Embrace credit asset "idiosyncracies" as volatility sets in, says KKR

The war in Ukraine has rocked global energy markets and also affected the so-called “soft commodities” of the agriculture sector – in addition to the conflict’s terrible human cost. But a wide-reaching macro-economic effect hasn’t been felt in global credit markets, KKR's Jeremiah Lane said during a recent interview with Livewire Markets.

One key effect has been the more fragmented energy markets around the world, particularly in Europe, where energy costs have become very high, said Lane, portfolio manager of the KKR Credit Income Fund (ASX: KKC). 

“The approach that we're taking is being a little bit more idiosyncratic to credits and trying to understand if individual credits are impacted by the changes that have come as a result of the conflict,” Lane said.

He also noted that the initial “risk-off” focus financial markets adopted when the war erupted has now largely reverted, as investor attention moves to the actions of the US Federal Reserve, inflation and interest rates. In this context, Lane cited an example of his team’s contrarian approach during the earlier stages of the COVID pandemic. 

 “If we can find opportunities that the market doesn't understand but we do, we can have some very successful investments for our investors.”

He also detailed where he sees the best opportunities in fixed income now, driven by “supply-demand dynamics that are coming because of the banks, because of the Fed, and because of changes in people's posture towards interest rates and the amount of credit risk they're willing to take.”

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Edited transcript

How has the Ukraine conflict affected credit markets, and what’s your outlook?

Jeremiah Lane: Firstly, we don't have any exposure to Ukraine. We don't have any exposure to Russia. We have a small amount of exposure in some other portfolios, mostly to the aircraft lessors, those have been in the press a lot as having some risk of losing aeroplanes that the Russian government decided to hold onto.

Initially, the market moved to a risk-off posture, markets traded off. Pretty quickly, that seemed to dissipate and really, I think it was because the market switched its attention from being concerned about Ukraine to being concerned about the Fed and interest rates, and what they were doing there.

The area where I think that we'll have really sustained impact is in the energy markets. Russia exports something like 7% of the global supply of oil. So there's something of a supply shock going on in the oil market. You had the price of a barrel of oil spike dramatically higher and now has started to come off. But I think that there's some sorting out that needs to happen in that market.

We also see an impact in the natural gas market, which is not a global market but is a regional market. Historically, Europe has really relied on Russia for its natural gas. And there's a possibility that they won't be able to procure gas from there going forward. And as a result, energy costs have become very high in Europe. The approach that we're taking to it is a little bit more idiosyncratic to credits, trying to understand if individual credits are impacted by the changes that have come as a result of the conflict.

There are some agricultural changes. As I mentioned, there are some energy changes and really, we’re just trying to get at whether there's a commodity price exposure that's going to deteriorate the credit or another element that we need to be concerned about. There hasn't been a macro impact because of the Ukraine-Russia conflict.

Why do you look for complexity as opposed to simplicity?

Lane: It's an interesting question and one that we get a lot. But I see it a little bit differently. At the most basic level, everything that we're investing in, in KKC, we pick because it has the durability of cash flow and downside protection. That is our North Star in credit investing. And for part of the portfolio, we do that by making deals with individual sponsors to support their acquisition of businesses – that's the European direct lending piece.

And for part of the portfolio, we find typically in the US, traded credits that are misunderstood by the market, which are perhaps in no man's land. And for whatever reason, they're out of favour and we can bring to bear our diligence expertise, to validate the durability of cash loan downside protection.

Just to bring it to life with an example, we had a big success during the pandemic with a company called Six Flags, which is a US amusement part business. And as you can imagine, when the pandemic started, there was a lot of concern about that business. Effectively, they closed the gates, locked the gates, sent the workers home, and put the business into hibernation. Pre-pandemic, it had been considered a very, very safe credit.

And so there was an incredible amount of uncertainty.

• How long are the shutdowns going to last?
• Does the company have enough liquidity to withstand the shutdown?
• How much of the costs can it eliminate to survive?

And what we saw was this loan that had been perceived as very low risk; we saw it collapse in price, trade to the low 80s, high 70s, and our analyst on that name, who had been following it in some of our other strategies – it wouldn't have been appropriate for KKC, but had been following it in other strategies – reached out to our European private equity team.

The European private equity team happened to own an amusement park business outside of Barcelona. So they were dealing with the exact same issues in a portfolio company. And through dialogue with them, we were able to build a lot of conviction around Six Flags' ability to really cut costs to the bone and mitigate the cash burn they were going to have during this period of being unable to operate.

And because we were able to do that diligence and were able to reach those conclusions faster than the market was, we were able to start to buy that loan before everyone realised that it was actually going to be just fine. 

They were going to get to the other side, they were going to reopen the gates and the rides were going to run again. That just brings to life the type of thing we're trying to do. We're just trying to validate that a business, in the case of Six Flags, can survive, that there's sufficient downside protection, and that there are other sources of value we can rely on. In the case of Six Flags, they own much of the real estate that underlies their amusement parks.

If we can validate that and we can find opportunities where the market doesn't understand but we do, we can have some very successful investments for our investors.

Which sectors of the credit markets offer the best opportunities in 2022 and why?

Lane: I think we're back to a period of more idiosyncratic company selection after a period in the pandemic when there were entire sectors that were disrupted. And I don't sit here and say, “I expect that 50% of the dollars that we deploy in the next three or six months will go into healthcare or IT”. I don't see major disruption in any individual industry that we're trying to chase into.

I see a market that is disrupted by the fact that the Fed is changing its posture so quickly and so significantly. And because of that market disruption, individual opportunities continue to bubble up in different spaces. I gave you the example earlier of the industrial flow control business. In other circumstances, we've seen some new issue loans that have been coming to market right at a point in time when CLOs, which are the biggest buyers of loans, have become inactive.

And it's these idiosyncratic supply-demand changes that we see really creating the opportunities that we're focused on right now, as opposed to entire sectors that are disrupted or thriving. There are of course sectors that are thriving, such as energy markets. We don't do a lot in the energy space because it doesn't have the durability of cash flow and downside protection attributes that we’re looking for. The energy businesses, typically when they're having success, the price of oil is high, they take all the money that they make, and they try to drill more wells or buy more acreage. So, they don't actually make cash.

And then when they're suffering and we need to rely on the downside protection, they actually just own acreage. Typically, in remote parts of the United States, it's not valuable for other purposes.

I do see sectors that are thriving and some sectors that are suffering. I don't think that's what's driving our specific opportunities for opportunistic credit right now. The primary thing driving our opportunities are supply-demand dynamics that are coming because of the banks, because of the Fed, and because of changes in people's posture towards interest rates and the amount of credit risk they're willing to take.

Learn more about investing in private credit

For further insights from one of the world's most recognisable names in private equity and alternative investments, visit the KKC Australia website. And if you would like to find out how to invest in the KKC listed investment trust (ASX: KKC), contact the local KKR team at this link or call them on 1300 737 760.