Credit managers to exploit market dislocations

Credit managers are expected to spend the balance of 2020 attempting to take advantage of investors' pivot toward private credit strategies focusing on perceived market stress and distress.

A number of managers are busy raising capital to take advantage of the current market dislocation impacting companies, real estate and infrastructure assets either now or in the future.

Some asset owners are hedging their bets by placing conditions on capital deployment.

For example, earlier this month, the $20.5 billion Louisiana Teachers' Retirement System, Baton Rouge, made an initial $50 million investment in a mortgage-backed securities strategy managed by Principal Real Estate Investors as well as an additional $50 million commitment to the strategy should credit spreads widen.

In June, CalPERS increased its maximum target by 2 percentage points to 5% to opportunistic strategies, a portfolio designed to invest in opportunities such as private credit that arise from extreme market dislocation from a crisis such as COVID-19, said Yu "Ben" Meng, CIO of the $385.2 billion California Public Employees' Retirement System, Sacramento.

Earlier in the year, CalPERS committed $1 billion each to two credit funds — Oak Hill Advisors LP's OHA Black Bear Fund and Oaktree Capital Management LP's Oaktree Latigo Investment Fund — structured with triggers so the mandate would be activated only when a set of conditions was met. The triggers were met immediately thereafter, Mr. Meng said.

These are not the only credit managers seeking to take advantage of market dislocation:

• Apollo Global Management Inc. is expected to soon start raising its Apollo Accord Fund IV, Josh Harris, senior managing director, said in the first-quarter earnings call. The Accord fund focuses on dislocated corporate credit. Apollo's third Accord fund became fully invested within seven business days in April. The following month, Apollo launched and then closed on $1.75 billion more for the strategy in Apollo Accord Fund III B, he said.
• Private equity and hedge fund manager Strategic Value Partners is seeking to raise $1.5 billion for SVP Strategic Value Dislocation Fund, a North America and Europe credit fund aiming to invest in distressed investments ranging from liquid trading and event-driven investments to less-liquid investments including the debt of companies in bankruptcy, reorganization or liquidation.
• Oaktree Capital is raising Oaktree Opportunities Fund XI, a distressed fund.
• Silver Point Capital LP is targeting $1 billion for Silver Point Specialty Credit Fund II to invest in companies, some in out-of-favor industries, needing some sort of bridge financing. Although Silver Point historically made first-lien whole loans, it expects this fund to have a larger allocation to existing or secondary loans, according to agenda materials from fund investor New Mexico State Investment Council's June 4 meeting.
• Real estate debt fund managers including Kayne Anderson Capital Advisors LP, Torchlight Investors and Varde Partners are also in the midst of raising capital for new funds, according to Pensions & Investments searches and hires database.

The risk for investors committing capital for distressed or stressed investments is that no one knows how long the COVID-19-sparked recession and market downturn will last.

"Such a high degree of uncertainty is challenging for even the most experienced investment professionals," according to a manager selection report for the $16.2 billion Orange County Employees Retirement System, Santa Ana, Calif., an investor in the latest SVP fund.

Even though managers are getting capital commitments, Jeffrey J. Eaton, Houston-based partner at placement agent Eaton Partners, expects fundraising to be down this year.

"Investors hit pause in March and April as things looked really bad, but the world didn't end," Mr. Eaton said.

While the public markets are coming back, which eliminates investors' denominator issues, the market is crowded and people still aren't meeting in person, he said.

"In our business, there is a saying 'no meeting, no money,'" Mr. Eaton said.

Some investors are making commitments anyway. Even so, Mr. Eaton expects that most of the money raised will go to large, established managers with whom investors already have relationships.

"It will be very competitive for emerging or lesser-known managers, even though those managers often times generate higher returns than their larger, more established competitors," Mr. Eaton said.

But private equity transactions are down, removing a major source of credit managers' deal flow. There were 888 buyouts worth a total of $61 billion in the second quarter, nearly half the deals as the year-earlier quarter when there were 1,567 transactions totaling $115 billion, according to Preqin.

"We have a health crisis and an economic crisis and they go hand in hand. ... It's hard to predict where the markets are going to end up," said Olamide "Lami" Ajibesin, New York-based managing director of the transaction advisory services practice at accounting and advisory firm Anchin, Block & Anchin LLP. "If there is a second wave in the health crisis, who knows what will happen."

In the last three months, some people have lost their jobs, while others are doing well, revealing significant economic inequalities, she said.

This all affects private equity firms and their current and potential portfolio companies. Certain industries such as aerospace are underperforming and executives are trying to recoup their investments, while technology, insurance and certain types of consumer-oriented businesses have seen revenue increases, Ms. Ajibesin said.

Even so, many private equity firms have dry powder and are waiting to deploy it, she said. Private equity managers had $1.5 trillion in dry powder as of June 30.

So, credit managers are shifting to distressed and stressed investments as well as to concentrating on lending to companies needing capital to survive the recession or to grow.

There's a lot of interest in non-performing loans, collateralized loan obligations, and certain distressed asset-lending, such as aviation finance, which are primarily strategies focused on purchasing loans and debt on the secondary market, Mr. Eaton said.

Executives in Ares Management Corp.'s credit business expect this type of deal flow to grow.

"For the second half of the year, we expect deployment to gradually strengthen as transaction activity picks up," said Kipp deVeer, director, partner and head of the credit group at Ares.

The credit business had $112.5 billion in assets as of March 31. "We believe private, middle-market companies will continue to need liquidity bridges and offensive acquisition capital."

Art Penn, New York-based founder and managing partner of middle-market credit firm PennantPark Investment Advisers LLC, said that buying loans in the secondary markets is a large part of the firm's focus this year.

"When there is market volatility, it could help us buy a loan or credit at a lower price as long as we can underwrite the cash flow … in the turbulence of COVID," Mr. Penn said.

For the second half of 2020, if the economy is choppy or shuts down again, there will be secondary opportunity, Mr. Penn said.

"If the recovery persists, there will be more primary loan activity," he said.

However, managers need to be cautious.

"For companies right in the crosshairs of COVID, no matter what you do, you are going to have a challenging situation," Mr. Penn said. Most of the defaults have been in companies in sectors that were already weak such as retail, which COVID pushed over the edge, he said.

"If companies are reasonably leveraged and not in the crosshairs of COVID-19 generally, they will handle the crisis, assuming we've seen the worst of it. If not, all bets are off," he said.

Some managers expect a degree of impairment for another year or two.

"While we're not anticipating a return to the severe credit market dislocation observed in March-April, we believe that many corners of the private credit market, specifically less-liquid ones, will be impaired in the short to medium term," said Peter Troisi, New York-based partner and head of investments, Americas at Balbec Capital LP, which has $2.4 billion in credit AUM.

"We expect greater matchmaking between distressed parties and longer locked-up structures with significant dry powder and that are best suited to weather gyrations in the next 12 to 24 months."