In the following Q&A, Ryan Kelly, PGIM’s Head of Special Situations, unravels opportunities arising from areas of credit market dislocation. Amidst the perception of a calm market with record tight spreads and a low default rate, special situations activity levels are elevated and rising as the need for capital solutions grows. This creates a favourable backdrop for well-equipped active managers with access to the growing opportunity set to uncover the right situations.
Q: How has the credit market landscape changed recently, and what does this mean for investors?
A: The need for opportunistic credit strategies has grown substantially in recent years as large pools of inflexible capital have been finding it increasingly difficult to contend with the growing complexity in corporate credit markets. Borne from the past 15 years of market disruptions brought on by massive central bank policy responses, lending facilities that were structured to capture carry (yield) in near-zero interest-rate environments are now seeding the next wave of special situations opportunities—i.e., strategies emphasising opportunities in distressed and mezzanine credit.
As markets focus on contours of trade wars and disjointed global efforts to fight inflation, credit market complexities—along with ownership problem—are driving stress levels higher. There is now a pressing need for capital solutions by companies and financial sponsors, despite near-record valuations across credit and equities.
Q: What are special situations investments and is this a good environment for them?
A: Special situations—or opportunistic credit—are credit investments opportunities in companies that have complex business or capital structure needs, or who are impacted by company specific events, dislocations in their industry, or unfavorable market conditions. These situations are generally difficult to analyse and often misunderstood. They can present mutually beneficial outcomes in environments in which managers can lean into complex situations with flexible capital and capture complexity premia at attractive valuations. These transactions consequently help companies address balance sheet and capital structure problems. For example, these may include liability management exercises (i.e., LMEs, discussed below) conducted via debt exchanges, preferred equity solutions (to reduce leverage), equity injections, and process loans. They can also include amend-and-extend transactions with equity kickers, which can push out loan maturities.
Special situations are an approximately $350 billion subset of the roughly $1.6 trillion private credit market. Sought for their uncorrelated, high-return streams (historically mid-teens), and low dependency on market momentum or credit cycle conditions, special situations originate from public and private leveraged finance markets. Traditionally, they generate attractive secondary-to-primary or public-to-private opportunities. These investments thrive in a complex environment where shifting financial conditions across sectors, industries, and companies drive dispersion and the mispricing of credit risk. They can also present notable credit risk, hence our emphasis on describing the situation in the context of a manager with extensive experience in the space.
Today these strategies can also effectively hedge private markets exposure, where the opportunity set is also expanding despite record valuations across markets. Poor underwriting when money was essentially free following the pandemic along with capital structures built for near-zero interest rates is creating many opportunities or needs for creative solutions across PE-sponsor companies and in the broadly syndicated loan (BSL) market (discussed further below). Artificial intelligence is set to amplify this dynamic through creative destruction as new industries are born, while strategic moats—once thought to be impenetrable—are shrunk or eliminated by new entrants or smaller competitors energized by efficiency gains and rapid product development. Lastly, we point to two excerpts from our PGIM colleagues in the recent Q4 2025 Fixed Income Outlook which speak to a more favorable backdrop for rising market complexities and opportunistic credit or special situation strategies:
“The last few years have seen plenty of volatility in the realms of geopolitics, policy, and—notably for investors—economic data. The trajectory of U.S. data has been particularly unstable with months of uncomfortably hot growth or inflation followed by months of cold conditions. But across most developed markets, things seem to keep pointing to one outcome: a “muddle through” scenario characterized by low to moderate growth with mildly-sticky inflation, especially at the core level.”
“And in the world of more frequent supply shocks, be it from commodity prices, trade disruptions, or labour constraints, will inflation shocks persist for longer if central banks are seen as being too accommodative and restoring credibility becomes too costly.”
Q: What is your outlook on default rates?
A: While we don’t see default rates reaching the highs seen in previous cycles, we expect elevated default rates over a prolonged period of time—a classic cycle characterized more for its persistence rather than its severity. As such, we believe there will be ample dislocations at various points in this cycle and in different areas of the market, which could create a host of opportunities for special situations solutions.
