European special situations outlook

That’s the bad news. But there’s good news, too: In our view, the opportunity set in European special situations credit is gearing up to be as fertile and attractive as it has been since the GFC (the first few months of COVID-19 excepted). In this new, higher-rates-for-longer reality, we believe the opportunity to provide liquidity, work with companies to recapitalize their balance sheets at attractive valuations and take advantage of temporary dislocations in the secondary market will likely surge. Meanwhile, loan documentation and economic remuneration will likely become more favorable for opportunistic credit investors, providing what we see as a very strong balance of risk-and-reward potential, complemented by strong running yields and the upside typical of equity markets.

Setting the foundation

How does the opportunity set today differ from past credit cycles?

The opportunity set today is broadly diversified across a wide range of geographies and sectors, including some historically considered defensive such as telecoms and food producers, which is highly unusual. During the expansion phase, ultra-low interest rates have encouraged borrowers to take on additional debt, while documentation has grown significantly looser. The cost of financing has essentially doubled in the last year or so. With banks pulling back and a wall of debt maturities on the horizon, we believe companies will react differently as they face their troubles. We anticipate elevated levels of distress and transaction opportunities for capital providers at lower valuations. We believe those with capital available to invest in such opportunities will be presented with favorable technicals over the next few years.

How big is the opportunity set?

In the actively traded secondary market for leveraged loans and high yield bonds, the opportunity for stressed and distressed credit in Europe stands at approximately €120 billion, twice as big as the pre-COVID-19 average. This data excludes the private credit market, where we expect similar dynamics to unfold over time. We believe the size of the opportunity set will continue to grow as companies report weaker performance and approach scheduled maturities. We expect to see economic fallout from the dramatic increase in global interest rates, regardless of whether economies fall into recession, and that will lead to an increase in the supply of opportunities in our market.

How long do we believe this window will last?

The maturity wall is a multi-year issue, and we are in the early stages of tackling it. Companies have issued record amounts of debt, and many people likely are looking to refinance under challenging conditions. We believe the macroeconomic drivers of the opportunity—the higher interest rates, the volatility, the myriad impacts of deglobalization—will likely be with us for at least the next 3-5 years.

Why is the asset class so attractive right now?

“Good company, bad balance sheet” is an oft-used phrase in our business. Today, we believe it is spot on. In today’s environment, companies are usually stressed because they have borrowed too much, not because of management underperformance or structural changes in an industry. The businesses themselves, in most cases, are in pretty good shape. We can work with a company to fix its balance sheet—that’s what we do. An investor can buy senior secured debt in companies with a claim on the company’s assets at a loan-to-value (LTV) of roughly 40% to 45%. Investors either get repaid at par, if the borrower successfully deleverages or refinances the debt, or can use their claim to recapitalize the balance sheet. We regard current valuation levels as very opportunistic. In our view, you won't find many other asset classes where there are senior secured, create companies at a 60% discount to what investors thought they were worth just two or three years ago, and yet still have a targeted internal rate of return at equity-like levels of 15% to 25%.

What is the difference between the opportunity set between the United States and Europe?

Given its impact on the cost of energy and other raw materials, the war in Ukraine and the nature of fiscal support in Europe are the key differences in the opportunity set. Europe’s inflationary problems are much more cost-driven than in the United States, where consumption has been a greater driver. As a result, the European Central Bank’s (ECB’s) efforts to tame inflation may come at the expense of suppressing further what are already depressed levels of demand. We’ve already seen several major European economies, including Italy and Germany, move into recessionary territory, and many others are teetering on the edge. Still, we believe the opportunity set and return potential in special situations would likely expand in the event of a prolonged, deeper recession.

