Trying to do something special

A lot of managers are establishing special situations strategies thanks to an expected turn in the credit cycle.

Worsening loan terms are causing plenty of alarm, but for one special situations fund manager it’s time to get excited. “We love riskier deals. We love that people are pushing their underwriting standards out a little bit. It will give us a lot of work to do for the next couple of years,” he says.

He’s not alone. Many institutional investors are ramping up their allocation to special situations debt strategies. The British Coal Staff Superannuation Scheme, for instance, is aiming to increase its allocation to 7.5 percent – more than double its existing commitments.

Fund managers are responding accordingly. Pemberton recently established a credit opportunities strategy, with a mandate to invest up and down the capital stack. ICG has appointed former Credit Suisse banker Luca Torchio to explore a distressed investment strategy.

There are 88 special sits funds in the market globally, seeking almost $94 billion, according to PDI data. That’s a lot ambition for a strategy which so far has operated on the margins of the asset class – nine funds closed on just under $11 billion in the first half of this year.

While everyone professes to know what a special sits strategy is, few are able to provide a concrete definition. Managers will tell you no transaction is the same. But strategic idiosyncrasies aside, these funds typically seek returns of between 15 and 20 percent.

With greater competition producing higher leverage multiples and fewer covenants, the high point of the credit cycle appears to have been reached.

However, this is less significant for special sits managers than you might think. They will take into account all manner of developments throughout the cycle. “Mismanagement is non-cyclical,” as Shary Moalemzadeh from Carlyle explained to PDI earlier this year.

Many industries are in distress due to unique pressures, rather than pressures from the credit cycle. Retail firms that have struggled to adapt to the technological revolution are beginning to hit the wall and oil and gas companies have suffered from low prices. Shipping has also reached a point of distress.

Looking forward, the restaurant and entertainment sector will have a rough ride as consumer confidence falls and uncertainty continues over the status of a workforce which features a large proportion of EU nationals.

Brexit is its own special situation. Few expected a referendum in the first place, let alone a subsequent vote to leave. A year on, it’s still hard to tell what the UK’s relationship with the EU will look like. Corporates have felt the stress of the plunge in sterling and a lack of clarity over their future trading. While default rates remain low at this point, hovering around the 2 percent mark, according to Standard & Poor’s, many are expecting a rise over the longer term.

Special sits is not a strategy for the faint-hearted. Increasing opportunities, whether as a result of the turn in the credit cycle or industries struggling to survive, will inevitably attract many firms to the space.

These firms will be motivated by the thought that the most successful strategies are invariably the ones that resist the herd mentality. However, as our fundraising figures suggest, if enough firms look to avoid the herd, they can end up forming a new one.