Opportunistic Credit Strategies for a Higher-Rate EnvironmentOpportunisticCreditStrategiesforaHigher-RateEnvironment

Peering across today’s credit markets, a common theme emerges: Companies are increasingly going outside traditional channels and relying far more on alternative solutions to meet capital needs. As such, leveraged finance markets have roughly doubled in size following the Global Financial Crisis. This shift will be ever more apparent as a result of the historic rate-hiking cycle, given the likelihood that central banks will not serve as a backstop to financial markets as they have for most of the post-GFC era. With a default cycle beginning to come into view, investors will likely find attractive opportunities in leveraged finance markets amid weakening credit fundamentals and a corresponding rise in special situations activity.

The coming default cycle may prove to be more of a classic one defined by its persistence in duration, rather than its severity. This cycle will play out in an environment that looks far different than the post-GFC years, when investors were accustomed to central bank policies acting as a backstop. Historically, a typical cycle that lasted around five years featured an average cumulative default rate of 30%. In this type of environment, companies must operate in “self-help” mode. With the era of cheap capital at its conclusion, reduced liquidity may prevent capital from flowing to where it is needed most.

After a decade-plus of loose covenants, borrowers today have flexibility that they can use to their advantage. We see many companies taking a proactive approach to addressing liquidity issues and future capital needs, initiating early conversations to get ahead of expected challenges. Opportunistic credit liability management solutions are poised to become a more pronounced feature among limited partner allocations, representing a durable opportunity in the search for uncorrelated, equity-like returns.

It is also important to consider how semi-liquid and illiquid strategies have grown in scale to become a central part of investors’ portfolios. The evolution of these strategies has benefited LPs in meeting their funding objectives. From an individual investor’s perspective, a greater level of sophistication in the markets has led to new investment vehicles that provide access to alternative opportunities.

The need for opportunistic credit strategies has grown substantially with the rise of complexity across corporate credit markets along with the large pools of inflexible capital that have been borne out of 15 years of financial repression by central banks around the world. Tranched strategies meant to capture excess spread and carry (yield) under zero-interest policies are seeding the next wave of opportunities that will become available to investors who target special situations, distressed and mezzanine strategies. As markets focus on the contours of a complicated fight against inflation around the world, credit market complexities along with ownership problems are driving increasing levels of stress and a need for capital solutions by companies and financial sponsors despite valuations across credit and equities at or nearing record levels. 

Special situations strategies typically benefit from an environment when they can lean into complex situations with flexible capital capture complexity premia at attractive valuations. We see this occurring regardless if a market drawdown occurs (traditional pathway) given the nature of the credit markets today: weakening market multiples, higher interest burden, slowing economies, excessive leverage and reduced corporate pricing power (versus the last three years). Helping companies address balance sheet and capital structure problems through liability management via debt exchanges, preferred equity solutions to reduce leverage, equity injections and process loans, and amend and extend transactions with warrant features are examples of the transactions we are increasingly seeing that can drive significant uncorrelated returns across the credit cycle.

Markets have recently displayed a heightened sense of uncertainty, with the macro implications of higher rates and inflation still taking shape. Investors are therefore taking a shorter-term approach. They are employing strategies that have worked more recently, driving a structural change across credit markets with investors showing a preference for moving up in quality, avoiding downside risk, and preserving capital in anticipation of greater volatility as rates normalize. 

Investors might be better served playing the long game. Higher borrowing costs, as well as the likelihood that rates remain higher for longer, are exposing fragilities in the market. Despite the broader array of financing options available to companies, challenges are still emerging as a result of tighter credit conditions and a shortage of dry powder. Companies are in need of solutions to navigate this environment, and they are increasingly seeking managers and pools of capital to help them overcome a challenging operating cycle. Distortions in leveraged finance markets may exacerbate the challenges that companies face. Many investors today are focused more on capturing yield, and they are less interested in taking on credit risk. These investors are likely to sell more quickly when risks do emerge. The flight to quality in the current market environment could therefore lead to further volatility, credit stress and defaults that fuel a rise in distressed and special situations activity—even against a macro backdrop that is relatively benign.

We expect liability management (LME) to be a main feature of the next credit cycle and are seeing a significant rise in activity as companies are not waiting for more favorable capital market conditions to materialize down the road to address capital structure needs. Rather, companies increasingly prefer to monetize the optionality provided to them by lenders through significant flexibility in credit agreements or bond indentures, and pull forward the conversation to address the needs now through coercive maneuvers with existing lenders by enlisting the help of small group lenders or managers that have flexible capital and good insight into the company’s setup value and operating condition. The rise of LME or lender violence is happening at a time when credit spreads are near record tight levels and default rates are still relatively low by historical standards. We believe the rise is tied to a degree of capital misallocation across levered credit as companies and lenders recognize there is a permanent reduction in enterprise value and that market conditions along with idiosyncratic factors suggest a lower terminal value or “backwardation” effect the company’s future value.

Conclusion

We believe higher dispersion across credit markets is structural and being driven by years of financial repression, which has driven a sizable amount of unnatural investors and inflexible capital into corporate credit. The added factor of lender violence or liability management is creating a circular dynamic whereby segments of the credit markets exposed are quickly assigned elevated risk premiums for investors to participate, which is seeding future distress especially as maturity walls loom.

As investors retreat from corners of the market, companies are further emboldened by advisors to apply increasingly aggressive tactics. In large part, the reason defaults and distress are rising with credit spreads near record tight levels is because of this feedback dynamic, which is set to amplify stresses and need for capital solutions if credit conditions deteriorate further.

Private equity sponsors are facing a challenging backdrop as exits plummet and leverage across portfolio companies remains elevated along with overall credit risks. The reaction function from sponsors is to dial up competitive pressure between the direct lending market and the broadly syndicated loan (BSL) market to achieve the best terms possible. Liquidity challenges within sponsor portfolios are ushering in the use of 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. We believe the next 15 years will look different from the post-GFC era, as the need for opportunistic credit through special situations and distressed strategies looks to capitalize on the structural challenges in the credit markets and excesses as measured through various forms such as underwriting and return expectations.

We believe the best way to achieve uncorrelated equity-like returns over the next decade will be through opportunistically owning the debt of companies. Specifically, special situations managers can capitalize on the weakened positioning of debt or private equity investors in good companies that require capital solutions regardless of the credit cycle condition.

The combination of constrained central bank liquidity, market distortions, and the need for alternative capital solutions create fertile ground for investors with experience navigating a variety of credit cycles. With a lengthy period of “self-help” for companies and sponsors likely just beginning, investors with dry powder who can anticipate the coming default cycle will be prepared to capture opportunities as they reveal themselves.