Distressed Credit: Introducing the asset class, and why now is an exciting time

What is Invesco’s private credit platform? How does distressed credit/special situations fit into it?

At Invesco, our private credit platform is actually incredibly unique versus our competitors in that we manage roughly $40 billion in assets and we do that across three different buckets of capital: broadly syndicated loans, direct lending, and distressed credit and special situations. What's unique about our private credit platform is it is entirely private side. Most of our competitors co-mingle their public high yield business and other public businesses with their credit platform.

Our private credit platform is not commingled with our high yield business. It's entirely separate. So what that means for us is that we are able to take private side information across all three of our verticals, distressed credit, broadly syndicated loans and direct lending. And that's very unique in today's market.

What exactly is distressed credit? Please could you give an overview of the asset class?

So if you think about distressed credit and special situations at its core, going back 20, 25 years, when this asset class began, it really began in many ways as a form of trying to find asymmetric returns for investors. And by that we mean thinking about taking credit risk but generating equity like returns. And in our view, that's really what distressed is meant to be and how we approach philosophically the asset class.

So when we think about an investment, we think about investments that can make investors 16 to 20% net internal rate of return two times plus or minus money multiples. But really, while they're taking primarily credit risk. If investors want symmetric return profiles where they can make a lot of money and lose all their money, they can find that in listed equity markets.

They can find that in private equity.

What are the risks and how do you mitigate them?

So in terms of risks, when we think about risk, there's really two things to think about. One is everything we look at has some level of risk to it because we're investing in companies that are in some level of distress, right? Whether they're stressed, distressed, restructuring, going through a bankruptcy process. Right. Something has gone wrong. Hopefully they're good companies in good industries and they're just going through a transitory period where we can come in, we can help them, we can reduce the amount of leverage on the company.

We can inject new capital into the business to help them grow, and we could help augment the management team, if necessary, with operating partners and C-suite executives that we've worked with in the past. We do have some sector expertise in six or seven different sectors so we can bring that to bear and install really a new form of governance with the business.

And it can, along with the injection of capital into the business, help the company really restart and begin growing again. But there's inherent risk in that, right, in terms of restructuring a business, changing the balance sheet, taking it through a restructuring process. So we try to mitigate that by doing things out of court. We don't like formal bankruptcy processes.

We generally take control of businesses in a consensual way where the other lenders and the equity owners of the business are incentivised to turn over the keys, if you will, of the business to us because we are willing to provide new capital and because we have a strategic vision for the business. The other way to think about risk goes back to thinking about the type of risk return profiles we're really looking for here in that we, as a private credit platform, are very focused on senior secured debt.

And that's true in our broadly syndicated loan group, it's true in our direct lending group, and it's also true in what we do in distressed credit and special situations. We generally enter situations through senior secured debt initially. That allows us to get a coupon payment, which helps us de-risk the investment. It allows us to control the restructuring process because secured creditors have tremendous control in a restructuring in the US, in Canada, in the UK, in certain southern European countries where UK English law is present, and in in the Nordics.

So we like secured creditor rights and they help mitigate risk in a material way. And then the final way to think about risk is that we're cheap. We don't pay fair prices for anything. We don't show up at auctions. We don't generally compete for companies or for pieces of debt. We try to pay as little as little as we can for our business, and we try to create the business, if you will, to use that term, well inside the intrinsic value of the business.

So not paying for it, not paying up for a business, not paying up for an investment is the easiest and quickest return we can make for an investor. So we're very focused on mitigating risk by just being cheap.

You’re a very active manager, partnering closely with the businesses you invest in. Tell us about this process.

The whole goal of our strategy right is really to be rescue and revitalisation capital for these businesses, right? That's really the heart of what we do.

And in many times coming into these situations, the company is under some kind of stress or distress, going through a transition period. It could be a failed integration of an acquisition. It could be a liquidity issue. It could simply be they took on too much debt and the economy is slowing and their earnings are going down and now they're over leveraged.

So it can be any number of issues. But what's important for us is to get into the company early, to speak with their owners of the business. In most cases, private equity firms. We are one of the largest financiers in our private credit platform of private equity firms in the world. So we have a lot of connectivity to the private equity firms that own many of the businesses we look at.

We have a great relationship with them. So our first goal is to talk to the owners, talk to the management teams about how we might be helpful. That could be by buying debt and helping restructure the balance sheet of the company. That can be by providing new capital to the business, which we do on certain occasions.

It could be partnering with the management team and thinking about ways that they can grow the business if they were to reduce the debt or to take incremental liquidity from us. But the whole goal is really to get in partner with the company, the management team and the private equity owner of the business generally, and find a solution that works and generates an outcome that's best for the business.

We've never been involved in a liquidation. We've never been involved in a reduction in force of any size. We don't generate value by liquidating or selling assets or by laying off folks en masse. Our whole goal is really to provide capital to these businesses in a way that allows them to take on growth initiatives that they were unable to do because they had so much debt on their balance sheet.

Can you talk a little about how you integrate ESG considerations into your investment process?

So ESG is a part of every investment committee memo that we write and everything that we bring to investment committee. We have the benefit of being part of a platform that was an early mover in the ESG space, in that we were the first loan manager in Europe and the US to launch dedicated ESG loan funds. And so we've incorporated some of that technology, if you will, into our underwriting process in distressed credit and special situations.

