Amid the downdraft in markets in late March and the continued uncertainty surrounding the impact of the coronavirus on the economy, the S&P 500 Index rose to all-time highs this past week after reaching its 52-week low on March 23. Thanks in part to government stimulus, aid from central banks, low interest rates and confidence that a coronavirus vaccine could hit the market at some point next year, investors have continued to bid up assets, illustrating confidence in a near-term recovery. Leading up to the onset of the pandemic, however, existed a leveraged credit market (high yield bonds and leveraged loans) that had grown to 2.3 times the size of 2008. In addition, over the last six years, average debt-to-EBITDA (earnings before interest, taxes, depreciation and amortization) multiples at new issue were over five times levered, a number not seen since 1998. These EBITDA numbers tend to be tied to leveraged buyouts, which contain a generous amount of add-backs or adjustments. In recent earnings reports, there have even been some companies citing EBITDAC (earnings before interest, taxes, depreciation, amortization and coronavirus) or some type of profitability adjustment due to the pandemic. As a result, these debt-to-EBITDA multiples are much higher than they appear at face value. Companies, particularly those in secular decline, will have trouble meeting debt obligations over the next few years. In a SALT Talk a few weeks ago, Joshua Friedman, co-founder and co-CEO at Canyon Partners, a distressed credit manager, stated, “the Fed helps to provide liquidity, but they do not fix balance sheets.”
Although stocks continue to rise, distressed investors are still finding places to invest. Certain sectors, such as retail and department stores, energy, software and travel and leisure, continue to experience near-term slowdowns or secular disruption. In late March and April, the immediate opportunity set was geared toward “dislocation trades,” or strong companies that traded down as investors liquidated portfolios amid the selloff. This phenomenon led to opportunities in investment-grade credits trading down from or near par, as well as in “fallen angels,” investment-grade companies that had recently been downgraded to high yield. As the market began to recover amid the Federal Reserve backstop, a majority of these securities traded back up and a large swath of investors exited their positions. In regard to the loan market, some investors rotated out of loans that had recovered in value and into secured and unsecured bonds in companies they knew well, as the underwriting of one debt security can be helpful in analyzing another part of the capital structure. Furthermore, a number of industries continue to experience secular change. With the economy slowing down, some businesses will begin to default on their debt, leading the way for distressed firms to take advantage of a longer and more complex opportunity set revolving around workouts, restructurings and distressed exchanges, as well as debtor-in-possession and exit financings.
Distressed investors take varying levels of risk, as some focus strictly on the top of the capital structure with the highest presumed recovery, while others purchase junior tranches of debt in hopes of generating outsized returns — albeit with more risk. In workouts and restructurings, firms tend to buy a sizable position in a tranche that offers the most attractive risk-reward, with plans to participate in a creditor or steering committee, putting themselves in the driver’s seat to negotiate an optimal recovery. Generally, firms have experience with understanding and negotiating credit agreements, in addition to in-depth knowledge of the bankruptcy process. Distressed firms can also create value through opportunistic avenues, including distressed exchanges, where a company will propose that existing debt holders take a discount on their principal in exchange for moving up in priority in the form of secured debt.
Finally, distressed funds also look to participate in debtor-in-possession and exit financings, in which investors provide companies in bankruptcy with fresh capital to fund the business through the balance of the bankruptcy negotiation. In some cases, these financing packages contain extremely high coupons and investors negotiate some type of equity incentive for providing this critical funding, which can include post-reorganization equity in the currently bankrupt entity or some form of new convertible debt financing.
Key Takeaway
Given the current landscape, many businesses, particularly those in secular decline, will struggle to meet their debt obligations, presenting a vast number of complex opportunities for distressed firms to take advantage of. It will be key for limited partners to critically evaluate a firm’s ability to understand the inner workings of credit agreements, the bankruptcy process and management teams, as well as to properly dissect each distressed investor’s strengths and weaknesses in regard to finding compelling investment opportunities while prioritizing preservation of capital.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
Opinions and statements of financial market trends that are based on current market conditions constitute judgment of the author and are subject to change without notice. The information and opinions contained in this material are derived from sources deemed to be reliable but should not be assumed to be accurate or complete. Statements that reflect projections or expectations of future financial or economic performance of the markets may be considered forward-looking statements. Actual results may differ significantly. Any forecasts contained in this material are based on various estimates and assumptions, and there can be no assurance that such estimates or assumptions will prove accurate.
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