This article is sponsored by RBC BlueBay Asset Management
How is today’s macro environment impacting corporates?
Corporates are facing a perfect storm. Most companies in the high-yield bond, leveraged loan and public credit markets went into covid with higher levels of debt than had been the norm for the preceding few decades. They then had to borrow more money to survive, which led to whole sectors emerging from the pandemic not only highly leveraged, but also with a decreased ability to make money because the world they were operating in had changed.
Cinemas provide a great example. When cinemas closed due to lockdowns, people turned to streaming services and the rebound in attendance has been slow. Most cinema chains globally are only at around 65-70 percent of 2019 attendance levels. Some are doing a good job of making more money out of the people that are going by charging higher prices and selling more food and drink. Nonetheless, a number of major cinema companies are restructuring.
In addition to higher leverage and a reduced ability to make profit, there have been extreme supply-chain disruptions, which have had a particularly acute effect on manufacturing companies. This disruption is abating but it has not gone away altogether. Then, of course, we are moving from a 30- year secular decline in interest rates into something that, in a long-term context, looks more normalised. The market is currently pricing US terminal rates at something like 5.5 percent. When you factor in higher leverage, increased interest rates can clearly cause issues.
Finally, I would point to war on the edge of Europe, which is having both micro and macro effects. From a micro perspective, many companies had operations in Eastern Europe, Ukraine and even Russia, some of which had to be abandoned. From a macro perspective, the war has caused further supply disruptions to commodities and other goods. Disruption to gas supply has exacerbated energy price inflation.
In summary, corporates are facing a range of challenges that are very much to the benefit of special situations investors because the scale of the opportunity set is growing dramatically.
How are banks responding to this situation in terms of appetite and ability to lend?
It should be no surprise that lending standards are tightening, and the ECB has been very open in warning about anticipated increases in non-performing loans. Banks are in a fundamentally different place from previous downturns in that they have slimmed down their workout departments, and they are penalised in terms of capital for holding onto NPLs. Hence, the banks are more likely to sell troubled assets earlier than in the past and, anecdotally, this is exactly what we are seeing. This is clearly advantageous to special situation investors.
Why do you feel that the European mid-market is particularly attractive?
We have chosen to focus our latest strategy on the European market precisely because we believe there will be more opportunities in that region. Europe is undoubtedly the epicentre of stress and distress this time around. There is something like €7 trillion of corporate bank lending in Europe today, so you really don’t need that many percentage points of stress or distress to create a very substantial special situations market.
Mid-market companies, meanwhile, are typically less diversified by geography and product and have less access to capital markets. Many large companies did a good job raising money at the back end of covid, but smaller companies just didn’t have access to the capital markets. These are businesses that are reliant on banks and if the banks won’t lend, then that can clearly cause huge disruption.
In summary, we believe that there is only limited capital focusing on the European mid-market, meaning that we see more opportunities and less competition.
Where are you seeing the most interesting opportunities by sector and by jurisdiction?
One of the biggest differences with this downturn is that it is so broad-based. The inflationary effects of war clearly affected base industries that use a lot of gas, but there has also been hyperinflation in commodities, and high levels of inflation in most other raw material inputs, that has affected lots of manufacturing companies.
Inflation expectations have already fed through to wage negotiations and many European nations are struggling to control wage inflation, particularly in the public sector. There is a cost-of-living crisis, in parts of Europe, which is impacting consumer discretionary expenditure. If you are struggling to pay your heating bill you will not be buying a new car or washing machine or updating your wardrobe.
Data suggests that consumers are trading down in terms of food shopping and F&B consumption. The downturn is affecting chemicals, paper and packaging, healthcare, autos/autoparts, cinemas, food, F&B, leisure, real estate, cruise shipping, manufacturing, travel, gyms, hotels, housebuilders and retail companies.
Equally, the opportunity set is broad when it comes to geography. The UK is in a particularly difficult place, partly because of political incompetence and partly due to Brexit, which reduced labour supply. We see opportunities right across Europe, although we are primarily focused on the UK, Germany, Spain, Netherlands, Scandinavia and Italy.
Given the scale of the opportunity set, how do you approach origination and asset selection?
BlueBay has AUM of nearly $100 billion and is very collaborative, so there is a lot of idea sharing on the investment floor. We work extensively with the Leveraged Finance team who are running over $15 billion of risk, so we see a lot of dealflow and some of the deals they have looked at in the past end up in our arena.
In addition, my team of six has over 130 years of combined special situations experience and with that comes multiple connections with restructuring advisers, lawyers, investment banks and other intermediaries. We have invested all over the world in almost every sector you can think of, so in many cases we can apply past experience to current situations. By contrast, many of our competitors have seen only one downturn, or perhaps none. I like to think that those decades of experience count for a lot at times like these.
Why is a special situations strategy the place to be for investors right now?
First and foremost, this is a big and growing opportunity. My watch list would have had 70 or 80 names on it a year ago, and that has increased to around 250 names in terms of the public markets alone. In an environment where equities and fixed income markets are down dramatically, the ability to make positive uncorrelated returns should be of real interest to many different types of investors.
Adam Phillips is Head of BlueBay DM Special Situations at RBC BlueBay Asset Management.