CONTRIBUTORS
Eric Larsson
Co-Head of Special Situations, Alcentra
Laurence Raven
Portfolio Manager, Co-Head of Special Situations
Alcentra
Eric Larsson and Laurence Raven, Portfolio Managers and Co-Heads of Special Situations, offer their answers and thoughts on the European special situations market.
Introduction
From the global financial crisis (GFC) until 2022, a decade-plus of extraordinarily dovish monetary policy and ultra-low interest rates fueled an explosion of leveraged finance, with the European sub-investment grade market quadrupling in size to US$1.2 trillion.1
In 2022, central banks slammed the policy brakes to cool off scorching inflation, raising interest rates at an unprecedented pace. As economic growth slowed and borrowing costs surged, banks pulled back, either unable or unwilling to lend, and the new financing market essentially shut down. In Europe, high-yield and leveraged-loan issuance fell 78% and 56% year-over-year, respectively.2 Valuations came under pressure and financial performance began declining, dramatically in some sectors. Credit spreads widened, and default rates, a lagging indicator of economic activity, started to rise. In July, Fitch Ratings forecast that European default rates will rise significantly in 2023 and 2024, with a massive maturity wall of nearly €300 billion looming in 2024–2026.3 With leverage levels at their highest point since the GFC, refinancing will be more challenging for many and likely impossible for some.
As a result, the opportunity for European Special Situations investors to take advantage of temporary dislocations in the market, provide liquidity and work with companies to recapitalize their balance sheets, is the most fertile it has been since the global financial crisis.
Special situations investments could capture better risk-adjusted return than other asset classes, achieving equity-like return through investing in senior secured debt:
- Low LTVs (typically 40-50%) of consideration paid by equity owner
- Strong downside protection through asset security
- High current yield with upside convexity
In this paperIn this paper, we focus on the European special situations credit:
- Setting the opportunity foundation.
- Digging deeper into the industries and geographies.
- Competition for assets and white lists.
- The Alcentra difference to sourcing opportunities.
- Looking ahead on interest rates.
We believe the confluence of these factors will result in a massive and disparate set of opportunities for savvy, well-positioned investors to combine strong running yields with the potential for equity-like returns over times, all with a risk/reward balance that’s arguably better than it has been for a very long time.
Endnotes
- Source: S&P Global Ratings, “Credit Trends: Global State Of Play: Debt Growth Diverging By Credit Quality,” September 6, 2023.
- Source: Fitch Ratings, “European Leveraged Finance Markets Face Recessionary Pressures,” October 31, 2022.
- Source: JPM European Leveraged Finance Capital Markets Update September 2023.
WHAT ARE THE RISKS?
All investments involve risks, including the possible loss of principal.
Equity securities are subject to price fluctuation and possible loss of principal.
involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls. Low-rated, high-yield bonds are subject to greater price volatility, illiquidity and possibility of default. Floating-rate loans and debt securities are typically rated below investment grade and are subject to greater risk of default, which could result in loss of principal.
Alternative strategies may be exposed to potentially significant fluctuations in value.
Privately held companies present certain challenges and involve incremental risks as opposed to investments in public companies, such as dealing with the lack of available information about these companies as well as their general lack of liquidity.
International investments are subject to special risks, including currency fluctuations and social, economic and political uncertainties, which could increase volatility.
Active management does not ensure gains or protect against market declines.