Beyond this, we believe—especially for local investors—that Europe is a more attractive market than the United States for several reasons. First, given the private and relationship-driven nature of the European market, it’s harder for most investors to find and access many of the most attractive opportunities. This contrasts with the United States, which tends to operate more as a level playing field, with investors benefiting from a more uniform access to information. As a result, information symmetry drives more efficient pricing, whereas in Europe it is commonplace for some investors in the same deal to be “more in the know” than others. Then you need to overlay the fact that Europe runs across multiple jurisdictions, with multiple languages and distinct business cultures. Relationships and networks are key. Also, the “white lists” of approved purchasers commonly restrict the transferability of loans. These white lists seek to exclude those investors deemed too aggressive to be allowed to enter transactions, curtailing competition for assets right at the time when motivated sellers want to exit. We believe that as long as individuals work with an asset manager that has access and visibility in the market, there are more opportunities to create alpha in Europe than in the United States.

Why is special situations more attractive than private debt?

While there’s plenty of room in a diversified portfolio for both, what we find attractive about special situations is that it allows an investor to access senior secured debt at very low implied LTV ratios in companies with a recent observable track record (thus offering individuals the opportunity to make the call on whether their underperformance is likely to continue), while generating equity-like returns.

What industries or geographies are we focused on?

There are a lot of opportunities in defensive sectors at attractive entry points, ones we might not have had a few years ago. For example, we are spending a lot of time researching healthcare, telecommunications and food producers alongside more cyclical sectors such as chemicals, industrials and autos. In the past, the opportunity set was often linked to certain sectors which were undergoing some structural change, which made it challenging to pick winners and losers from a defined group. Now, the universe is much broader, because the issue of taking on too much leverage runs across all sectors—even defensive ones.

For many years we have focused on northern and western Europe, where there are reliable, creditor-friendly bankruptcy codes and tried and tested legal regimes. These are established, predictable jurisdictions, where investors can be reasonably assured that if there is an opportunity at an attractive valuation, they are going to be able to get their hands on the assets when needed. We do a lot of our business in the United Kingdom, Germany, the Netherlands, France, Luxembourg and Scandinavia. That’s not to say that under no circumstances will we ever invest in southern or eastern Europe, but all other things being equal, we believe the better relative value is to be found in the north and west of the continent.

Can you speak to the relative value of stressed and distressed situations in today’s environment?

At the moment, the majority of our investment pipeline is concentrated in stressed opportunities, because we’re finding attractive entry points in sustainable capital structures at lower implied LTV ratios against a backdrop of macro uncertainty and market dislocation. We expect, over time, that the universe will gradually pivot toward distressed opportunities as we move through this cycle. We do believe that one must be capable to do both types of investments in order to be successful in this asset class, not least because a detailed knowledge of how a company is capitalized and how any restructuring processes could play out is a critical part of the initial diligence process. Indeed, we believe some of the most lucrative opportunities in the space are to be found in those cases where investors are able to navigate a restructuring process and own the company on the back end.

Do we have an expectation for default rates in the next 12-24 months?

Historically, we have not found default rates to be a particularly reliable or timely indicator of corporate distress and certainly not a good predictor given that it is very much a lagging indicator. The definition of default is subject to interpretation, and the numbers can be stretched in any direction to fit the required needs. Maybe the official stats will indicate default rates rising to between 3% and 5% in the years ahead, but the number of near-defaults will likely be much, much higher, in our view. We’ve seen several situations during 2023 where companies are looking for solutions to upcoming maturities and enter negotiations with creditors. Those may not end up as defaults, under the technical definition, but all the same, represent interesting investment opportunities for us.

Conclusion

With higher interest rates causing stress to borrowers, with inflation pressuring margins, and with maturities pending for hundreds of billions of euros’ worth of debt issuance, we believe the opportunity set in European special situations investing is very attractive and will remain so for several years. Some companies are going to need liquidity as they navigate this challenging environment, while others are going to need debt rescheduling or recapitalisation in order to manage inflated leverage levels. We believe the confluence of these factors will result in a massive and disparate set of opportunities for savvy, well-positioned investors to combine strong running yields with the potential for equity-like returns over times, all with a risk/reward balance that’s arguably better than it has been for a very long time.