, rather than propping up the many challenged businesses seeking funding.
Europe has its own special set of constraints, according to Fabian Chrobog, the founder and chief investment officer of North Wall Capital, a London-based fund manager. “If you are a business experiencing a reduction in margin, temporary or otherwise, plus an increased cost of capital and the need to refinance, you are going to struggle in the current environment,” he says.
“At the same time, there is a reduction in the availability of capital from LPs driven by the denominator effect, which means opportunistic lenders are raising less capital and therefore have less capital to deploy to help solve problems.”
US funds are also retreating to exploit their home market, Chrobog says, further reducing the capital available to European borrowers in stress.
Chrysanth Herr, a partner at Triton Debt Opportunities, says that with a wall of maturities looming and the refinancing market still very challenging and expensive, if not closed, many companies are turning to lenders for extensions. “This creates exciting opportunities for us as an opportunistic credit fund, as more existing lenders become motivated sellers of their debt, typically commercial banks and CLOs,” he says.
“Commercial banks are starting to make some profits on their loan book again, given the rising interest rate environment, which gives them the ability to absorb the losses to sell to funds at a discount. CLOs are very much driven by ratings, and the weakened credit metrics are gradually leading to downgrades, which turns CLOs into motivated sellers,” he adds.
Christine Farquhar, global co-head of credit investment at Cambridge Associates, says this year is not so much about distressed strategies as opportunistic ones: “Managers who are nimble and flexible and good at picking up dislocations in public markets and getting involved in workouts for distressed sellers will do well. That has proven to be a good part of several managers’ strategies already and will continue to be a source of value in 2023 and 2024.”