Best Ideas: The Next Opportunity In Credit

Key Concepts

Private credit, distressed debt, restructurings, opportunistic credit, amend and extend, private equity, high yield debt, commercial mortgage debt, bifurcated market, operational improvement, infrastructure deals, syndicated debt.

Strategic Value Partners (SVP) Overview

• Firm Profile: SVP is an all-weather opportunistic credit firm with $22 billion in assets under management.
• Historical Focus: Started 25 years ago in distressed debt and restructurings.
• Current Capabilities: Buys debt, takes control of businesses, fixes and improves businesses, and buys real assets (airplanes, power plants, real estate).
• Geographic Focus: US and Europe (60% US, 40% Europe).
• Operating Capabilities: SVP possesses the operational expertise to improve the real assets they acquire.
• Cyclical Nature of Distressed Debt: Distressed debt is interesting only two years out of ten due to its cyclical nature.

The Bifurcated Market and Underlying Problems

• Headline vs. Reality: Headline markets appear fine (equity markets up, high yield spreads tight at 340 basis points), but significant problems exist beneath the surface.
• Default Rates: Current high yield default rates are at 5%, lower than COVID (6.5%) and the GFC (12%), but this doesn't reflect the full picture.
• Accumulating Problems: Defaults and problems have been accumulating, especially in the last five to six years.
• Private Equity Challenges: Private equity firms are facing difficulties in monetizing assets due to uncertainty after COVID, Fed rate hikes, and policy volatility.
• Amend and Extend Strategy: Private equity firms are using "amend and extend" strategies, which increase debt burdens (e.g., $1 billion becomes $1.3 billion).
• Impact of Rising Rates: Deals were done when rates were 0%, but current rates are significantly higher, leading to a "reckoning" in the private equity world.
• Management Team Exodus: Good management teams are leaving distressed companies, exacerbating operational issues.
• Aging Private Equity Portfolios: Half of the private equity portfolio is five+ years old.
• European Struggles: Europe is facing more intense challenges due to a prolonged malaise compared to the US.

Opportunities in Credit

• Opportunity Size: $5 trillion in high yield debt, 26,000 companies in the private equity portfolio, and $8 trillion in commercial mortgage debt.
• Commercial Mortgage Debt: A "slow-moving tsunami" is developing in commercial mortgage debt.
• Sectors of Interest: Industrials, building materials, consumer brands, business services.
• Geographic Focus: Europe presents more intense problems and opportunities.
• Active Management Required: These are not passive, traded debt opportunities; requires stepping in to improve operations and fix businesses.
• Skills Required: Requires real operational skills, not just trading expertise.

Recession Outlook

• Coexistence of Opportunities and Okay Economy: The credit opportunities coexist with a generally okay economy and good stock markets.
• Base Case: SVP's base case is that the US economy is flexible and resilient, and a recession is unlikely.
• No Systemic Issue: There is no expectation of a major systemic issue or crisis.
• Long-Term Opportunity: The opportunities in corporate and real estate credit will take three to four years to work through.

Examples of Portfolio Holdings

• Hornblower Ferry: Owns the Statue of Liberty Ferry and Niagara Falls Ferry, with long-term contracts.
• SH130 Toll Road (Texas): A toll road between Austin and San Antonio with an 85 mph speed limit (highest in the US).

Sourcing Deals: SH130 Toll Road Case Study

• Infrastructure Deals: These deals are typically sought after by sovereign wealth funds and pension funds at competitive returns (7-9%).
• Debt Acquisition Strategy: SVP bought the debt of SH130, which had $1.6 billion syndicated to about 10 Spanish banks.
• Piece-by-Piece Acquisition: SVP acquired the debt piece by piece over a year and a half from the Spanish banks.
• Strategic Advantage: Avoided competing with larger funds by acquiring the debt before it was packaged and marketed as a whole.
• Positive Outcome: The investment has worked out very well.
• Elon Musk Impact: Elon Musk built the Tesla Gigafactory right on the highway.

Synthesis/Conclusion

Victor Kosla of Strategic Value Partners highlights a significant disconnect between the perceived health of the market and the underlying challenges in private credit, particularly within private equity-backed companies. The "amend and extend" strategy, coupled with rising interest rates, has created a reckoning for many firms. While SVP doesn't anticipate a major recession, they see a multi-year opportunity to acquire distressed debt, improve operations, and unlock value in undervalued assets, especially in Europe. Their strategy involves active management, operational expertise, and a willingness to acquire assets piece-by-piece, as demonstrated by their successful investment in the SH130 toll road.