Exploring the unique opportunity set in one alternative asset class
Benjamin Graham, the “father of value investing” and author of the classic The Intelligent Investor, wrote: “Successful investing is about managing risk, not avoiding it.” Few strategies capture this idea better than stressed and distressed debt. These assets offer investors attractive risk/return propositions but there is no off-the-shelf ETF for these types of opportunities. Investing in stressed and distressed companies is more akin to a bespoke strategy where alpha is created and built up one business situation at a time because no two businesses are alike.
Success requires expertise not only in fundamental analysis but also in having a “Swiss army knife” set of skills that is not common, including: excellence in balance sheet restructuring, and collaborating with various stakeholders including the distressed company, legal experts, and accountants, and experience in dealing with the bankruptcy process. Each opportunity is unique and requires a nuanced and nimble approach to managing both known and unknown risks. In stressed and distressed credits, investors do not have to wait for favourable market conditions to generate alpha, they can do so independently through debt restructuring or by extending maturities.
The goal of the Pender Credit Opportunity Fund II (“Fund”) is to target strong absolute returns, with the aim to invest in undervalued assets where the market does not fully realize the potential of a company's future. Sometimes specific companies face difficulties, industries fall out of favour, and obstacles in refinancing can lead to situations that don't follow the typical market trend. These situations create unique investment opportunities for returns that do not fit neatly into the broad narrative of a market cycle, creating the potential to earn uncorrelated, asymmetric returns.
In our view, investing in the credits of financially challenged public businesses trading at deeply discounted prices relative to the assessment of their fair market value can generate strong alpha during all market cycles because there will always be businesses facing challenges along the continuum of mild-to-severe stress and distress. However, we believe the next 2-5 years offer a greater than average number of opportunities due to five favourable tailwinds, namely: softening consumer spending, higher-for-longer interest rates, a looming debt maturity wall, geopolitical uncertainty, and a normalization following a prolonged period of underperformance in small- to mid-cap companies.
Dangerous currents
On the surface the general economy appears resilient. Consensus has cycled through ‘hard landing’ and ‘soft landing’ to ‘no landing’. Consumer spending remains moderate and credit spreads are tight. Yet despite the relative complacency of the markets, on closer inspection, there are dangerous currents.
Inflation, higher interest rates, rising wages, and slower growth in consumer demand with signs of greater price sensitivity are leading to a decline in discretionary spending, according to the recent edition of the Federal Reserve Beige Book. Firms are struggling to pass on higher costs in such areas as energy, insurance, and raw materials to consumers. Highly leveraged businesses are disproportionately affected. These companies must offer investors higher yields to accept the greater risk of default. Servicing the compounding debt can lead to financial distress for these businesses.
Since the start of 2024, more companies have defaulted on their debt than during any start of the year since 2008 and the global financial crisis, according to S&P Global Ratings. Specific sectors, such as commercial real estate, regional banks, cinemas, and healthcare all of which have been in a technical recession, appear to be the most vulnerable. For example, early in 2024, three US-based healthcare companies defaulted, along with UK-based cinema group Vue Entertainment International. Consumer facing, negative cash flow companies in healthcare and chemicals are also at risk should interest rates remain elevated.
So far, the weaknesses in specific sectors and geographies have remain siloed and have not spilled over into the debt markets. For example, in March high-yield spreads touched 305 bps, their tightest level in a decade.
One reason the Fund targets small to mid-size issuers is these are often overlooked by large investors with billions of dollars they must deploy, making it a less crowded trade. Pockets in the market experiencing relative capital scarcity often create attractive investment opportunities. It is no secret that valuations—both on an absolute and relative basis— among publicly traded small cap companies has not been this low since the early 2000s. (Approximately 5.6X discount for the S&P600 vs. S&P 500, as of March 2024.) When smaller companies have financial problems, such as being over-leveraged, the credit spreads in these issuers tend to have bigger swings compared to larger companies due to the persistence of negative sentiment against smaller companies. We can take advantage of this volatility because, in many cases, these companies are already well known to Pender through our other investment mandates. We have a deep understanding of their enterprise values relative to their debt loads or other major stressors.
For highly leveraged companies, the upcoming multi-trillion-dollar debt wall, is an existential threat. The same company which raised cash at 3 or 4 per cent may have to offer double or triple when the debt is turned over in the next 3-5 years which could trigger contagion in the markets. Nowhere is this more acute than in the commercial real estate sector which had a period of over-expansion a decade ago when interest rates were low but is now faced with tremendous losses due to having to refinance at current, much higher rates, amid a downturn in demand due to the WFH or the hybrid-work trend.
Active portfolio management is a pivotal cornerstone of our stressed/distressed credit strategy, for navigating the intricacies of these idiosyncratic markets. This hands-on approach is required to adapt swiftly to evolving market conditions, seize timely opportunities, and proficiently manage risk. The next 3-5 years offer investors a historic opportunity to benefit from this non-correlated and diversified strategy.
