All-Weather Allocation in Opportunistic Credit

Introduction

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In the wake of the recent (thus far short-lived) equity vol turmoil, carry trade unwinds, and recession concerns in July/August, some private market investors have shifted their focus away from Direct Lending and toward Opportunistic Credit strategies instead. Since the Global Financial Crisis (GFC), the sector has evolved into a versatile and all-weather segment of the Private Debt market.

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At Klarphos, Opportunistic Credit has a permanent place within our asset allocation for most mandates, providing equity-like returns, no J-curve, and low correlation (Figure 1) to other asset classes. Before elaborating further, let us first define the scope of Opportunistic Credit that this article addresses, which ranges from Distressed and Stressed Debt to Special Situations and Mezzanine Debt. When assessing the Opportunistic Credit market, it is worthwhile to retrace its development over the past few decades. Around the GFC, Mezzanine Debt, Special Situations and Distressed Debt comprised the ‘traditional’ Opportunistic Credit strategies and represented most of the Private Debt market. The ensuing 15 years brought a bull market in interest rates, low macroeconomic volatility, and global central bank balance sheet expansion, which in turn provided favourable financing conditions and easier access to credit. Borrowers took advantage of “easy credit” to increase their leverage (Figure 2) by more than one turn of debt/EBITDA at tight risk-adjusted spreads.

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The Opportunistic Credit market share shrank in comparison to Direct Lending (Figure 3), which was exacerbated by ongoing US bank regulations pertaining to leveraged lending guidance. Proliferation of unitranche structures in Direct Lending deals no doubt also contributed.

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In recent years, to combat elevated inflation, global central banks removed accommodative monetary policy and implemented a series of rapid interest rate hikes and quantitative tightening over a relatively short period. Debt coverage ratios deteriorated due to the heightened interest rates, fostering an increase in deal flow for Opportunistic Credit once again.

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Figure 1. Correlation heatmap – Opportunistic Credit vs other asset classes

_{Direct Lending; Cliffwater Direct Lending Index; Source: Preqin as of September 2023.}

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Figure 2. Debt / EBITDA Ratio - leverage at origination

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_{Source: Preqin as of December 2023.}

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Over the ensuing quarters, an increase in borrowers' deleveraging should be expected due to a significantly higher cost of capital. However, despite smooth transitions thus far owing to auspicious resiliency in earnings developments, one should expect that such a backdrop of challenged interest coverage ratios (ICRs) continues to create opportunities across performing, non-performing, and Distressed Debt, as debt restructuring, and liquidity needs are likely to dominate the credit landscape. With all-in borrowing costs remaining very high (i.e., all-in yields still double digits), borrowers and sponsors are increasingly resorting to liability management exercises (LME) to optimize capital efficiency and avoid a costly bankruptcy process, thereby shaping default practices.

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Figure 3. Private Debt market composition (North America & Europe) - Opportunistic Credit landscape has significantly changed since the GFC

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_{Source: Pitchbook US LoanStats Weekly Trend Line.}

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Table 1. Opportunistic Credit sub-strategies

_{Source: Klarphos as of Q3 2024.}

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Distressed and Stressed Debt

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Distressed Debt was the largest segment of the Private Debt market during the GFC, accounting for nearly half of the total market. Traditional distressed lenders (as opposed to long-term, deep-value, private-equity style distressed players) generally seek relatively inexpensive ways to gain access to businesses, typically by acquiring a 'fulcrum’ security to create asymmetric return opportunities by purchasing the last dollar value of debt that is most likely to be converted to equity in a restructuring. Credit activism is involved, and creditor groups are usually formed to achieve a voting quorum for negotiating a debt-to-equity conversion or for conducting LME. With the aim of reviving a decent business plagued by (hopefully) temporary balance sheet woes, new lenders seek to obtain a majority vote of a capital structure from existing lenders in order to take over companies, influence business and management decisions, as well as to conduct balance sheet optimization or debt restructuring.

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Case study Distressed Debt

The below Swissport case demonstrates some of the key features of a distressed strategy, namely converting from senior debt to equity and turning around a business, then via an active ownership to capture the upside potential.

