In this Ropes & Gray podcast, asset management partners Tom Alabaster (London) and Jason Kolman (Boston), along with business restructuring partners Matt Czyzyk (London) and Matt Roose (New York), compare recent trends in the credit/distressed space throughout Europe and the U.S. in light of COVID-19. These global colleagues share the distinctions and commonalities between both geographies in regards to 1) changes in fund terms and structures, 2) government support, and 3) market predictions.
Tom Alabaster: Hello, and thank you for joining us today on this Ropes & Gray podcast, the latest in a series of podcasts aimed at credit funds. I'm Tom Alabaster, an asset management partner, and head of the firm's fund practice in EMEA. Joining me are my colleagues, Matt Czyzyk, a business restructuring partner who's also based in London, Jason Kolman, an asset management partner based in Boston, and Matt Roose, a business restructuring partner based in New York. On this episode, we'll be talking about credit funds, the raising and deployment of credit funds, and the distinctions and commonalities between U.S. and European products. So, a very topical subject for us to tackle today in the current climate. Diving straight in with Jason, maybe a broad-brush question first on the trends you are seeing in the current climate?
Jason Kolman: Thanks Tom. It’s been a turbulent time in the credit funds space, but there have been some trends that have emerged. We’ve been seeing a lot of volatility in fundraising timeframes, which isn’t surprising given the general market turmoil. This has manifested in sponsors bringing large fundraises to market on extremely compressed timeframes, to take advantage of market dislocations that may be short-lived, where time is of the essence. Conversely, we’ve seen sponsors delay or cancel launches, in particular where their performance has been hammered by COVID and they need some time to rebuild a track record. We’ve also seen a general push for flexibility in terms and mandates. The credit market landscape is changing on an almost daily basis, and the general sentiment has been that managers need to stay nimble to capitalize on specific opportunities that may not have existed at the time of launch. So there’s a real reluctance among sponsors to agree to restrictive guidelines and advance consent rights that can hamstring the ability to act quickly. Lastly, I think we’ve seen a renewed focus on topics such as conflicts and valuations, which are front-of-mind given the increasing number of issuers in distress or dislocation. So you have both sponsors making sure their disclosures and policies are state of the art, and investors trying to figure out protections on these topics that won’t hamstring a sponsor’s ability to be nimble. Tom, how does this compare to what you’ve been seeing in Europe?
Tom Alabaster: Thank you. Yes, very, very similar to be fair. We've had the compressed timeline you talk about taking funds to market as quickly as possible. I guess contrasting to the U.S., this has been constrained by some of the European regulation that exists around marketing. It's simply not possible to market a fund very quickly into Europe without getting certain AIFMD clearances. This has hampered fundraises that just were not able to rally quickly enough. I guess also in Europe, we've seen the quickness of government action hamper some of the ability of managers to deploy distressed funds in time. When that government action comes off, it's unclear to us whether or not there'll be another opportunity for such distressed products. So included in the compressed timeline, we've also seen what you were talking about in terms of flexibility of remits, and a sense from managers that they want as wide as investor remits as possible to take on as many opportunities as may present themselves in the coming months. This has been countered though by a proliferation of single strategy funds that we've also seen in the market. Lastly, I guess we've also seen in recent months traditional PE players coming to market with credit products in order to court investors that are used to investing with them and not specialized credit managers. So that's one thing that I would say may be different from what you're seeing in the States. So moving on from trends, how have you seen fund terms and fund structures change as a result of the crisis at the moment?
Jason Kolman: Thanks Tom. Similar to what you just mentioned, in terms of investment strategies, it’s been a time of extremes, similar to what we’ve seen with fundraising timeframes. So we’ve been seeing both extremely broad mandates that give sponsors maximum flexibility, and also much more targeted mandates designed to take advantage of specific sectors where the sponsor has a high conviction. We’ve also been seeing a number of funds of course launch specifically to invest in the TALF program. We’ve also seen sponsors think creatively about and try to loosen provisions such as drawdown notice periods, recycling ability and investment period durations, to ensure funds can act opportunistically. In particular, we’ve seen an increased interest in contingent capital vehicles, where sponsors line up commitments in advance and wait to activate the fund when opportunities arise. And of course for closed-end funds, there’s been a renewed focus on making sure default provisions make sense and are practical to implement, though in general, we haven’t seen the mass defaults that were feared at one point. Finally, we’ve also seen a greater number of managers getting some form of premium incentive compensation, to reward upside and performance in the current climate. At one point, there was talk of a general shift to a lower-fee, higher-carry model in the credit fund space, but we generally haven’t seen that materialize to a significant extent. Tom, what are your thoughts on how this has played out in Europe?