Q: How do different economic scenarios impact this outlook?
A: U.S. high yield spreads are in the 99th percentile, investment-grade spreads are at record tights, and equity valuations are at all-time highs on a supportive earnings backdrop. Yet, a default cycle has been underway since late 2022 and will likely continue—even if recessions are avoided and economies continue to grow (Figure 1). We have been expecting this rising default tide to come in given the nature of debt underwriting over the past several years: capital structures that were in many cases built for near-zero interest-rate policies; the substantial amount of capital rapidly deployed post-COVID at excessive valuations; and, very loose documentation or lack of covenant protections given to lenders.
Figure 1
The coming default cycle: more an extended rising tide than a breaking wave (U.S. Speculative-Grade)
As of June 30, 2025. Chart is provided for illustrative purposes only. Projections are not guaranteed, and actual results may vary. Source: PGIM Bloomberg, JPMorgan and Moody’s.
Under our muddle-though scenario noted above, we expect the coming cycle for defaults and stresses to resemble a classic shape known more for its persistence and duration versus severity, which was the case during the COVID-19 pandemic and the Global Financial Crisis (GFC) of 2008-09. Under a classic credit cycle, defaults typically rise steadily over three to four years, cumulating over five years around the 30% to 35% mark—at which point companies must navigate challenges using capital market channels when there is no central backstop. The recent rise in defaults led by issuer-weighted statistics is following historical patterns, or a lagged effect, of what was typically experienced across previous hiking cycles. Under a more moderate economic-stress scenario (again, see our Q4 Outlook for our risk scenarios and probabilities), the classic shape of defaults could be notably higher-bound, given ownership problems and maturity walls. Asset or equity valuations also play a pivotal role in seeding stress and driving defaults; a stagflation scenario could have a meaningfully negative impact on equity markets and asset prices, and drive a more severe credit cycle—especially with looming maturity walls (discussed later).
Q: What is a Liability Management Exercise?
A: Liability management exercise (LME)—or “lender on lender violence,” as it colloquially referred to—is a tactic used by issuers/borrowers and sponsors in the case of leveraged buyouts (LBOs). LMEs are used to address capital structure complexities, such as elevated leverage or looming maturities, by coercing lenders into a suboptimal outcome that benefits the company (as we discussed earlier this year in a PGIM All the Credit podcast). Companies can receive additional liquidity, extend maturities at favourable terms, or even reduce debt outside of a court restructuring. This effectively creates a “soft default” (Figure 2), which rebuilds equity through the willingness of lenders to accept a permanent loss on their loan without impairing the equity. Loose documentation, lack of covenants, lenders with inflexible capital, and game theory work against lenders by shifting negotiating leverage to companies and sponsors.
Figure 2
Years of loose documents and light covenants paved the way for today’s LME growth (Default and Distressed Exchange Volume ($B))
As of June 30, 2025. Chart is provided for illustrative purposes only. Projections are not guaranteed, and actual results may vary. Source: JPMorgan, Pitchbook Data, Inc., Bloomberg and S&P/HIS Market.
LMEs predate the GFC and have grown steadily since then. Their recent rise is correlated with the increase of covenant-lite capital structures over the last 15 years, and the media attention on LMEs is driven by their greater frequency and severity. They can take many forms and even benefit select groups of lenders in certain circumstances as companies drive toward specific capital solutions. Aggressive structures have become more numerous as lenders often discover that their first-lien loan is now a third-lien instrument that has been primed and trades significantly lower in price, only to have the company offer to crystalise the loss through an exchange offer.
Q: What role will LME play in the coming credit cycle?
A: We expect LMEs to be a main feature of the coming credit cycle and are seeing significantly more activity as companies proactively address their capital structure needs. Rather, companies increasingly prefer to monetise the optionality that lenders provided through significant flexibility in credit agreements or bond indentures, and they are advancing conversations to address their current needs through coercive maneuvers with existing lenders. To achieve this, they may enlist the help of small group lenders or managers that have flexible capital and good insight into the company’s set-up value and operating conditions. Notably, the rise of LMEs is happening with credit spreads at near-record tights and default rates still relatively low by historical standards. We believe the increase in LME transactions is tied to a degree of capital misallocation across levered credit. In these circumstances, companies and lenders recognise that there is a permanent reduction in enterprise value and that market conditions, along with idiosyncratic factors, suggest a lower terminal value—a “backwardation” effect of the company’s future value.
