(August 8, 2022) - Aymen Mahmoud of London's McDermott Will & Emery discusses the potential for investment in stressed and distressed assets during a period of fluctuating liquidity.

In recent years, global events have driven macroeconomics to be increasingly difficult to predict. This has led to analysts, investors and other market participants to question fundamentals through all aspects of investing but also to try to develop and articulate methods for maximising value.

As with any such historic period of unpredictability, market volatility can result in financial difficulty for some players, but also provide significant opportunity elsewhere. This article will consider some of the considerations within the value chain as well as the types of opportunity that may represent value as time goes on.

Firstly, it is important to understand the dynamics that create the current environment, and how they have impacted and will continue to impact markets. In particular, one should consider the meanings of stress and distress.

In current parlance, "stress" often refers to a company which has had some difficulty. That difficulty could be operational (a product issue, liquidity, management, low margins being squeezed) or structural (supply chains, increasing interest rates or geopolitical buying issues).

Distress typically refers to a company that has moved past stress and instead is now in need of taking swift action (typically within six months) before becoming balance sheet insolvent, i.e., it will no longer be able to pay its debts as they fall due. There are certain signs of distress which are commonly known (e.g., financial reporting showing prospective covenant breaches, high interest payments, stagnated or reducing cash flow, falling margins, extended creditor days and even employee disenfranchisement). Those are important to be aware of, but in most contexts a company will be aware that it is under stress or distress.

The starting point of consideration for any market participant over recent years has been the availability of liquidity and its many and varied impacts on the market. Investment data company Prequin considers there to have been $63.2bn of private credit raised in 2021 alone (compared to $51.5bn in 2020). With its absence becoming a real source of consternation for the markets (and therefore for growth) during the global financial crisis of 2008, the contrast of the last few years is stark.

Committed, unallocated capital or 'dry powder' can be found both in equity and credit markets, as well as in the form of economic intervention from governments and supra-national institutions, whether by way of Covid-19 relief or incentives or through quantitative easing (QE) (a monetary policy whereby a central bank purchases (among other items) existing government bonds to restore liquidity in the financial system). This very liquid market has manifested its impact in various ways.

Buoyant liquidity has provided stressed credits with easier access to the credit markets, with the opportunity of paying only a small premium to refinance what might, during less liquid times, be seen as over-levered and which may not have easily attracted new money for a financial sponsor or company director. It has allowed buyout houses to explore new opportunities in non-traditional sectors such as pre- EBITDA technologies.

Conversely, for the special situations or secondary market investor the opportunity to buy performing bonds trading at significant discounts has been substantially reduced.

As a third example, where there has been more dry powder available as a relative matter, a greater number of private equity investors have been competing for a smaller number of assets, driving valuation multiples higher.

None of these consequences of markets with deep pockets is much of a secret, yet the impact of them draws a range of views, both academic and practical. Some consider that the markets may have become more reckless, while others have suggested the markets have been forced to become more efficient.

At a minimum, it is clear that with liquidity, the majority of the markets have found it easier to transact in 2018-2020 than in 2008-2010.

In the second quarter of 2022, it is clear that the credit markets have become more cautious with knock-on effects for equity investors who were able to maximise their own value and returns by utilising cheap debt. For those special situations and distressed investors, it is clear that a greater number of opportunities will present themselves for consideration in the short term.

What is less clear is whether a quick return to liquidity (and the settling of other areas driving caution) will render those opportunities obsolete, perhaps even as quickly as in the immediate aftermath of the pandemic in the spring of 2020. The key question is therefore how, and on what timeline, should market participants look to drive value?

Alongside this highly liquid market, the world witnessed the most impactive pandemic of recent times in Covid-19. With consequences running well into 2022 for many nations, and punctuated by a range of fiscal actualities to counteract closed businesses and inactive workforces, it became increasingly clear during 2020 that the full impact of the pandemic from an economic perspective would not be known until some years later.

There was huge financial cost to governments in providing loans and other support schemes, e.g., furlough schemes, all with significantly depleted tax coffers and at the same time, central banks continued to stimulate the economy. Fundamental economic theory pointed to inflation as the pandemic took real hold through the end of 2020 despite many commentators saying that their expectations on inflation were very limited. Then followed 2021, and, by many metrics, the most active market in the last ten years.

The bearish voice was therefore quietened (or at least less heard). Firms of all kinds invested in distressed investment professionals but the performing markets, liquidity and slow run-off of fiscal intervention continued to support active markets in the first part of 2022. It was almost as though the world was slightly short of the perfect storm required to allow the distressed markets to flourish, even with supply chain issues further weakening economic activity.

Perhaps the final piece of the jigsaw needed to slow things down took more of a geopolitical form. While perhaps a pandemic is hard to prevent, armed conflict is arguably more of a 'choice'.

The declaration of armed conflict in Ukraine carried with it several adjunct consequences — some more predictable than others (e.g. oil and commodity prices being driven higher and supply chains being further disrupted) but also less ostensible impacts, for example, the impacts on grain exports which has driven food prices higher.

For the purposes of this article, it is important to note that not one of these factors is singularly responsible for where we are today or what happens next.

Where are we today? Certainly the liquidity in the markets is being deployed in a more cautious and restrained manner. Equity prices have seen some downward adjustment over the last twelve months, some of which has been significant.

The huge asset class of private credit can be seen to be marginally more restrained or a little more expensive, or both.

Interest rate rises have made corporate borrowers mindful of extending themselves in leverage terms and there is a large increase in the number of conversations being had around stressed or distressed credits. This compounding effect has been meaningful and the length of compounding is very likely to inform how the market responds in all aspects of driving value.