Tom Alabaster: I think again, very similar, to be fair. Maximum flexibility on investment restrictions has been the main focus of managers to date. The other items you mentioned have also been present in the European market. But one thing I would note – there's also been a lot of consistency with prior fund terms in some managers, and I think that has been a focus of managers attempting to get people into those funds as quickly as possible, and to create as little noise as possible when negotiating terms and raising the funds. So one thing that I guess as maybe a contrast to what we're seeing in the U.S. is fund managers coming out with European products that do incorporate the maximum flexibility on investment restrictions, allowing them to get as much opportunity into the fund as possible, but keeping the other provisions as consistent as possible in order to minimize noise and get those investors into the fund as quickly as possible. Finally I guess, what are we seeing as the market going forward – what do we think the market will look like as we come out of this crisis?
Jason Kolman: Sure. In the U.S., I think there may be a general calming down of some of the time pressures and extremes that we’ve seen in the credit fund space recently. In particular, COVID and the resulting market dislocation seem longer-term than they initially appeared, so there may be a little less urgency to take advantage of temporary dislocations, which are now longer-term and more permanent in nature. In addition, some of the initial rush to take advantage of the TALF program has abated, since the program has been rolled out and extended through the end of 2020. Finally, I think there’s a general sense that credit funds were stress-tested by the events of the last six months and largely weathered the storm fairly well, which may lessen the desire for more drastic changes in the fund landscape. Still, given the general market uncertainty with no clear end date in sight, I think we’ll continue to see funds pushing for flexibility so they can react opportunistically to new developments in the credit markets. Finally, I think we’ve started to see and may continue to see sponsors having reservations about launching new NAV-based open-end products. I think that’s due to the continuing uncertainty and volatility around valuations, as well as a desire to have a more stable pool of capital available during a prolonged period of market uncertainty. Tom, what are your predictions going forward from a European perspective?
Tom Alabaster: Picking up on what you just said about evergreen products, we are seeing something similar here. I think there is decreased investor demand for those evergreen products, as we've seen trouble with the NAV and calculating valuation. That process was potentially underway a little bit before COVID, but has certainly accelerated through COVID. Maybe we will see those products replaced by hybrid vehicles attempting to do some level of evergreen in a traditional run-off period or funds with different debt vintages included throughout that vehicle. Otherwise, I think the increased credit market that we have seen growing in Europe since the GFC is likely to continue, and likely to continue quicker than it was before the current crisis. This may be emphasized by the fact that vintages raised around the last crisis were seen to be the best performing. We're also seeing increasing number of investors look at credit products in Europe. That had been until recent days a small universe, where the risk-return profile was only attractive to certain investors within the European market. In the changes in valuation and performance, the potential upside from some of these credit products means they have become more attractive to a larger number of investors in Europe, so we may see a proliferation of players on the continent and here in the UK. We've also seen an increased shift away from direct lending and to more special situation and global credit strategies, and a particular focus for investors on big managers doing these products – I expect that this will continue as well. Lastly, it is worth noting that here in Europe particularly, but I'm sure also in the U.S., there is a focus on ESG on the mind of all investors when they invest, and we have seen this even in the credit space during this crisis. Investors want to make sure that managers when investing in credit, and particularly at a time of crisis, are having regard for ESG factors and making sure that there isn't too much opportunistic play within the opportunistic space. So I think for the downstream side, I wanted to ask the same question: Could you describe the key trends you've seen in the distressed market so far this year, maybe turning to Matt in the first instance?
Matt Czyzyk: Great. Thanks, Tom. So we started the year with a prevailing view across the market that this would be another flat year in European distressed, very similar to 2019. The same names were on everyone's radar, but in many cases, there was no catalyst on the horizon. Of course, the onset of the pandemic changed that, albeit it was a catalyst that nobody saw coming. As the effects of the pandemic worsened, many in the market predicted a tsunami of filings and restructuring processes. Although a number of credits that were already on distressed watchlists actually did proceed to enter into insolvency or process, many of those names were businesses that were likely to do so sooner rather than later, and the pandemic simply served as a last straw. So we're yet to see that torrent of filings and processes in Europe, but nonetheless, it's a much busier market than it was last year. And I think there's three reasons why we haven't seen that torrent:
- The first reason is, investment banks are much better capitalized than they were during the last downturn. And for the most part, we've seen them being very supportive of their borrowers – we've seen multiple amend and extend transactions, waivers, payment holidays, covenant resets or amendments.
