Amid the coronavirus pandemic, extraordinary market volatility and disappointing economic data continue to challenge investors. At the same time, gains from investments entered during previous recessions are influencing investors’ decision making, along with a frame of mind to, as Warren Buffet says, “be fearful when others are greedy, and greedy when others are fearful." Many market participants seek to strike while the iron is hot and take advantage of opportunities that have emerged in the current downturn.
In a June 10 webinar, BBH’s Andrew Ritchie led a panel of experts, including Diala Minott of Paul Hastings, Milko Pavlov of Houlihan Lokey, and Tim West of EY on the topic of distressed debt. The group provided their perspectives on the types of investments available, the trends in the distressed space, and the differences between the current recession and the global financial crisis. What follows is a selection of highlights from that discussion.
Andrew Ritchie, BBH: Let's start by discussing the current market with respect to terminology and asset class designations. Is this an opportunistic market? A distressed market? Special situations? Or, a set up for turnarounds?
Milko Pavlov, Houlihan Lokey: Certainly, opportunities exist in the market. Companies are trying to manage their liquidity and looking for ways to preserve value. This has created openings for private equity and direct lending firms to invest capital—even though leveraged loan pricing and new issuances has, for the most part, recovered from March lows. That recovery is due in part to central bank intervention and stronger market sentiment in certain sectors. Nevertheless, we will are likely to see negative GDP across a number of key economies.
Diala Minott, Paul Hastings: I agree with Milko; the market is ripe with opportunity, and investors are entering the market with varied goals. That said, the lines between the different types of investors are becoming increasingly blurred. I see two main camps of market participants seeking to lend or invest in impaired businesses. In the first camp, you have opportunistic traders. They want to realize value and simply trade in and out of securities, and they do not necessarily aim to work the businesses. In the second camp, you have distressed lenders and distressed funds, who actually do roll up their sleeves and perform deep dives on the businesses, working through the business challenges. These types of traders, of course, have varying different skill sets.
Tim West, EY: I agree that there is a whole host of opportunities in the market. But in extreme times like the present, the phrase “distressed” is no longer a differentiator. The whole market is in turmoil. So, at this point it is less about consciously investing in the distressed space, and more about timing. If you are already in the market, you are managing volatility and fighting existential threats. However, if you are coming in fresh, with a new strategy, then you are finding once-in-a-lifetime opportunities.
Andrew Ritchie, BBH: How long will these opportunities be available for investors? Is this a short-term circumstance or one that will continue into 2021 and beyond?
Milko Pavlov, Houlihan Lokey: The answer—one that is now all-too familiar to investors—is that it depends. The legs on this wave of opportunities will depend on how long we are in lockdown; how long until society returns to normal; and how society is shaped when the new “normality” begins to come back. Over the midterm, I expect continued fertile ground for investments, with the precise level of opportunities dependent on second- and third-quarter results and how quickly valuations catch up with financial performance as well as how lenders react to any concerns of the underlying collateral.
Tim West, EY: It also depends on whether we experience a W- or V-shaped recovery. A “W” is our house view, as expect a rise and fall of recover and falter, recover and falter, to occur for a while. Many others expect markets to recover quickly, with just a small amount of queasiness afterwards.
Andrew Ritchie, BBH: What—if any—challenges have you seen for private fund managers seeking to capitalize on opportunities?
Diala Minott, Paul Hastings: We see managers considering both opportunistic trading and distressed trading. They are examining their existing platforms to see if they can access certain attractive trades and to determine whether potential investments are in a bucket within their investment restrictions. If not, managers are often approaching their advisory council and their limited partners (LPs) and asking for permission to take on these trades in the fund. Some LPs resist, and request that managers set up a different fund for these trades to avoid mingling diverging strategies and conflicting LP interests. That said, managers can set up a wide array of platforms, it just depends on the strategy. The first step for managers is to know exactly what strategy they are investing in.
Andrew Ritchie, BBH: We are still seeing viable businesses today, so private companies now have the opportunity to invest in resilient companies with strong operations, with better terms. Is this a turnaround story that is being presented to private equity and private debt?
Tim West, EY: Yes. In the last crisis, we note that those who moved quickly and jumped on opportunities have massively outperformed in the past 9-10 years — particularly those firms who were very hands on as investors.
Andrew Ritchie, BBH: Tim, can you talk more about the differences between today's environment and the global financial crisis?
Tim West, EY: There are some obvious, huge similarities between the 2008-2009 crisis and the ongoing recession, and hopefully we can apply some of the lessons learned from the banking crisis to our current situation. However, this time around, we have a larger government response. For example, the Fed has been purchasing corporate bond ETFs to buttress the corporate credit market since that program launched last month. The European Central Bank (ECB) is also talking about implementing this strategy.
And as Milko mentioned, leveraged-loan issuance rebounded thanks to market intervention.
Andrew Ritchie, BBH: Could the group weigh in on investors' action plans as they plan for future quarters?
Tim West, EY: Investors are remodeling after the market's repricing. As investors dust themselves off and look to the future, we advise them to focus on quality. We are receiving requests around product set and product innovation, and we are creating solutions for clients to give them a way forward.
Also, for today's investors, data is crucial. Traditional economic data sources, such as credit ratings, are not necessarily providing relevant, actionable information now. So, people are looking at new sources of data to figure out where to invest.
Milko Pavlov, Houlihan Lokey: For investors looking ahead, valuation has been a hot topic, particularly as assets that have generated predictable revenues are suddenly seeing no sales for three months and more, as well as facing challenges with updating their business plans. The outcomes for each company will depend partly on its industry, as we are expecting further impairments in the second quarter for sectors such as travel, leisure, retail, and parts of real estate (operators in particular).
For lenders focused on maintaining the integrity of their credit agreements, the extent of action will depend on components including the level of government intervention and its reach and effect on the businesses in question; and the amount of leverage in the system. In the direct lending space, we are seeing credit tightening, and lenders are doing significantly more due diligence on the underlying businesses before underwriting new debt. After a period of covenant-lite loans and borrower friendly terms in credit agreement, the pendulum is expected to swing towards lenders. The quality of credit documentation is likely to go up, with more restrictive covenants and baskets, greater information rights, less leverage and better collateral.
Andrew Ritchie, BBH: So Milko, how bad will valuations get in the third quarter?
Milko Pavlov, Houlihan Lokey: Declines are likely to be asset and industry specific. Company valuations are a function of cash flows, financial performance, and market dynamics. For certain industries, forecasted cash flows will be lower and LTM performance will be affected. Add to that end, there is no recent transaction data that can be utilized as comparable data points, creating further complexity to determine where fair value ranges will be in Q2 and Q3 of 2020.
Andrew Ritchie, BBH: Thank you, panelists, for this behind-the-scenes view of investors' concerns and perspectives in today's turbulent market. Listen to the full webinar here.
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