Today we are seeing several attempts by PE sponsors to capitalise on inflexible capital provided by collateralised loan obligations (CLOs)—which own 70% of the $1.4 trillion BSL market—through aggressive LMEs. Since the GFC, the loan market has funded nearly 85% of private equity LBOs, and the substantial flexibility that lenders have been given to private equity is showing up in default activity and tighter financial conditions in this cohort of credits as quality declines. While we believe LME activity will thrive in a slow-to-no-growth environment, we expect that a more challenged market backdrop will push LME out of the money for more companies as lenders become more willing to “take the keys” and force a hard default or classic restructuring. In the meantime, LME is tightening financial conditions across leveraged credit markets, especially lower in the quality spectrum (Figure 3). This leaves select companies and industries largely un-investable from a performing credit perspective.
Figure 3
LME activity driving financial conditions tighter (BB vs. CCC HY spreads and differential)
As of September 30, 2025. Chart is provided for illustrative purposes only. Projections are not guaranteed, and actual results may vary. Source: Bloomberg.
Q: What does the rise of LMEs indicate for sponsors?
A: While maturity walls were a real concern for corporate balance sheets when the rate-hiking cycle began a few years ago, capital markets have since pushed out near-term maturities on the expectation that stable earnings and cash flows across leverage finance and private direct lending markets would ultimately prevail through the extensions. Even though forward three-year maturities across U.S. high yield and broadly syndicated loan (BSL) markets persists at record highs (Figure 4), confidence remains that robust investor appetite will continue to address the problem.
Figure 4
Forward maturities persist at record highs (% of High Yield and Leveraged Loans Indices)
As of June 30, 2025. Chart is provided for illustrative purposes only. Projections are not guaranteed, and actual results may vary. Source: PGIM and Bloomberg.
The fund maturity wall for private equity sponsors is another matter—as they are far more restricted in their ability to choose a path forward—and one that represents a unique opportunity set for opportunistic credit investors. The struggles of private equity have expanded beyond low-vehicle returns and into reduced recycling or position exits, leading to multi-decade low DPIs (distributions to paid in capital) for limited partners (LPs, i.e., the investors in a private equity fund). The path to higher exits remains greatly uncertain and dependent in some cases on a significant reflation of fundamentals or a boost in valuations despite broader markets already near-record valuations—all of which is further complicated by the lack of runway for the sponsored-led companies to handle looming debt maturities and generally higher interest rates. There is now a logjam of exits waiting to happen and a record amount of aging portfolio companies across sponsor-led structures requiring creative capital solutions. The push by sponsors toward continuation vehicles and NAV loans, as well as the rise of the secondaries, do not address the core problem, rather they only delay the inevitable reckoning in these situations.
As the runway shortens from a vehicle perspective, sponsors are increasingly looking for solutions to bridge their companies to the much needed exits, either through debt maturity extension or a holistic approach that fixes the capital structure altogether. A more aggressive stance with existing lenders (via LME) is also becoming a preferred approach when those lenders have “excessive” demands—i.e. require too high of rate to refinance or do not want to extend maturities. In essence, the fund maturity wall problem is driving more use of LME and more aggressive tactics by sponsors as desperation increases. The knock-on effect is more volatility in capital structures of companies facing leverage, maturity, or liquidity problems. This dispersion—despite record market valuations—is being driven by traditional long-only managers selling ahead of these aggressive maneuvers, while improving the entry price or attachment point for opportunistic managers who can better navigate the situation.
