The search for opportunities in an uncertain market

During the first half of 2020, the covid-19 pandemic and resulting shutdown of large portions of the global economy created an environment of unprecedented uncertainty around the world. While the conversation in the US recently shifted to reopening, many states are now considering or are already implementing reinstated closures as infection rates continue to climb.

Amid this ongoing turmoil, there remains ample opportunities to generate attractive risk adjusted returns in both the mid-market and select areas of the broadly syndicated loan market, as we believe capital will be scarcer in both the secondary and primary markets as many market participants continue to be preoccupied with managing troubled portfolios.

Regarding the secondary market, we have seen loan prices gain significant ground in general, but this phenomenon is more pronounced in the broadly syndicated market where companies have larger, more liquid loans that are traded more frequently. For true mid-market (companies with $10 million to $50 million of EBITDA) loans and mid-market lightly syndicated loans (companies that sit between the mid-market and broadly syndicated market), the rebound in prices has not been as pronounced and we believe there are still compelling opportunities in this space.

Additionally, given the uncertainty that remains, we anticipate there may well be even more attractive opportunities as a result of forced selling out of collateralised loan obligations, retail funds and exchange traded funds, following rating agency downgrades, as well as from CLO warehouses and total return swap programs that need to unwind as a result of not being able to obtain take out financing.

In the current environment, we are focused on identifying these opportunities that remain dislocated, despite the recent rally in the broader markets, as we believe certain high-quality bank loans and mid-market loans offer attractive risk-adjusted returns and considerable upside. We believe certain sectors, including government services, defence contractors, cybersecurity, telecommunications, food and grocery, certain areas of business services (including software) and select healthcare, which have been less impacted by the pandemic, remain attractive.

Regarding the primary market, the middle market M&A deal economy has slowed significantly since the onset of covid-19, as the pandemic and ensuing volatility in the broader markets has made it difficult for buyers and sellers to agree on asset pricing and complete diligence.

Additionally, we have observed some cases where it was not a straightforward process for private equity sponsors to obtain financing to support their acquisitions, as lenders have dramatically scaled back their desired ultimate holds, and are less willing to underwrite entire loans. That said, we have still seen select deals come to market in the mid-market as companies seek to refinance existing liabilities and certain private equity sponsors seek to close on what they believe are well-positioned acquisition targets.

We are also seeing signs that activity is beginning to gradually come back, especially in sectors that have been less impacted by the pandemic, such as those mentioned above. These are the areas in which buyers have greater confidence given the relatively steady, and in some cases growing, earnings streams of those companies.

Similar to what we experienced in the period following the global financial crisis of 2007-09, we expect there to be attractive opportunities to invest in tightly structured, directly originated loans. Although it is still early days, we are already seeing the opportunity for lender-friendly changes to loan documentation, including lower leverage, higher returns, stronger covenants, greater equity cushions and ample equity co-investment opportunities. We believe it is crucial to remain highly selective when evaluating new opportunities.

Often, vintage is among the most important determinants of performance in private markets. Mid-market credit is a vintage business. Taking the GFC as an example, leverage multiples peaked in 2007, and in the wake of the GFC, the 2009-11 period produced excellent vintages. The 2019 vintage, with average debt to EBITDA of 5.5x for mid-market leveraged buyouts, was remarkably similar in terms of leverage to the 2007 vintage, where debt to EBITDA was 5.6x. The 2009 and 2010 vintages had debt to EBITDA of 3.3x and 4.2 for mid-market LBOs, respectively, both of which turned out to be attractive vintages. As a result, we believe that late 2020/early 2021 is shaping up to be an excellent vintage.

There remains much work to be done but we have reasons to be hopeful. Given the tremendous amount of resources globally being poured into vaccine development and treatment research, it is our hope that in the not too distant future, we will all be able to put the public health crisis portion of the pandemic behind us and focus on economic recovery.

Art Penn is founder and managing partner at PennantPark