A special situation

Investing in high yielding corporate credit has received a significant amount of attention from both institutional investors and their advisors in recent years. Capital allocators have been expanding their credit portfolios, seeking return across the capital structure and throughout the risk spectrum, encompassing both performing assets and the more distressed and stressed price end of the market.

Many early distressed allocators however have been left disappointed by the rate of capital deployment over recent years as the wave of bank selling predicted by many has so far failed to materialise. In such an environment, smaller and more nimble investors who are able to be flexible in their approach have benefited. Europe remains an opportunity. The current distressed
cycle is still playing out and the markets are already underwriting the next round of defaults.

With the ECB asset quality review set to publish its findings later this year, the need for banks to provide transparency on collateral may encourage future disposals. Also many older vintage European CLO funds are likely at some point to sell legacy distressed positions.

As multiple distressed managers with contrasting styles seek to capitalise, thinking small could provide investors access to the opportunity and returns they are looking for.

EUROPE – A CHALLENGE AND AN OPPORTUNITY

Europe’s slow emergence from recession and expected shallow growth trajectory will leave certain economies fragile. In contrast, most companies are in good health. The focus on cost control coupled to persistently low interest rates has enabled borrowers to strengthen their balance sheets and establish healthy liquidity levels. For a minority of companies however, the story is very different. A low level of demand has extended their earnings underperformance and continues to limit free cash flow generation.

Consequently, these highly leveraged companies struggle to service their debt obligations as they come due. During the period immediately following the financial crisis the solution for many issuers was for their owners and lenders to amend covenants in the hope that a company might stabilize and in time grow back into its capital structure; in essence, the solution was a “band aid” which failed to address the fundamental issue of excessive leverage.

With the debt now maturing this approach is much less likely to be implemented or accepted today. Indeed, in the current market environment for companies that are unable to access fresh capital, the inevitable and only solution is often a more material restructuring process.

It is evident that over half of the loan defaults which were recorded in Europe throughout 2013 were repeat offenders, having previously defaulted over the course of the last five years and then opting for a quick fix ‘amend and extend’ solution. Whilst the maturity wall itself was once the contested issue, the reality is that good companies have been able to attract capital and refinance leaving those with unmanageable balance sheets to face their issues.

This has left a high proportion of European loan debt maturing in 2014-2016 unable to access the markets and trading at a material discount to par. This is an opportunity for investors. Since the start of 2014 the European market has already seen a number of highly geared debt structures capitulate, as the debt has become too significant to manage.

In comparison to Europe, the U.S. economy looks to be gaining carry-forward momentum and is expected to see lower defaults. The sheer size and depth of the US market however, which remains a multiple of Europe in issuance terms, will provide investment opportunities on a selective basis.

A THRIVING MARKET IS TODAY LAYING THE PLATFORM FOR FUTURE DISTRESSED OPPORTUNITIES

In the current low rate environment, the search for returns has seen the high yield markets attract huge inflows of capital. Inevitably this has led to a weakening credit discipline and has allowed issuers to slowly stretch their corporate leverage multiples and drive less stringent structures. Recent statistics suggest that in 2013, average leverage multiples (debt to EBITDA) in European loans had risen to 4.7x for the year, regarded as the highest level recorded since 2009. With Q4 Statistics recently published, data suggests this trend is continuing with leverage multiples increasing to 5.17x for the final quarter alone. (Source: S&P LCD Euro Stats, Jan 14).

Such trends in European markets have been mirrored across the US, with a material step up in the volume of lower rated debt (CCC) issuance and PIK toggle instruments. S&P acknowledge that statistically those issuers that are rated CCC, have at least a 1 in 5 chance of defaulting within 12 months. (S&P 2012). With in excess of $220 billion (CS Leveraged Finance Review, 2013) of lower rated debt having been issued over the last 3 years, the markets have already underwritten the next wave of defaults. This may not unfold in the very near term but will underpin distressed supply as the next default cycle plays through.

EFFICIENT DEPLOYMENT OF CAPITAL

At Babson Capital, our approach to distressed investing mirrors how we operate across both our global and regional credit platforms. A selective value driven investment process with a focus around secured debt and underpinned by rigorous bottom-up credit research. We do not seek outright control and in fact often target value through taking up minority positions.

Operating relatively small funds allows us to effectively grow and exit positions through the secondary markets. This in turn enables us to efficiently deploy capital and has been key to the success of our distressed platform. Returns in our current strategy are tracking significantly above expectation today, with over 70% of the committed capital having been invested after a period of just 15 months.

We continue to favour situations in senior secured debt that we believe provide compelling risk-adjusted returns for our investors. The depth of Babson’s credit platform, the size of our team and our familiarity of operating in the sub-investment grade credit market gives us a unique lens across an unrivalled number of issuers. From this universe we seek to build highly selective and relatively concentrated pools targeting 20 to 30 investments, of our best distressed ideas.

Many of these ideas are, for a variety of reasons, not suited to the larger funds that need to deploy significant amounts of capital, but play to the strengths of those running smaller special situation strategies. With Europe only just out of recession and the current credit cycle providing ample opportunity today, investors will be rewarded for diversifying away from traditional distressed for control funds and partnering with specialist high yield managers.