Our general view is that businesses that score negatively on those scales are businesses that we need to be very, very careful with and businesses that don't warrant a good multiple in terms of their valuation and may ultimately be very challenging to exit. So, while we are not an ESG specific fund, we do consider ESG in everything we do.

It's part of every investment committee memo we write, and we generally think businesses that score negatively on those metrics are ones that we ought to be very, very thoughtful about. And very, very careful about and think pretty hard about, not only what we would pay for those, but whether we can ultimately exit those investments at a certain point in time.

Now, taking apart the E for a second and just talking about the S and G, we would think about what we do from an investing point of view as very, very much focused on the S and G part of these businesses. Our whole goal in looking at companies and working with them is to partner with them. To provide them with capital. To help them deleverage, and to help them embark on a new growth plan which, ultimately, should create jobs and create more wealth for the employees and the management team and ultimately our clients and investors.

And so we think one of the ways that that we find, particularly in smaller businesses, that that can be very beneficial, is that focusing on the governance piece is something that's typically missing there. And so we try to construct boards that have a diversity of thought and opinion. We try to construct management incentive plans that don't just have all of the equity with the top three people in the company.

We push that equity as far down as it's valued because we think having all of the employees rowing the boat in the same direction generally leads to a better outcome. We would argue there's a tremendous amount of social good where when you step into a business that would otherwise be liquidating and actually provide it capital and help it transition to becoming a healthy business that grows and can employ people and actually contribute to the economy.

So we think what we do is actually an incredibly friendly strategy from an ESG point of view, albeit one that most investors don't often think of as an ESG specific strategy. So I think many of us in the distressed and special-sits space in the last 12 months have really looked forward to the next two three years as what's likely to be the golden age of distressed investing.

What is your outlook for the asset class?

I think most distressed managers today, and we would agree with this, believe that this next cycle will be the best cycle that we've ever seen. I think we have a bit of a different view as to why and and it's worth expanding on that for a moment. Our view is that while many out there are focused on generating higher returns in this distressed cycle, we think actually returns will probably be about what we normally target: 16 to 20% net two times plus or minus money multiple.

But your probability of achieving those returns and the risk you're going to take to achieve those returns is going to be very different than we've ever seen in any cycle in the last 20, 25 years. Your probability of getting good returns is higher and the risk you're taking is a lot lower. And we would prefer investors focus on less risk and a higher probability of good returns than aiming for a higher return target overall.

The reason we think there's a lot less risk and a higher probability of returns today than prior cycles, is that what we're going to experience, in our view, in the next two or three years is probably a good old fashioned recession. It's probably not like any cycle we've seen before. And if you go back and you think about prior cycles, in 2001, we had a tech telecom cycle. In 2005-6, we had an auto cycle in Europe. 2007-8, we had the global financial crisis, which everyone remembers, right?

Very mortgage related, banking related. Homebuilders, housing, casinos, building products, etc. In 2015, we had a crisis driven by OPEC increasing production. Thanksgiving in the US. And then we had an Amazon period of time for the last ten plus years, where Amazon has disintermediated everyone in the retail space, practically. The interesting combination of all of those cycles, if you will, is that they're all driven by an industry change, if you will, right?

There's an industry event or series of industries that are in transition, in secular change that are causing those periods of distress or recessions. What we're going to see in the next two or three years is just a general slowdown in the economy that impacts all businesses. And if you look at any business today, every part of their cost structure is inflated. Labor, wages, energy, utilities, rent, transportation, logistics, cost of borrowing, interest rates. Everybody's cost structure is inflated and everybody's top line is going down because consumers aren't willing to pay higher prices for things anymore.

So the reason that that's important is that the opportunity set is no longer industry specific. It's across everything. And so you should be able, as a distressed manager, to really skew your portfolio to really, really nice companies in really good industries that are just over leveraged. So we're going to get a crack at good companies with bad balance sheets for really the first time in the last 25 years.

And that's why we're really excited about this next vintage.

In today’s environment, why choose private credit over private equity?

All of our senior team began their life in private equity. So we all came from that industry. It's an industry that's been around now for 50 years, so it's a very mature industry. It's incredibly competitive. And if you look at where private equity is today and you can look in Prequin or Pitchbook or any of the publications that cover private equity, right now, private equity sponsors are being forced to put down about 50, 55% of equity in terms of funding their acquisitions and their borrowing costs, which were 4 to 6%, are now 12%.

So their cost of financing has gone up two, three, four times, and the amount of equity they have to put down went from 20% to 50% plus. So you can imagine the only thing that can give there is price. They have to pay a lot less to buy businesses in order to make a decent return.

So one of the one of the things that you see as a result of that is that M&A activity is down to record lows today because there really is no private equity ability to pay a fair price for something. That's great if you're a strategic business looking to acquire something because you don't have competition from private equity anymore.

But it's really, really challenging right now to deploy money as a private equity investor. The other part about private equity that's worth noting is that, when you invest in a private equity fund, your goal in our view, is to double your money or more. But there is a chance that equity, while it has the ability to have infinite returns, it also has the ability to go to zero.

And we would argue that's a much more symmetric return profile than what we're looking at today. We're looking at a market today where the distressed opportunity set is exploding. There is more leveraged credit out today by a factor of somewhere between three times on the low end, five times on the high end, than there was during the GFC.

The maturities over the next 36 months, half of the maturities over that period, are split B-rated or lower, and almost half of them are in the small cap universe. In our world.