NEW YORK, July 2 (LPC) - Global asset managers CVC Capital Partners and Ares Management each raised more than a billion dollars in June for respective distressed investment funds, an indication that portfolio managers are readying capital to pick up shaky leveraged loans cheaply in the secondary market when the economic cycle turns.
Fund managers wary of increasing corporate debt levels are betting more leveraged loan borrowers will struggle to refinance debt in coming years as global growth slows and high interest costs strain liquidity for companies left with outstanding term loans trading at distressed levels.
“Ratings downgrades are increasing in the US and this impacts highly-leveraged companies. GSS II will enable us to take advantage of that development and invest in the debt of some of those distressed companies,” said Mark DeNatale, global head of special situations at CVC, which raised US$1.42bn in capital for its Global Special Situations Fund II (GSS II) in June. “Banks are continuing to reduce their risk exposure by de-leveraging and we see value investing in distressed credit opportunities in the US and Europe.”
Accommodative credit conditions in recent years have enabled borrowers to tack on cheap debt thanks to low interest rates and insatiable investor appetite for floating-rate debt instruments.
But a dovish interest rate policy and aggressive term loan language has investors pushing back on leveraged loans and underwriters are already feeling the pinch, having offered a slew of transactions in June at higher spreads over Libor and steeper discounts to obtain sufficient investor demand.
“Having this uncertain backdrop provides opportunities for distressed players,” a US credit investor said. “And from a secondary perspective, there is a chance to pick up yield and engage in transactions that may have been mispriced.”
AHEAD OF THE GAME
CVC snared capital commitments for its second special situations fund in just eight months, the private equity firm said in a June 24 press release. The target capital raise was US$1bn, but demand enabled CVC to pull in US$1.42bn, more than double the size of the first distressed investment vehicle, a US$726m fund raised in June 2016.
Ares, which manages US$125bn of assets globally, roped in more than US$1bn in capital commitments for its own special situations fund, according to a June 20 filing with the US Securities and Exchange Commission, and could increase the size of the fund to as much as US$2bn within the next 12 months.
“Whether it’s a year, or two years from now, everybody expects a recession or some kind of slowdown, so these distressed firms are getting ready for that” said Lawrence Chu, a managing director at Moelis & Company, an independent investment bank and advisory services firm.
This sentiment is echoed by the majority of lenders in the US, according to the 2019 Loan Market Survey from FTI Consulting released on June 24. Approximately 78% of respondents from bank and non-bank lenders expect the number of loans managed by their workout groups, a department that handles a financial institution’s troubled loans, to increase over the next year, the survey found.
Energy companies, hampered by slumping oil prices, and retail borrowers, adjusting to a shift in consumer spending habits, are expected to face the most duress. Fitch Ratings forecasts a 10% default rate for energy credits in 2020 due to large-scale defaults effecting a US$45bn universe of debt.
Retail makes up 29% of the ratings agency’s outstanding Tier Two Loans of Concern, the most of any sector, and includes luxury store Neiman Marcus and pet retailer PetSmart, which both restructured their debt earlier this year.
Despite the warning signs, private equity shops are flush with dry powder and demand for leveraged loans is expected to remain strong through 2019, according to FTI Consulting.
Covenant-lite term loans, which made up more than 75% of institutional loan volume in 2018, are the debt instrument of choice for corporate borrowers. The absence of financial covenants strips away lender protections and allows companies, and sponsors, more control in deteriorating financial situations.
“With leveraged loan default activity so low, it’s too soon to render judgment on covenant-lite provisions on loan recoveries,” Mark Laber, a senior managing director and author of FTI Consulting’s loan survey said.
Projected default rates for institutional leveraged term loans are expected to reach 2% by the end of 2020, however, higher than the forecast 1.5% for 2019, Fitch Ratings said in a June 27 report. (Reporting by Aaron Weinman. Editing by Leela Parker Deo and Jon Methven)