Four alternative credit strategies for this credit cycle

In prior pieces on the credit cycle, we looked at the progression of a typical credit cycle, and how today’s markets fit into that timeline (VIEW LINK), and how investors might dynamically shift exposure in their portfolios to achieve an improved risk-reward profile via hedge fund strategies (VIEW LINK). 

In this piece we’ll expand on some of the types of credit transactions we’re seeing successfully executed in the market (Amend and Extend, Private Credit, Distressed and Bankruptcy), and recap credit allocation ideas for various timelines and scenarios. Each of these example transactions has been executed by one or more of the alternative credit managers we work with.

Amend and Extend - Example Playbook Transaction:

This example involves one of the largest emergency medical services provider in the US. The company generates >US$6 billion in revenues at an EBITDA margin of ~15%. In the second half of 2023, operational challenges and concerns about government reimbursement caused its capital structure to trade significantly lower, allowing market participants to acquire 1st lien loans at prices in the mid-60s. 

Despite its solid operations, the company's capital structure was heavily leveraged, and the sponsor was looking for a solution to address an upcoming maturity. Participants worked with the sponsor to create a mutually beneficial restructuring. The transaction extended the maturity of senior debt by three years and saved the sponsor US$100 million annually in cash interest. 

In return, the sponsor and junior creditors, confident in the business's potential, contributed over US$300 million in preferred equity (sponsor) and converted US$600 million in 2nd lien debt to preferred equity (junior creditors), in order to reduce net debt. Creditors also gained from additional OID (Original Issue Discount), a 125bps increase in the coupon, tighter covenants, and a credit rating upgrade, enhancing their total return and margin of safety. The loans now trade in the high-90s.

Private Credit - Example Playbook Transaction:

This example involves a private credit transaction for a global biotech company that specializes in bio-similar medicines. The company benefits from long-term agreements with established pharmaceutical market participants, driving milestone payments which creates a steady cash flow. 

Unlike CLOs, which cannot participate in unrated transactions, some market participants do not rely on public ratings to evaluate the margin of safety. In this transaction, the company had a negative trailing 12-month EBITDA that did not fit the leverage lending guidelines of banks.

The market participant's experience in pharma allowed them to assess the company’s forward earnings profile. The transaction involved a 1st lien loan that had the following characteristics: LTV of 20%, coupon of S+650, with OID and call protection that generates a return profile of 15%+ and strong covenants (i.e., protection against affiliate transactions, minimum liquidity requirements).

Distressed - Example Playbook Transaction:

This example involves a distressed transaction for a UK-based budget hotel operator. Some market participants having been creditors to the company, stepped in to take control (debt for equity swap) when the company urgently needed to raise cash to avoid being put into liquidation. Fund led the restructuring and operational turnaround of the company:

1. They renegotiated and terminated underperforming leases
2. They optimized the balance sheet to secure new capital
3. They enhanced governance by bringing in a new independent board of directors and new management team

The company has managed to grow EBITDA at double-digits annually, rising from £30 million pre-restructuring to £130 million by the start of 2020 and £213 million by 2022. Market participants also led the refinancing of the company’s debt to extend maturity, and pay dividends to shareholders.

Bankruptcy - Example Playbook Transaction:

This example involves claims against a bankrupt crypto exchange, FTX. After the company filed for Chapter 11, a number of hedge funds purchased FTX claims at a meaningful discount (well under 20 cents on the dollar). FTX claims refer to the rights to recover funds from the exchange's estate. These claims were typically sold by creditors (who are owed money by FTX) at a discount to their face value because of the uncertainty surrounding the recovery process.

The managers assessed the potential recovery based on FTX’s remaining assets, any ongoing litigation, and the legal process involved in unwinding the company's finances. Expected recoveries on these claims have improved due to favourable developments in the bankruptcy process and an increase in expected available cash within the estate. 

This boost was largely driven by the broader crypto rally, most notably Solana, and the agreement to sell their majority stake in AI startup Anthropic for US$884 million. In May 2024, the company filed its amended reorganization plan and disclosure statement, estimating customer claim recoveries to exceed par value (the total par value of FTX claims is US$12 billion, and total recoveries reached US$15 billion).

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A consistent theme across these transaction examples is that deal access and deep expertise is required to capitalize on market developments and situations. Dispersion in the various alternative credit management sectors suggests that allocation is key to optimizing credit sector returns – some examples of strategies that may be suitable for various credit timelines and scenarios are as follow. 

Now

We are seeing attractive trades in stressed/distressed LME, structured product sourcing, convertible bond issuance, and LME, all investment themes accessible via a couple of different alternative investment strategies. One option is a diversified credit strategy, with a manager able to trade across sub-strategies as market conditions evolve, including increasing exposure to distressed situations. 

We work with one of the longstanding diversified credit managers whose strategy has an annualised return of >9% net of fees since 2000. In our view they will be able to generate double digit returns in the coming period, given the yields across credit markets, offering equity-like returns with a higher margin of safety. Currently, the strategy is up >11% YTD 2024, with a YTM in excess of 14% with attractive convexity built into certain positions. 

Another strategy that lends itself to the current and emerging credit environment is convertible arbitrage strategy.

We work with one of the largest dedicated convertible arbitrage managers whose strategy has an annualized return of >10% net of fees since 2003, effectively generating >3x bond index returns at ~2x the volatility (Sharpe ratio close to 1) - up >16% YTD 2024. This strategy has been a good diversifier, and has low downside correlation to the majority of other managers with multi-strategy portfolios (especially outside of large dislocation events).

12-18 month outlook

In the event of credit sector deterioration we expect a diversified credit strategy (refer above) to increase shift into distressed opportunities, as in prior cycles, and another option available to allocators is an opportunistic event driven strategy, to access credits trading at a deep discount. 

We work with a relatively new but well pedigreed opportunistic event driven manager strategy has an annualized return of 29% net of fees since 2020, with a Sharpe ratio >1.2. One of our highest conviction strategies, the manager has delivered strong TYD performance (>24%) predominantly from credit exposures, and who continues to see compelling opportunities across various industries with communication services and technology being in its view the most attractive across both credit and equity asset classes

Possible scenario: hard landing

Allocators should expect net performance of flat to ~5%, offering decent protection while being ready to capture opportunities. Allocators have a couple of strategy options with varying upside/downside trade offs, including a low volatility and low drawdown strategy, or an opportunistic event driven strategy (refer above) for higher gross levels, and active involvement in deep discount credit and equity turnaround trades. 

For a low volatility and low drawdown strategy, we work with a manager that many clients use as a cornerstone position, given the limited downside in periods of stress. This strategy has generated annualised returns of ~8% since 2006 (up >7% YTD) with volatility just over 4% and a Sharpe ratio of ~1.5%. We currently expect this strategy to generate high single-digit to low double-digit returns with low volatility, correlation, and beta to wider markets. Given the increasingly rich opportunity set in credit, the strategy offers a risk-controlled method to participate in the upside. This strategy has historically capped downside via a market-tested approach that focused on all investments being beta-neutral or close, sized appropriately, and high conviction.

Possible scenario: dislocation event

A convertible arbitrage strategy (refer prior fund description) is suited to a dislocation scenario, as the mark to market for convertible bonds often leads to a compelling 12-18 month period.

We continue to believe this cycle will create good opportunities for investors and allocators with (available) capital, a plan, and access to the leading credit managers.

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