- The second reason is the credit funds. So as we've heard, they have large amounts of dry powder to deploy. They're very active in the market and looking for opportunities to lend into good quality businesses, which need to improve their liquidity profile. And during the first few months of the pandemic, we saw credit funds very actively looking at secondary opportunities, often with respect to credits and sectors that previously wouldn't have been on distressed watchlists. Over recent weeks, many names have started to trade up, meaning there's reduced focus on the secondary market. But funds are continuing to look at these new money opportunities, and these can be accessed as an incumbent creditor, where there's a willingness to put in additional funding or as a new funding provider. And in all cases, the clients are carefully analyzing the downside – so what might happen if that credit deteriorates, and how can they protect themselves as new money providers?
- And then the third reason, which Tom you referred to earlier, is this government response across the region, which has seen economies put into a holding pattern. So most European governments, the UK included, have introduced comprehensive support measures, such as state-guaranteed credit lines, employee wage support, temporary changes to directors’ duties and insolvency filing tests, sector-specific government grants, and additional flexibility on things such as company filings, and the deferral of certain tax payments. And these measures taken as a whole have been very effective, but I think they're very much a sticking plaster.
Tom Alabaster: You mentioned that government support—we probably should dig into that a bit more—it's been so profound here in Europe, and then also the nature of it as a sticking plaster. I mean, what do you think lies ahead for the market over the next coming months as that sticking plaster comes off?
Matt Czyzyk: I think as we move into the third and fourth quarter, we expect to see those government support measures winding down across Europe, because ultimately it's not sustainable for the long-term. In addition, some of those waivers, payment holidays and temporary changes to covenants that I mentioned earlier will start to end. So businesses will be faced with the “new normal,” whatever that may mean for that particular business, and there will be many businesses that simply don't have the ability to find that right path back to commercial success. During the course of the pandemic, of course many businesses have had to increase their leverage, whether that's through state-guaranteed loans drawing down on their RCF, or as we mentioned earlier, seeking that new money from existing or new creditors, particularly from the credit funds. So this increased leverage may well prove to be unsustainable for many businesses, so borrowers and their creditors will need to engage in some difficult discussions over the coming months as to how to right-size the capital structure in this new context. And we expect these factors will result in increased volatility in the secondary market, particularly as we see Q3 and Q4 results reported, and that's going to mean more opportunities for the credit funds. And finally, we expect that these catalysts will lead to an increased volume, both in terms of filings and in terms of restructuring processes.
Tom Alabaster: That's really interesting. Thanks, Matt. Aside from the temporary government support measures, have European governments introduced other legislation that will affect the European restructuring market?
Matt Czyzyk: Thanks Tom. Yes, certainly. It's actually been a very active year in the European market with respect to legislative changes. So in England and Wales, the Corporate Insolvency and Governance Act, often referred to as CIGA, came into force in late June. Now this introduced the most significant changes to insolvency law in a generation. Some of the changes introduced were temporary, so we saw changes to directors’ duties and to insolvency filing requirements – this I mentioned earlier, but there are two important permanent changes. The first is, there's an introduction of a free-standing moratorium, so that gives eligible companies breathing space from creditor action in order to facilitate a rescue as a going concern or to facilitate a restructuring. The second big change is the introduction of a “restructuring plan.” So the plan is similar to our existing scheme of arrangement, but there are two key differences. The first is that, to obtain approval from creditors or a class of creditors, you only need approval of 75% by value, but you don't need the majority of those voting on the proposed plan, and this makes it more difficult for a high volume of creditors with low-value debt to block the restructuring, which is always a risk with the scheme of arrangements. And the other big change is, it introduces cross-class cram-down, which is inspired by Chapter 11.
Then more broadly looking across Europe, mid-last year, the European Parliament and Council published a restructuring directive. This aims to introduce a minimum standard among EU member states with respect to preventative restructuring frameworks. So these new minimum standards will see all European or EU member states move closer to a debtor-in-possession restructuring regime similar to those we see in the common law jurisdictions, such as Chapter 11 in the United States or restructuring plans or schemes of arrangements in England. And the member states now have until July 2021 to implement these changes. So what I think this means is, we'll start seeing increased competition between member states as they look to become a leading jurisdiction for cross-border restructuring work. And I think a lot of jurisdictions will be looking to the UK, particularly London, which is very much a restructuring hub in the European market. So we've already seen a number of European jurisdictions that are making great strides.
So in Spain, they have a number of processes, but one in particular is called homologacion, which is a means of compromising the debt of Spanish companies. And we've seen stakeholders, particularly those international investors, the credit funds, they've become increasingly comfortable investing in Spain because they're increasingly comfortable with those kind of processes, should a situation become increasingly distressed. And then in the Netherlands, there's talk about a “Dutch scheme,” and this is expected to come into force later this year. And like the UK restructuring plan, it takes inspiration from Chapter 11. So this will offer cross-class cram-down, and importantly, it will only require two-thirds majority of each voting class. And it will be available to both Dutch and certain non-Dutch companies. So I think whilst inevitably you'll see stakeholders cautious about being the first to test the Dutch scheme, we think we'll see an increased number of restructurings using this procedure over the coming months. So I think looking ahead, we're going to see a lot more competition between European jurisdictions fighting to get that top-ticket restructuring work.
