Guest comment by Amyn Pesnani
As we face shorter days and colder, wetter weather, many of us will be ensuring our winter coats are on before leaving the house. Some others might reach for a scarf and gloves. Even fewer still may take an umbrella, just in case – preparing for a storm. It’s those few who consider all outcomes that will be best prepared for the challenges a gloomy day may bring.
Investing in European corporate credit has rarely been as challenging as it is today. Separating the business fundamentals from the noise of macroeconomic uncertainty is increasingly difficult.
Facing the very real prospect of recession in many parts of Europe, picking the right companies to invest in is more crucial than ever. There are several ways to successfully invest in corporate credit when faced with complex market conditions. We believe one of the most effective is backing companies which are structurally sound but are experiencing cyclical headwinds. In practice, this means buying into the debt of companies at a discount, before exiting when its intrinsic value and quality shows through.
More importantly, we believe the key to investing in such challenging circumstances, and on the precipice of potential recession in much of Europe, is downside protection. Investors must be disciplined in their weighing up of returns and safety as we come to terms with the prospect of a multi-year downturn. Portfolios must be tested and bolstered now, long before the storm itself arrives.
While studying past data can never guarantee downside protection in the future, it is essential to conduct rigorous due diligence and detailed stress testing through robust modelling of real and potential downturn scenarios. Let’s take some consumer businesses as examples – a particularly tricky sector in which to invest in today’s inflationary environment. When we studied a gym chain, we looked at membership data across past recessions, including 2008, 2000 and the 1990s. However, we felt it necessary to take this further, developing worse-case scenarios by doubling and tripling those declines in membership. Only then were we comfortable with the level of stress testing to make an investment decision.
Another good example of this approach in action came from a private label foods business. Yes, consumers tend to trade down in recessionary environments and private label manufacturers tend to benefit. However, we were not comfortable with simply accepting a sector-wide assumption and, therefore, modelled declining sales, rather than increasing sales. Unlike past downturns, it is important to factor in and account for the unprecedented input cost inflation that such companies are experiencing. While no guarantee of downside protection, this degree of stress testing is what investors require to make the most informed investment decisions in market downturns.
Assessing opportunities from multiple angles can complement the decision-making process. Larger, multi-strategy firms often benefit from the insights and perspectives of both equity and debt investors. For example, ownership of an online package holidays business via our private equity strategy, including during its recovery in the aftermath of the pandemic, helped contextualise potential credit investments that we analysed in the travel and leisure space this year.
Capital structure & entry price
Credit selection is just one piece in the puzzle for investors seeking downside protection. Other key factors include your position in the capital structure and your entry price. To weather the coming storm, some investors are prioritising credits at the top of the structure. Those who did the preparatory work to construct a robust portfolio before the most challenging conditions arrived have been able to focus on deployment. For Triton, 90 percent of our latest fund is now first lien, and 2022 was our busiest ever period as more and more fundamentally good companies began to experience short-term issues. Equally as important, of course, is entry price – reducing leverage at entry and increasing entry price on the dollar needs to have been part of investors’ playbooks since as early as 2020.
European corporate credit investors have performed well since the pandemic; responsible managers should not expect to enjoy such returns consistently in a downturn, and those that look to instead insulate their investors with downside protection will benefit over the coming years.
Lowering risk through pricing and moving up the capital structure can only achieve so much. Unless you are a distressed specialist, investing in the debt of companies which struggle and fail as conditions worsen is problematic. Being able to differentiate between fundamentally solid businesses from those that won’t weather the coming recession, therefore, remains crucial for credit investors.
Where we sit, the answer seems to be to always look beyond the base case; to the downside case, the 2008 case, and even the “Armageddon case”. We always take an umbrella with us. That’s the level of certainty around downside protection that investors should seek, to help inform how to pick out a sound business from a challenged industry.
Amyn Pesnani is the Head of Triton Debt Opportunities, the opportunistic credit strategy of European investment firm Triton Partners.