Oaktree Insights: Thriving in an Era of ‘Lower for Longer’

Investing

Major effects of today’s low-interest rate environment on the investing landscape in Europe?

Pedro Urquidi (Head of Distressed Debt Europe)

  • Low-rate environment has clearly pushed valuation multiples to cyclically high levels. While it’s most prominent in the public markets, it has spread to private markets
  • Increased use of leverage in an attempt to push single-digit returns into double-digit territory
  • Sustained low rates have caused many public-market investors to shift their attention, and their allocations in turn, to private markets, where higher yields are more prevalent
  • Europe went from having almost no private market for direct lending before the credit crisis, to having outstanding loan value that is now estimated to be $75-100 billion

Nael Khatoun (Managing Director, European Principal and European Private Debt)

  • Really attractive time to exit investments. Most of these exits have materialized via highly competitive auctions, resulting in valuations that are reliant on excessive leverage
  • Average EV/EBITDA multiple in Europe now exceeds 9.5x, including over 5x Debt/EBITDA
  • Behavior of some PE sponsors creates cause for concern. We recently sold a portfolio company where the bidder entered into a binding purchase agreement in less than 48 hours in order to pre-empt the auction

How has the low-rate environment affected middle market lending in the US?

Bill Casperson (Managing Director, US Private Debt)

  • Higher returns offered by middle-market and direct loans have attracted a host of non-bank lenders to the table, particularly as US banks have exited the middle market, largely for regulatory reasons
  • These non-traditional lenders have been very successful in fundraising to finance middle-market LBO’s but they’ve also created a very “crowded” marketplace dynamic

How do you think about impact of a low-interest rate environment on investor base? Have any increased risks arisen as a result?

Francoise Giacalone (Managing Director, US High Yield Bonds)

  • Investors are taking on more risk in an effort to increase returns. One way credit investors have done this is by moving down the credit-quality spectrum
  • In some cases, investors are now fully utilizing or expanding their allowable high yield bond allocation

Bill Casperson (Managing Director, US Private Debt)

  • In the middle markets, investors have been pivoting between sponsor-led and non-sponsor-led deal investing
  • Lending to non-sponsored companies generally means you’re dealing directly with management team, so if there’s a bump in the road and that team is hesitant to make material changes or terminate key executives, as a lender you may be more limited in your ability to force change
  • Investors should be wary of new or less-experienced investment managers who suddenly pivot toward non-sponsor backed deals, because while yields may be more generous, these transactions generally entail greater risk

Thoughts on managers taking a more creative and flexible approach to their core mandate in search of returns?

Matt Wilson (Managing Director, Special Situations)

  • Within Special Situations Group, our investment strategy calls for us to pivot our investment focus in sanguine times like today by making investments in companies, rather than attempting to buy distressed debt in the open marketplace or pursuing “distress-for-control” investments, which we do when markets experience dislocation
  • It can be a sign of significant danger when you see a manager go outside its wheelhouse. For example, while we may make a direct or structured equity investment in a private company, we would not pursue a leveraged buyout, because it does not align with our emphasis on managing downside risk

Francoise Giacalone (Managing Director, US High Yield Bonds)

  • Of course, the most flexible bond mandates have the ability to be more broadly creative than the more tightly defined ones. That said, we’re dealing with low interest rates, high valuations, and high leverage
  • Our job is to dig beyond the headlines to understand a company’s underlying business in order to determine if its cash flows will be able to support its debt incurrence

Pedro Urquidi (Head of Distressed Debt Europe)

  • In overall benign times, we look for idiosyncratic or sector- and company-specific distress, whereas in a downturn, we avail ourselves of systemic distress opportunities and largely concentrate our buying in the public debt markets
  • What doesn’t change irrespective of the environment we’re in is our emphasis on working with the right partners and counterparties, and ensuring appropriate resourcing to underwrite, manage and exit investments successfully

Josh Connor (Managing Director, Infrastructure Investing)

  • Our team focuses on midstream energy and power generation in the energy sector and on airports, ports, freight rail, and other transportation infrastructure assets in the transportation sector
  • We have flexibility in the way we structure a particular investment but we always evaluate the same criteria before buying an asset – things like barriers to entry, business cyclicality, seasonality, regulatory and political dynamics
  • We’ve seen a surprising amount of wiggle room in what some of our competitors consider an infrastructure investment or mandate – example would be aircraft leasing, which we think is too much of a stretch

Where do you see sensible, attractive investment opportunities today?