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Source: S&P Global; Swissport

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We expect to see an uptick in LME manoeuvres as borrowers encounter liquidity and financial constraints in the coming credit cycle. LME includes both drop-down cases, such as Altice, Pluralsight, J.Crew, Travelport, Cirque du Soleil and Revlon, and uptier cases, such as Trimark, Murray Energy, Serta Simmons and Boardriders. Distressed lenders provide new capital to borrowers and sponsors, often negotiating stronger covenants and attractive terms, sometimes at the expense of existing creditors, earning the term “lender on lender violence”. The existing majority lenders of distressed companies would obtain a seat at the negotiation table, while minority debtholders’ interests might be subjugated in such a process. In default cases, Distressed Debt exchanges, which are also considered as LME, have clearly increased in activities compared to historical levels (Figure 4).

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Figure 4. 12 Month default rate including LME – increasingly, borrowers resort to LME in default process

_{Source: Pitchbook as of July 2024.}

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It is worth mentioning that LME and Distressed Debt exchanges are not only Private Debt market practice; in fact, they are rather more commonly seen among public market obligors, ranging from sovereign debt with collective action clause (CAC) to high yield and investment grade corporates LMEs. Private Debt mid-market (MM) and lower mid-market (LMM) lenders generate repeat business (so-called ‘incumbency’) from sponsors with whom they have long working relationships and who tend to hold a dominant share of borrowers’ debt compared to the syndicated market. Such nuances could lead to fewer sponsor-led LMEs in MM deals. Additionally, LME tends to be more common in the US than in Europe due to more favourable court rulings towards new capital lenders in the US.

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It is crucial for investors to partner with managers who have a willingness to deal with complex restructuring processes and have extensive workout capacity and experience in creditor activism. Successful distressed lenders are those who can identify the drivers of a business’s failure and transform the target company to re-emerge from bankruptcy, turning the business around operationally and/or financially, by means of increasing operational efficiency, optimizing marketing strategies, management reorganization, financial restructuring, asset retrenchment, etc. The workout of a portfolio company could be highly sector- or jurisdiction-specific; hence, the track record of the manager in their focus area is crucial. Additionally, it often requires that lenders operate with a private equity mindset while being adaptive to the ever-changing landscape of credit underwriting to enable effective downside protection. Our observation is that increasingly, managers are diversifying from distressed lending and extending to stressed lending, to portfolio companies that are not yet in bankruptcy. This might have been exacerbated by the long period of low interest rates that pushed managers to focus on capital velocity and efficiency.

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Special Situations

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The Opportunistic Credit landscape has evolved rapidly in recent years, with the opportunity set expanding beyond traditional distressed debt and mezzanine, with Special Situations lending experiencing increased demand for Capital Solutions, as well as secondary market risk transfer types of transactions. The asset class can take on many shapes and forms and ranges from corporate lending, including bridge financing for short-term liquidity, to Capital Solutions and Special Situations Secondaries.

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Capital Solutions

As the name indicates, Capital Solutions  involves providing new money (i.e., ‘primary’ capital) but usually involves deals that are more complex than traditional senior direct lending. Lenders require a higher complexity premium and have the flexibility to pivot across capital structures, from senior to junior, and, to a lesser degree, equity, in seeking the best striking point of risk-reward when providing capital. The risk premium for a Capital Solutions transaction ranges from 200-500 basis points (bps) or even higher versus a direct lending deal, subject to the complexity of the loans originated. Capital Solutions can range from rescue financing and stressed refinancing to Debtor-in-Possession (DIP)/Exit Financing. Most Capital Solutions deals cater to core middle market and upper middle market performing borrowers, facilitating borrowers gain higher capital efficiency by addressing idiosyncratic business factors, such as geographic industry-specifics. With the current elevated cost of debt and high equity valuations, demand for Capital Solutions is expected to surge.

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Capital Solutions lenders are likely to benefit from abundant deal flow as borrowers deleverage across geographies and sectors. Lenders can obtain pricing power over deals that closely match the risk profiles they seek. New money lenders have the flexibility to structure deals using coupons, origination fees, and potentially detachable warrants on a deal-by-deal basis. Additionally, call protection provision, either time-based (standard percentage premium and make-whole) or return-based (min MOIC), are typically embedded in the structure to compensate the lender in the event of early repayment by the borrower. With increasing deal flow, it is essential for lenders to remain disciplined and vigilant when underwriting credit and create watertight covenants.