What strategies, behaviours and other tactics are then proving most instrumental in creating and maximising value? There are likely some more structural characteristics at play here in terms of the usual origination of deals as well as the use of thoughtful and creative interplay between ownership and growth.

In particular, one asset class that has seen one of the more sustained and noticeable increases in its valuation is that of technology. It is a common feature of early-stage companies that they require significant expenditure and even with significant revenues, profitability can have a lengthy horizon.

However, the continued investment from venture capital, private equity and other asset managers (whether from a growth or a control standpoint) has meant that lenders are seeking solutions to finance pre-EBITDA businesses, to help develop relationships with those borrowing counterparts.

Whilst this has been the case in the last couple of years, it is clear that the equity markets have seen something of a correction for tech-related stock, suggesting that the valuations that existed were simply too high. It may well be that there is some truth here, or that the markets more generally are overvaluing public stocks, or there may be something of a more emotional reaction driving this as can be the case in public markets.

Either way, adjusted valuations may lead to either a need or desire to consolidate to drive future growth among certain asset types, but it may also lead to the need to restructure to ensure going concern protection and to minimise value destruction.

If a business is facing difficulty which can be overcome with liquidity, and in particular where there is some vertical integration, we can expect to see significant investments from special situations credit firms.

The pure weight of capital provides a very strong base for creative and opportunist thinking. One way of doing this is to combine scale with the ability to utilise pockets of capital that can invest in both debt and equity, giving an investor the ability to participate in both parts of the capital structure.

For borrowers, allowing lenders to access their equity also helps to align interests in creating upside, while also unlocking what has historically been very cheap debt capital.

For lenders trying to unlock higher returns, this type of investment creates a platform to deepen relationships with borrowers without significant additional work and provides greater information about the underlying credit, all while providing those higher returns in an otherwise competitive debt market.

In addition, courts in much of Europe and the U.S. are amenable to the provision of debtor-in-possession or similar financing during a restructuring which provides additional runway. That debt is often 'super senior' or ranks prior to other indebtedness, avoids liability and can be enforced even during a stay. This area of investment provides huge possibilities for lenders to become involved in liquidity-style financings in the event of distress.

For smaller firms, the less capitalised market will likely be a focal point of restructurings in the coming years. The move from being a 'zombie' company supported with government support measures, contractual forbearance and standstill arrangements will expire.

The absence of any covenant or an uncompelling one means that there is no longer a canary in the coal mine to signal any issues. As such, the period of time for investment, for restructuring and in some instances for preserving the going concern will be reduced.

There may also be reputational implications of not acting quickly enough, as underlying limited partner investors (LPs) start to look at existing portfolios when assessing reinvestment in a particular fund. This provides a neat segue into the question of LPs.

Asset managers around the world are now invested across capital structures through other vehicles, such as private credit or private equity. It is not inconceivable that there may come a time where an LP is an equity and a debt investor in the same asset, where creating value for one necessitates removing value from the other.

In these instances, it will be interesting to see if the LP community behaves any differently, or otherwise tries to inform the behaviour of the platform managing the investment for that LP despite the potential for conflicts of interest.

Within the secondary market 'capital markets' space at present, there are significant numbers of credits with bonds trading at discounts. Within the credit markets, this allows bond traders and CLO houses to trade in more liquid names and crystallise positions to drive value — that includes stemming losses but also crystallising gains on other names.

There are also various equity names which are trading below the '200-day-moving average' (an index popularly affiliated with a suggested time to buy or sell).

Whilst much of this paper focuses on 'performing' investors in 'performing' assets or markets, or 'special situations' investors in special situations credits or markets, it is very important not to forget the role of 'performing' purchasers.

For those purchasers, the 'take private' (P2P) transactions during which publicly listed businesses are purchased, de-listed and driven through periods of growth ahead of secondary, or tertiary buyouts — have become very popular. They allow private equity firms to look for real opportunities to make large scale investments (most public companies are well-capitalised and of a requisite size).

In addition, for very large listed corporates, looking for under-performing segments of their business and divesting of those usually provides a jump in share price — many private equity institutions look for these corporate carve-outs where they are not of the size required to undertake large-scale P2Ps. For these non- core segments, there are often inefficiencies that private equity institutions are familiar with and for which they have significant skill and resource in turnaround.

For those investors with access to huge sums of capital, the market will continue to provide opportunity, if for no other reason than the scale of opportunity which is limited to only a few players.

For others, the belief that a return to more basic product types will yield significant returns will be tested in the coming months — will food businesses and planting regenerate significant business interest in an inflationary environment? Will ESG and other environmental considerations play a very large part in investment thesis? Will the lack of legal protections in documentation mean that it will be too late to save businesses where management has not engaged with advisors proactively and early?

Time will tell, but what is clear is that wages, inflation, cash flow, raw material cost, supply chain and geopolitics can combine to cause tremendous volatility in valuations. That volatility can create as much opportunity as it can cause fracture — it is for the participants who have shown so much creativity in the past — to remain flexible, thoughtful and exploratory in evaluating great and new opportunities for growth.

In a world where so many investments were judged on their historic and look-forward statistical matrices, we may now see a greater focus on liquidity, margin and the ability to 'stay alive' during the hard times.

Whilst simplistic, the approach of maximising gains is only one half of driving value. The other half is softening any losses and this aspect may well be influential in the value chain in the coming years. After all, if one wants to consider how to maximise value, one must first accept that all value is relative.