Nael Khatoun (Managing Director, European Principal and European Private Debt)

  • Opportunity available to investors focused on smaller transactions. In Europe, there is a significant difference between the average EV/EBITDA entry multiple for transactions over €250 million and for businesses valued between €25 million and €100 million
  • You see the same in European direct lending market, where large companies can get easy access to liquidity, while small and medium-sized enterprises have limited access to ECB funding and, thus, may be priced inefficiently
  • Another opportunity is in making direct loans to companies outside of a competitive process
  • Many European direct lending funds today are taking on subordinated debt risk in an effort to achieve the same yield as they might have several years ago when the market was in its infancy
  • Focusing on less competitive situations enables us to get our desired yield and be at the right place in the capital structure to maximize recovery in the event of a default or restructuring

Pedro Urquidi (Head of Distressed Debt Europe)

  • Distressed debt opportunity set in Europe has been largely tied to the sale of non-core assets by European banks, to the tune of about $100 bn annually
  • We’ve been investing heavily in these non-core assets, mostly in the form of non-performing loan portfolios. It has now gotten too competitive
  • Areas that appear less competitive and where we are finding more attractive and interesting opportunities and therefore are making more investments, are in single-loan acquisitions and stretch-senior recapitalization deals
  • Stretch-senior recapitalization lending is where we might lend capital to a borrower so they can buy back their loan from a bank, for example
  • Distressed Debt strategy is also finding interesting investment opportunities in Asia where markets are currently more dislocated and generally more disparate
  • In Asia, also working on recapitalization lending with real estate developers, where there are very high quality assets and an opportunity to potentially earn what we consider very attractive returns
  • Finally, we have been able to invest capital at deep discounts in select EM credits thanks to episodic dislocation
  • Corporate high yield bond market within EM has grown from $191bn before the GFC to about $820bn today, and the EM loan market has doubled from $1 trillion to $2 trillion

Francoise Giacalone (Managing Director, US High Yield Bonds)

  • Opportunity set more robust in the new issue market for high yield bonds
  • Amount of issuance is very high – this year alone expected to be around $290bn
  • Generally maturities are up to 10 years but due to the callable nature of the bonds within 3 to 4 years, there is continuous flow of issuance for refinancing
  • Also, by actively monitoring the secondary market, we may encounter the same credit we liked at issue but with improved economics if the price has declined

Bill Casperson (Managing Director, US Private Debt)

  • We see about 300 to 400 deals a year
  • Selecting the 15 to 20 transactions that we’ll invest in from the initial 300 to 400 deals available is a challenge, but our approach is to be highly selective and patient

Josh Connor (Managing Director, Infrastructure Investing)

  • Ironically, US spends $350bn/yr on transportation infrastructure, yet one doesn’t need a survey to show that such spending has done little to improve or even to maintain our infrastructure assets
  • While at one time governments were able to fund infrastructure financing needs, they’ve been unable to keep pace as asset quality has declined precipitously
  • This has created a great need for alternative financing

Matt Wilson (Managing Director, Special Situations)

  • Backbone of our strategy is a focus on distress that is idiosyncratic or situational
  • Example of this would be acquiring a company or providing capital solution to a company, that has found itself in trouble as a result of overpaying for an acquisition and assuming more debt than it could reasonably service (classic “good company, bad balance sheet” that can occur irrespective of systemic or cyclical distress)
  • In a benign economic environment our strategy seeks to find investment opportunities that arise from something going wrong at the company or at the micro-levels, rather than at macro-levels
    • Mismanagement isn’t cyclical!
  • Over the past 18 months, bulk of our capital has been deployed in what we call “structured equity” deals – effectively rescue financing
  • Like structured equity investments because they allow us to establish a priority position in the capital structure, often with an attractive interest coupon; yield enhancement through an OID; call protection; significant warrant coverage or convertibility into the company’s equity; plus governance rights
  • When the cycle finally turns, I suspect we’ll continue to do structured equity deals, but a decline in public debt markets will inevitably create even more opportunities for capital deployment in distress-for-control-type situations

Oaktree: Surviving and Thriving in an Era of ‘Lower for Longer’, May 2018

Image Source: Oaktree Capital

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