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Case study Capital Solutions

_{Note: As a non-public transaction, no disclosure in borrower name or exact transaction terms, serves as representative transaction only.}

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Other types of Capital Solutions opportunities include loans originated as part of the bankruptcy proceedings, also known as DIP and exit financing. DIP loans are loans made to bankrupt borrowers to facilitate liquidity of the borrower during the bankruptcy process. These loans constitute super-priority claims in the bankruptcy distribution scheme and are often further secured by priming liens on the debtor’s collateral. Exit loans finance borrowers that emerge from bankruptcy and are typically part of the companies’ reorganization plan. These loans constitute a small part of the Capital Solutions market and usually require extensive expertise of jurisdictional bankruptcy proceedings.

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Special Situations Secondaries

The Special Situations Secondaries, as its name implies, pertains to opportunities in existing securities, which include bonds, loans (performing, re-performing and non-performing), and securitizations (ABS, CLOs and CLO equities). For example, hung deals clogged up bank balance sheets in 2022 and significantly impacted banks’ underwriting capabilities. A large amount of hung deals were trading at a hefty discount as banks tried to offload tens of billions of exposures, creating compelling opportunities for investors. When it comes to Special Situations Secondaries, borrowers and sponsors sometimes require the buyer to be one of their “whitelist” lenders, whom they trust and are willing to work with, to avoid aggressive Special Situations funds and loan-to-own players. The depth of the lenders’ relationship to borrowers and sponsors and the availability of dry power are often what set managers apart. It is essential for managers to have a dedicated investment team with asset specific expertise and good access to borrowers, sponsors and advisors to be able to source the best deals.

Mezzanine Debt

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Before the GFC, Mezzanine Debt used to be more commonly utilized by borrowers. Given a decade-long period of favourable financing conditions, borrowers and sponsors have increasingly tapped into the senior part of capital structure and relied upon unitranche financing, leading to a significant decrease in the mezzanine financing market share. However, given the current high-interest rate environment, borrowers may view Mezzanine Debt as a more efficient source of capital that can provide greater flexibility (Figure 5). Mezzanine Debt can take the form of a 2^nd lien loan, HoldCo PIK loan or other structure. Strong relationships with sponsors and other creditors in the capital structure benefit mezzanine managers from a sourcing perspective.

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Figure 5. Corporate borrowers may increase use of capital structures using mezzanine loans given better resultant risk-reward

_{Source: Pitchbook as of July 2024.}

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Case study Mezzanine Debt

Source: Ottobock; Bloomberg

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Conclusion

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Opportunistic Credit remains a versatile and well-diversified part of the Private Debt market despite losing share over time to Direct Lending. Some sub-strategies within this vertical benefit disproportionately in a rising economic environment (e.g., Mezzanine), while others prosper in a more volatile macro backdrop (e.g., Distressed or Capital Solutions). With a secular trend of tighter financing conditions, augmented by the current high funding costs, we expect Opportunistic Credit to present investors with a long-term, all-weather opportunity set and a compelling diversifier to a traditional liquid credit portfolio. Investors can achieve equity-like returns with a well-managed, diversified Opportunistic Credit allocation throughout the cycle. Manager selection and a thorough understanding of managers’ capabilities to deliver the key return drivers of their respective strategies are key to investment success.

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Important Information

This document is informative purposes only. It does not constitute research, investment advice nor solicitation to invest in any investment product or service that Klarphos offers or may offer in the future in any jurisdiction. The information contained herein is based on projections, estimates and/or other financial data and has been prepared internally by Klarphos. Opinions expressed therein are current opinions as of the date of this document only and are subject to change at any time without notice.

No representations are made as to the accuracy of the observations, assumptions, and projections. No subscriptions to any Klarphos products are possible based solely on this document. Any investment decisions should be made in accordance with the legal documentation of a fund such as its offering memorandum.

Klarphos is not entitled to provide any tax, regulatory or legal advice.

Past performance is not indicative of future returns. There can be no assurance that the strategy objectives will be realized or that the strategy will not experience losses. Target returns are hypothetical and are neither guarantees nor predictions of future performance. There can be no assurance that the target returns will be achieved.

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