Adam Phillips, Head of Special Situations within Developed Markets at RBC Global Asset Management (UK) Limited, discusses how high levels of leverage, rising interest rates, changing consumer behaviours, and the geopolitical situation are coming together to create a surge in special situations opportunities.
1. How is today’s macro environment impacting corporate issuers?
Corporates are facing a perfect storm. Most companies in the high-yield bond, leveraged loan, and public credit markets went into the Covid pandemic with higher levels of debt than had been the norm for the preceding few decades. They then had to borrow more money to survive, which led to whole sectors emerging from the pandemic not only highly leveraged, but also with a decreased ability to make money because the world they were operating in had changed.
Movie theatres provide a great example. When theatres closed due to lockdowns, people turned to streaming services, and since reopening, the rebound in attendance has been slow. Based on our research, most movie theatre chains globally remain at around 65-70 percent of 2019 attendance levels. Some are managing to help offset weaker attendance numbers by charging higher prices for tickets and selling more food and drink, but nonetheless, a number of major cinema companies are restructuring.
In addition to higher leverage and a reduced ability to make profit, there have been extreme supply-chain disruptions, which have had a particularly acute effect on manufacturing companies. This disruption is abating but has not gone away altogether. Then, of course, we are moving from a 30-year secular decline in interest rates into something that, in a longterm context, looks more normalized. The market is currently pricing U.S. terminal rates at around 5.3 percent1 . When you factor in higher leverage, increased interest rates can clearly cause issues.
Finally, I would point to war on the edge of Europe, which is having both micro- and macroeconomic effects. From a micro perspective, many companies have had to abandon operations in Eastern Europe, Ukraine, and Russia. From a macro perspective, the war has caused further supply disruptions to commodities and other goods. Disruption to the gas supply, for example, has exacerbated energy price inflation.
In summary, corporate issuers are facing a range of challenges that are very much to the benefit of special situations investors because the scale of the opportunity set is growing dramatically.
2. How are banks responding to this situation in terms of appetite and ability to lend?
It should be no surprise that lending standards are tightening, and the European Central Bank (ECB) has been very open in warning about anticipated increases in non-performing loans. Banks are in a fundamentally different place than in previous downturns in that they have slimmed down their workout departments, and they are penalized in terms of capital for holding onto non-performing loans. Hence, the banks are more likely to sell troubled assets earlier than in the past and, anecdotally, this is exactly what we are seeing. This is clearly advantageous to special situation investors.
3. Where are you seeing the most interesting opportunities by region and by sector?
Europe is undoubtedly the epicentre of stress and distress this time around. There is something like €7 trillion of corporate bank lending in Europe today, so you really don’t need many percentage points of stress or distress to create a substantial special situations market. Of the various European jurisdictions, the UK is in a particularly difficult place, partly because of political instability and partly due to Brexit, which reduced labour supply. That having been said, we see opportunities right across Europe, although we are primarily focused on the UK, Germany, Spain, Netherlands, Scandinavia, and Italy.
One of the biggest differences with this downturn is that it is so broad-based. The inflationary effects of the war in Ukraine affected base industries that use a lot of gas, but there has also been hyperinflation in commodities, and high levels of inflation in most other raw material inputs, which has affected many manufacturing companies. Inflation expectations have already fed through to wage negotiations, and many European nations are struggling to control wage inflation, particularly in the public sector. There is a cost-of-living crisis in parts of Europe, which is impacting consumer discretionary expenditure. If you are struggling to pay your heating bill, you will not be buying a new car or washing machine or updating your wardrobe. Data suggests that consumers are trading down in terms of food shopping and consumption within the food & beverage (F&B) sector. The downturn is affecting chemicals, paper and packaging, health care, autos/autoparts, cinemas, food, F&B, leisure, real estate, cruise shipping, manufacturing, travel, gyms, hotels, housebuilders, and retail companies.
4. Given the scale of the opportunity set, how do you approach origination and asset selection?
RBC Global Asset Management (UK) Limited has a significant market presence and is a very collaborative group, so there is a lot of idea sharing within the investment teams. We work extensively with the Leveraged Finance Team, who manage over USD$15 billion of assets, so we see a lot of deal flow, and some of the deals they have looked at in the past end up in our arena.
In addition, our Special Situations Team of six dedicated professionals has over 130 years of combined experience and with that comes multiple connections with restructuring advisors, lawyers, investment banks, and other intermediaries. We have invested all over the world in almost every sector you can think of, so in many cases we can apply past experience to current situations. We like to think that those decades of experience count for a lot at times like these.
5. Why are event-driven, special situations strategies attractive for investors right now?
First and foremost, this is a big and growing opportunity set. Our watchlist would have had 70 or 80 names on it a year ago, and has increased to around 300 names in terms of the public markets alone. In an environment where equities and fixed income markets are down, the ability to make positive uncorrelated returns should be of real interest to many different types of investors.