‘Complex to understand and difficult to put in place’

Special situations strategies can offer high returns but also involve a lot of spadework. Jaime Prieto of Kartesia explains how such deals can be made to work

What does special situations mean to you?

There are myriad definitions. In general it refers to investors in equity or debt, or a combination of the two, looking for returns in the mid- to high-teens. For us, it involves buying debt from existing lenders, either totally or partially, and simultaneously reaching agreement on the provision of additional liquidity facilities for the company and the renegotiation of the terms of the debt.

Do you think it’s a strategy that is well understood by investors?

It takes a lot of explanation. Investment managers have a myriad of definitions of special situations and it can simply come down to anything that can’t be classified according to their existing buckets. Any investment fund with a unique way of approaching the market may be  seen as special situations and it will take some explanation. When we go to an LP with this theme, some put us in a special situation bucket but others have a bucket for it already. Some have existing buckets that are fully allocated so they’ll just put us elsewhere. My experience is that LPs will place us in the special situations bucket because of the return profile rather than the risk profile.

How do you evaluate the risk/return to make sure deals make sense?

The big question for us is how we exit these situations, as exit is often the biggest risk. You can’t count on the exit as a refinancing or even as a sale. Some of these businesses may have a tainted aspect because they have taken too long to achieve their business plan. We get into them at good leverage multiples so that’s ok but the tainted aspect limits the ability to achieve upside potential.

When we compare ourselves with others, we are more focused on downside protection. We don’t need to stretch to the 20 percent-plus returns which fit with some LP buckets. We prefer not to increase the risk to that level.

What are the keys to successfully originating these kinds of deals?

Trust is definitely a big factor, and having the credibility that people know we will actually deliver. These deals involve agreement by different parties and all the parties need to be assured that they have a credible partner. Are you sufficiently flexible that you can accommodate a deal that works for everyone? The best outcome for us is not necessarily the best outcome for everyone.

It’s essential to have done secondary trading in the market because for sponsors and management teams working with an investor that has done deals with most of the European banks assures them that we can make deals happen. And the banks know we’re not a party that will seek to create value through distressed-for-control.

Also important is the ability to put in additional capital and improve performance and share the value creation benefit. To get to the sponsors and management teams you need good relationships with advisers and a good knowledge of the secondary markets.

How much operational/advisory input do you have?

These are consensual deals where all the parties know what will happen on day one. We spend a lot of time with the sponsors determining how we’re going to create value. We learn about the business and we come with a fresh approach to the business which in itself creates value. The deal may have been in place for between three to six years and all the focus has been on the downside rather than the upside, so coming in with a fresh perspective on the upside is tremendously valuable.

We are very involved in the deals we do. We meet the companies every month and go for dinner twice a year with management. Mistrust can be generated when things go wrong but things can be contained when you are close to management.

Do you think special situations will be a growing theme in private debt?

I think so but as soon as a special situations strategy becomes common then it stops being a special situation and becomes a new bucket. Direct lending was arguably a special situation once as you could have got a mid-teens return five to seven years ago. Special situations will continue to be a good source of strategies that could become mainstream – almost like an incubator of ideas.

One of the keys to what we do is that we are not taking more risk than a direct lender would take. In sponsor portfolios there are companies that are growing at around 1 percent and they’re not awful companies by any means but they will end up breaching covenants and the banks will decide not to support them going forward and they will not be able to deliver on their full potential. There’s a place for someone like us to come in at the senior debt level and replace the bank and extend the maturities.

Jaime Prieto is a founding partner of Kartesia, a London-based European investment firm