Tom Alabaster: Great. Thank you very much, Matt. Matt Roose, can you tell us what you're seeing in the U.S.?
Matt Roose: Yes, thanks. And it's great to be joining you today. Similar to Europe, we started the year with many market participants of the view that this could be another flat year in U.S. distressed. There were no catalysts on the horizon, and liquidity was readily available, so companies were able to continue to borrow their way out of trouble. Of course, all that changed with the onset of COVID-19. Since the onset of COVID-19, we've seen a torrent of Chapter 11 filings. Overall, by sector, energy and retail have been the hardest hit, with brick and mortar retailers and EMP companies making up the largest percentage of the Chapter 11 filings. In addition, our “watchlists” have swelled with companies with credit ratings at CCC or securities price in the 60s and 70s. Since April though, with the help of significant government support, asset prices have taken a fundamental turn upwards. Bond and equity prices have soared – as just one example, the S&P 500 has rebounded from its March lows, and it's trading at levels just below where it was pre-COVID. High-yield bond issuances climbed to $151 billion in the second quarter, with June posting a record month of volume.
The capital markets are open for business, and even for companies with little revenue (think airlines, theme parks, and cruises) borrowing has been easy. That said, the U.S. economy remains on shaky ground. The U.S. recently reported an annualized 32.9% drop in Q2 GDP, a 1 million increase in continuing weekly jobless claims and waning consumer confidence. Overall, this has created an odd investing climate. At the outset of COVID-19, many clients moved capital to investment-grade debt that had traded down, and were looking to be capital providers to financially distressed companies. There was a real opportunity for many funds to become direct lenders, something distressed funds have been eyeing for years. However, as asset prices have risen, clients are sellers – exiting investments made in March and April, and biding their time looking for new investment opportunities. In addition, with capital markets open, clients have not been able to put nearly as much capital to work on the lending side as they expected, or frankly, wanted. Companies have been able to access cheaper, regular way capital, taking away an opportunity that many clients were looking to take advantage of when COVID hit. Right now, I think clients are in a wait-and-see approach. Asset prices are high, and lending opportunities are scarce. The overall sentiment is that more opportunities will arise in the fourth quarter of 2020 and the first quarter of 2021.
Tom Alabaster: You mention government support measures. What has been happening in the U.S.?
Matt Roose: Well, the U.S. Fed has done just about everything it can to support the U.S. economy. Among many other actions, it has cut the Federal fund rates to zero, resumed purchasing securities, a key tool employed during the Great Recession, and initiated a main street lending program. Congress, of course, implemented the PPP lending program to help companies pay employees and other expenses. In addition, on the demand side, Congress increased unemployment benefits, though those increased benefits have expired. Congress is currently negotiating another COVID relief bill, and I know distressed investors are paying keen attention to the continuation of expanded unemployment benefits as well as money for state and local governments. Anything that could increase the unemployment roles or scale back unemployment benefits will have a direct impact on the many U.S. companies that serve consumers directly or support consumer-facing companies.
Tom Alabaster: Thank you very much. That's very interesting. So what do you see is next?
Matt Roose: I think the answer is still very unclear. COVID cases continue unabated in the United States, falling in some areas while rising in others. Return to school is on the horizon, as is the flu season. It is unclear how the U.S. manages through this. On the business side, U.S. companies that cut expenses starting in April through rent deferrals and employee furloughs are seeing the expense side of the ledger starting to come back. I think there is an open question of whether the revenue side of the ledger comes back as well. Moreover, even with economies "open," many industries will continue to see disruption from COVID – airlines, entertainment, leisure, and food and beverage to name a few. All this provides opportunities for credit funds looking to deploy capital in loan-to-own strategies or through direct loans to financially distressed companies. I know clients are preparing for those opportunities now by looking ahead to what industries will need capital and what businesses will be good to own when COVID is behind us.
Tom Alabaster: Thanks to the three of you for joining me today, and thank you to our listeners. For more information on the topics that we discussed, or other topics of interest to the asset management and credit fund communities, please visit our website at www.ropesgray.com. And of course, if we can help you navigate any of the topics we discussed, please don't hesitate to get in touch. You can also subscribe to this series wherever you regularly listen to podcasts, including on Apple, Google and Spotify. Thanks again for listening.
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