Looking backwards, looking forwards: Edgehaven 2020 review and outlook for 2021 Alternative investing

Bev Durston, Dec 2020

Although the distressed opportunity set from Covid-19 is significant, my concern is there is going to be a lot of liquidity available for companies at very low yields and so companies will be able to borrow heavily to survive this cycle. In other words, we may experience “zombie capitalism” and come out of the period more indebted than when we entered it.

In the words of most global commentators, 2020 has been an unprecedented year. Unless you have been outside the orbit of planet Earth for the the past 12 months, you will undoubtedly have been affected by the pandemic that reared its ugly head and spread around the globe since this time last year. At last, the end does seem in sight with the announcement of several vaccines due to be administered over the course of 2021, although many new challenges in distribution remain.

So how have we fared and what have been the talking points this year in the Alternatives industry? Well, I have spent many a virtual conference and client meeting discussing the typical three stages of the distressed debt cycle, explaining “zombie capitalism” and why this crisis is likely to be different from previous ones. There are numerous articles in our press section – here are links to some of this content:

Edgehaven Principal discusses Zombie Capitalism with i3 September 2020

Zombie capitalism will distort the distressed debt cycle – Edgehaven principal Bev Durston talks to Family Capital magazine

Where are we now and how do we go forward?

The key question now is how big ‘phase three’ of the distressed debt cycle will be and whether it even eventuates given the volume of liquidity and support being provided by fiscal policy and central banks. Although the opportunity set is significant, my concern is that there is going to be a lot of liquidity available for companies at very low yields so troubled companies are going to be able to borrow from the markets to survive rather than default. In other words, we may experience “zombie capitalism” i.e. companies that should default will instead be able to borrow at low rates, leading to lower defaults available for a large volume of newly-raised distressed debt funds.

How are we dealing with today’s situation?

By being well prepared for end of cycle distress and focusing on what looks attractive now. We had already pre-prepared clients for some dislocation because it was our view that we were close to the end of the economic cycle. And whilst we didn't expect the health crisis that eventuated, we had pre-committed them into funds that would only start investing or would pivot into that area if there was a significant disruption in markets.

So, phase one is done and we had already got phase two capital pre-committed. The distressed, opportunistic funds that we prefunded are going to be running out of those moneys in the second half of 2021. We are now evaluating how much money we want to invest in stage three distressed and how long that opportunity set is going to last. There remains a big dislocation between what's happening in the real economy and how market yields are currently priced.

Whether there is going to be more distress to come very much depends upon how long governments continue to provide this support. Thus far, the Fed has only needed to jawbone a lot. It basically hasn’t had to actually invest significantly even though it has launched seven separate purchase programs. If the government and central bank support remains as strong into the first half of next year, then I think phase three may not eventuate in any way, shape or form the amount that people expect. Companies will be able to borrow their way for many years ahead through what would normally been a restructuring or a bankruptcy.

The opportunity sets going forward

However, the opportunity set in Asia is different from the U.S. and European markets because Asia was impacted by Covid-19 earlier, has coped very well with it, and is now largely through it with occasional lockdown's happening. What looks attractive there is a mixture of direct lending and special situations, particularly backed by real estate hard assets. We're also using mezzanine debt in Asia to assist companies with growth capital because the M&A trend has kicked in for the strong survivors. So the attraction is more on the growth side in Asia than necessarily the distressed opportunity set, while we're not sure how much that is also going to eventuate in the US and Europe.

Renewable funds also remain a considerably attractive space in the real assets sphere. Covering different technologies in the most attractive parts of the world yields some interesting opportunities to conduct deep due diligence.

There is another opportunity set that we think makes sense as well. This is the asset backed markets, which turned out to have a lot more leverage in them and was significantly impacted. These seized up entirely in the March period as leverage and repos were withdrawn. That market hasn't snapped back anywhere near as much relative to other segments that have easily snapped back. That space has, particularly in the single-B, double-B, and below, seems significantly illiquid and we think that's going to remain a significant opportunity set, particularly amongst things like mortgages, commercial real estate, CLOs.

Thus far, we’ve largely stuck to our global contacts and our list of more than sixty existing and potential managers and funds. It's difficult for LPs to conduct significant operational due diligence and investment due diligence when many are still working from home and very few are travelling. We've got the advantage that we've got on the ground, local teams, which form part of our open architecture platform for both investment due diligence and operational due diligence. We’ve also got a number of providers in each of those spaces who, if necessary, can organize local visits in situ. That sees us well-placed to continue investing throughout 2021 even though international travel will still be severely curtailed.

Summary

Who knows the outcome for 2021? The outcome is finely balanced between further upside as the vaccine is distributed and industries return to more normal behavior versus experiencing a traditional, phase three, distressed bankruptcy cycle. Despite this, markets have bounced considerably. With govt promises of low rates for years to come, markets don’t seem nearly as despondent as the economic numbers would otherwise indicate. It’s unclear whether we will experience a typical, phase three distress cycle or whether the market snapback supported by government liquidity opens the door to enable zombie capitalism, resulting in a very different cycle.

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