Current market dislocations in private credit: Distressed debt

As part of the recent Invesco Asia Pacific Forum, Paul Triggiani from Invesco’s Private Credit team spoke with Jeffrey Reemer, Senior Client Portfolio Manager, on how the landscape for distressed debt has evolved in recent years and the opportunities he is seeing in this space. Below are some excerpts from this insightful session. 

Q: What are you seeing in the distressed opportunity set and where specifically do you focus?

A: Today’s macroeconomy continues to be characterized by higher inflation across the globe, contraction in global industrial production, and a markedly more challenging outlook for the UK and Europe relative to the United States and Asia. Interest rates continue to rise, challenging many existing leveraged borrowers with significantly higher interest rates, as most of these companies today are paying over double the interest expense compared to this time last year. Companies continue to experience inflation in almost all parts of their cost structures – labor, wages, rent, utilities, energy, transportation and logistics costs, raw material and aggregate inputs, as well as the above-mentioned borrowing costs.

At the same time, it has been far more difficult for businesses to pass along price increases in their products to offset falling demand. We have not only seen a pullback in industrial production, as evidenced by a general slowdown in global manufacturing, but we have also seen consumers postponing discretionary purchases and substituting lower-cost, non-discretionary items where they can. All these factors have contributed to what we describe as a broad-based, global margin squeeze impacting all industries in all geographies. This backdrop provides an opportunity for distressed investors to focus on solid, operationally sound companies in stable industries.

Our team focuses specifically on small cap distressed debt, which we define generally as sub US $500 million in market value of debt outstanding and well below US $100 million in EBITDA. We target senior secured entry points and seek out inefficient debtholder bases which may include a large club of regional banks and maybe some direct lending firms, or a lightly syndicated loan where you'd have 10 or 20 collateralized loan obligations (CLOs) as participants. We believe being senior secured in the capital structure can help mitigate downside risk and that such holder bases may be forced sellers at times allowing us to potentially enter positions at attractive valuations.

In our view, the small cap space is particularly interesting for a couple reasons. First, it tends to be is more evergreen in nature and not cycle dependent. Small companies tend to face trouble more routinely due to idiosyncratic company-specific reasons that are completely independent of the macro environment. This is very different relative to large cap distressed debt, where you typically need a cycle to for a distressed opportunity set to materialize.

The small cap space is also an incredibly opaque and inefficient market. These are all private companies without listed financials. You need to sign confidentiality agreements to access company information. Also, small cap companies are not widely followed allowing us to buy into these capital structures at attractive prices.

Q: To address the elephant in the room of a potential recession, if we agree there will be one, how do you go out and source these opportunities?

A: Due our preferred small cap habitat, we're a bit indifferent as to whether a recession occurs or not. We're obviously baking a recession into our base case and that's very important in terms of underwriting new opportunities. However, we think it is more important to consider what will happen with the rate environment. We believe as long as rates remain elevated, companies that have upcoming maturities are going to have a very difficult time refinancing.

We believe these issues may materialize across all industries. Interestingly, almost half of the senior loans and high yield bonds maturing over the next 36 months are split B-rated, potentially also increasing the number of company issuers experiencing distress and/or downgrades in a challenged economic environment. Importantly for us, over 40% of these businesses have less than US $500 million in debt outstanding – meaning they fall well within our small capitalization target zone. In addition, significant percentages (30-40%) of recent new issuance across these markets are similarly situated – being B3/B- or unrated as well as issued by smaller companies. A period of significant downgrades could result in selling pressure for many original or “par” holders of this debt, particularly CLOs, who represent approximately 70% of the leveraged loan market¹ and are limited in the amount of CCC-rated debt they can hold.

Q: Could you compare the distressed opportunities today versus what you've seen in past cycles?

A: Today’s environment is very different than anything this asset class has ever seen. If you think about the cycles we’ve seen in the past 20+ years, they have mostly been very industry driven. The 2001 recession was tech, telecom and broadband-based. Then if you look in 2005 and 2006, we had an auto cycle in Europe. The GFC was also obviously very industry specific: financials, mortgages, home builders, building products; while 2015’s cycle was energy focused. Further, the last 10 to 15 years have seen issues in the retail sector as an e-commerce giant has disintermediated every non-experiential retailer in the market. Most recently, the COVID pandemic created an artificial economic cycle in that we slammed the door on the economy and then two and a half years later reopened it. This meant certain industries were more impacted than others such as travel, quick service restaurants, cinemas, etcetera.

In contrast, the opportunity set we're seeing today is much more broad-based. There's no one industry that's being impacted to a significant degree more than others. As distressed investors, we want to focus on the most compelling investments in robust companies and industries. Interestingly, and maybe more so than ever in the past, our opportunity set is less comprised of companies experiencing operational issues. This means we can spend more of our time investing in strong businesses and focusing on right-sizing company balance sheets or liquidity issues. As a result, the next couple of years look far less risky in terms of the market environment on a risk adjusted basis than what we've seen in prior vintages of distress.