Of the 30,466 sponsor-led companies globally, 55% are at least six years old and 26% are 10 years or older versus a typical fund life of 10 years (12 years with extension option), according to Pitchbook. At the current pace of exits, it will take nine years to clear all U.S. PE fund investments and eight years to clear it globally. With an average fund life of six years with four years remaining, PE sponsors and their LPs are facing a considerable challenge over the next several years. Making matters worse is a looming valuation standoff between PE and would-be buyers given where these businesses were purchased—e.g. 2021 and 2022 vintages—against a backdrop of slower growth and materially higher rates. Opportunistic investors are uniquely situated to capitalize on this dynamic, as we expect a steady progression of sponsors looking to cede equity to lenders in holistic solutions whereby they can address the problems and capture the equity upside.
Q: What does this all mean for investors?
A: Credit market complexities are driving tighter financial conditions and higher stress—a persistent and unpleasant feedback loop that requires creative capital solutions. We believe higher dispersion across credit markets is structural, which in turn has given rise to a sizable increase in unnatural lenders and inflexible capital invested in corporate credit. The added factor of lender-on-lender violence—or aggressive LMEs—is creating a circular dynamic, whereby exposed segments of the credit markets are quickly assigned elevated risk premiums for investors to participate, which is seeding future distress especially as maturity walls loom.
As investors retreat from various corners of the market, companies are further emboldened by advisors to apply increasingly aggressive tactics. A large part of why defaults and distress are rising with credit spreads near record tight levels is due to this feedback dynamic, which is set to amplify stresses and the need for capital solutions, should credit conditions deteriorate further. Private equity sponsors are also facing a challenging backdrop as exits plummet and leverage across portfolio companies remains elevated along with overall heightened credit risks. Sponsors react by dialing-up competitive pressure between the direct lending market and the BSL market to achieve the best terms possible. Additionally, liquidity challenges within sponsors’ portfolios is ushering in the use of net asset value (NAV) lending, which is sub-optimal from the LP perspective. In short, sponsors are set to become increasingly aggressive, which could drive even tighter conditions.
Q: Where can investors find credit opportunities going forward?
A: The next 15 years are likely to look much different from the post-GFC area. Opportunistic credit or special situations strategies can take advantage of structural challenges in the credit markets and excesses—as measured through various forms, such as underwriting and return expectations. Many of these opportunities will come from the $4.5 trillion U.S. and European leveraged finance markets (high yield bond and BSL) or from bespoke financing needs that originate out of the private credit sector. We believe the best way to achieve uncorrelated equity-like returns over the next decade will be through opportunistically owning the debt of select companies. More specifically, a savvy special situations manager can capitalise on the weakened positioning of debt or private equity investors in fundamentally-sound companies that require capital solutions, regardless of the state of the credit cycle.
Q: What should investors consider in an opportunistic credit manager?
A: Investors should seek a top counterparty in the credit markets and, as such, one that benefits from differentiated access to high-quality deal flow. Sourcing and due diligence are critical in special situations: Our team targets over 1,000 active lending relationships across the firm’s platform to create attractive public-to-private and secondary-to primary investment opportunities by engaging with companies to provide capital solutions that unlock value. The special situations team works closely with 29 senior credit analysts across the U.S., emerging markets, and Europe who provide specialisation across industry verticals to help identify, due-diligence, and structure impactful opportunities. In the context of PGIM’s operating model, the firm may see numerous opportunities regardless of credit cycle phase. This reduces dependency on market drawdowns allowing us to operate from a position of high selectivity. Our scale and deep strategic insights spanning both public and private credit markets are critical to turning dislocations into opportunities.
A Primer of the Types of Special Situations Investments
The value of investments can go down as well as up. Source: PGIM. For illustrative purpose only. There is no guarantee that these outcomes will be achieved. Subject to change. ¹Actual allocations and investment targets may differ materially. Target universe is subject to change. ²Based on market comparables, previous investments and current market outlook. Debtor in Possession (DIP) financing is a type of financing that allows companies in Chapter 11 bankruptcy to continue operating, fund their reorganisation and emerge from bankruptcy in a stronger financial position. 3“MOIC” refers to Multiple of Invested Capital. MOIC is a ratio of the sum of realized proceeds and unrealized value divided by capital invested. In nearly all cases, loans are repaid by each borrower and not traded to third party investors as a means of achieving full realisation.
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