Is distress finally dawning?
Interest rates and high liquidity have typically helped keep work-out at bay, but is it different today?
“We are currently in a low default rate environment,” says Blair Jacobson, Partner and Co-Head of European Credit at Ares Management. “That could mean that the only way is up. If that happens, those who are in control of their capital structures and have the resources and experience in these kinds of situations are better positioned for recovery. As we go through 2024, the ink is still not dry on that yet.”
“There will be an increased focus on existing portfolios because there will be more defaults,” says Vijay Padmanabhan, Managing Director, Private Credit at Cambridge Associates. “But these situations will be well managed, especially in Europe where there is a lot of senior secured direct lending involving a sole lender. We will see more covenant breaches and defaults, but not significant losses. Companies are being proactive and, unlike in 2008, there is a lot of dry powder, so there’s not a liquidity issue.”
“There are capital structures from private equity deals that were written three to four years ago when interest rates were close to zero,” says an investor specialising in private wealth asset management. “They may have been perfectly acceptable capital structures then, but today many of these companies are seeing their free cash flows swallowed up by interest payments and they’ll need new solutions. There will be some interesting opportunities to write junior credit, where we can get downside protection and generate equity-like returns.”
“We’re definitely seeing stress, but the question is: will it become distress?,” asks Mitesh Pabari, Principal, Fund Investments at Hamilton Lane. “We saw some credit groups invest on the back of the GFC and if there’s one place that has at times overpromised and underdelivered, historically it’s been distressed. The situation today is that there are a lot of firms that can offer capital solutions and can generate private equity-like returns in special situations. As for distress, I think we have to tread carefully.”
“We may see some pressure ahead in legacy portfolios if interest rates stay higher for longer,” says Corrado Pistarino, CIO at Foresters Friendly Society. “This will be more severe in Europe than the US, where conditions for growth are more challenging - the employment market is tight in historical terms and it’s seeing close to zero growth in productivity. In the US, conditions are more favourable, but even there, we’ve seen up to seven Federal Reserve rates priced in at the end of last year fall to expectations of no more than two.”
There will be an increased focus on existing portfolios because there will be more defaults
“Regulatory capital is driving a distress theme,” says a managing partner at a private credit firm. “Banks have a large exposure to traditional real estate assets and they will be constrained as to how much they can hold as fundamentals continue to deteriorate. There is an opportunity to work with regional banks to source non-performing loans to tangible assets that we know well. Some of these will be great assets, but they have a bad balance sheet – they’ll need restructuring with a new sponsor.”
“Distressed and special situations come up a lot more in conversations with clients today,” says Jakob Schramm, Partner and Head of Private Credit at Golding Capital Partners. “We can have a long debate about whether distressed managers can time the market, but it is clear that doing this is even more difficult for the ultimate clients committing to these strategies. Rather, we should be building a broad credit exposure that includes between 15% and 20% distressed debt so there is exposure through the cycle.”
We may see some pressure ahead in legacy portfolios if interest rates stay higher for longer
“We are seeing a growing amount of stress in the market today,” says Duncan Priston, Co- Head and Managing Director at HIG Bayside. “Many companies in the US and Europe took on way too much debt over the last decade when interest rates were near zero. Now with inflation and interest rates rising, many of these companies have balance sheets that are unsustainable. We haven’t seen a lot of defaults yet, largely because of loose credit documentation, but defaults are certainly coming.”
Priston adds: “Near-term maturity walls in 2024, 2025 and 2026 are not going away and will provide a hard catalyst for payment defaults and restructurings. Traditional lenders are now providing less leverage to businesses and on more punitive terms. In addition, banks and par lenders are also generally not well positioned or willing to participate in defaults or restructurings, so they often become motivated or forced sellers. We believe this next credit cycle will provide many compelling secondary and primary investment opportunities for firms, like ourselves, that have flexible capital and can be nimble and creative in its deployment.”
“Currently, a lot of the private equity people I speak to have more and more concerns for the future,” says Robert Meyer zu Starten, Managing Partner at Octane Capital. “The direct lending funds are also starting to see signs and they have more names on their watchlists. I’m surprised by how close we are already to seeing major defaults on the corporate side. Recently, we’ve been spending more than 50% of our time on real estate investment opportunities, but by 2025, I expect we’ll be having a serious look into corporate situations – these are coming.”
