Speaker 1: Hello, and welcome to the Credit Edge Weekly Markets podcast.
Speaker 1: My name is James Crombie. I'm a senior editor at
Speaker 1: Bloomberg and.
Speaker 2: I'm Tim Rimington, a senior analyst covering basic materials at
Speaker 2: Bloomberg Intelligence. This week, we're very pleased to welcome Rob Deforne,
Speaker 2: chief investment officer at Polus Capital Management, which invests in
Speaker 2: special situations leveraged and structured credit.
Speaker 3: How are you, Rob, Oh, very well, thank you, Thanks
Speaker 3: for having me today.
Speaker 2: Great to have you here. So Rob, you founded baby
Speaker 2: Brook Capital back in twenty fourteen, which, after a merger
Speaker 2: with Karen Capital, went on to become Polus and now
Speaker 2: manages more than twelve billion in aum. Before that, you
Speaker 2: were a partner at Eton Park and previously at Millennium.
Speaker 2: So I have to say, as a highield analyst, I'm
Speaker 2: very excited to be here asking you the questions. It's
Speaker 2: normally the other way around, so I'm very excited to
Speaker 2: hear what you have to say and heading over to James.
Speaker 1: Yeah, So before we get to the questions, I just
Speaker 1: want to set the scene a bit. Markets are on
Speaker 1: edge after the US lost its triple A credit rating,
Speaker 1: Moody's was only really following the lead of the other
Speaker 1: rating agencies, so the cut should not have been a surprise,
Speaker 1: but it does come as another reminder of the fragile
Speaker 1: state of US government finances, calling into question the concept
Speaker 1: of risk free rate while also reigniting the Cell America trade.
Speaker 1: Despite this, credit markets are projecting an air of calm
Speaker 1: and optimism about the economy. All the losses from the
Speaker 1: so called Liberation Day have been erased. Bond spreads are
Speaker 1: back to where they were before the US announced tariffs
Speaker 1: that were effectively embargoes, but the tide didn't lift all boats.
Speaker 1: Spreads on the lowest quality corporate debt remain wide to
Speaker 1: long term averages, indicating some concern about whether the weak,
Speaker 1: highly indebted companies can survive as earnings decline and stagflation
Speaker 1: risks rise. So what do you make of it? Credit
Speaker 1: spreads would suggest that we're all in the clear now,
Speaker 1: everything's going to be okay. What's your take?
Speaker 3: Well, yes, I think the there's obviously been an amount
Speaker 3: of technical strength and credit hasn't there as they have
Speaker 3: been in most risk markets over the last few weeks.
Speaker 3: But you know, I don't think we necessarily see the
Speaker 3: fundamental picture having been the sounding of an all clear.
Speaker 3: You know, for us, I think as you as you
Speaker 3: alluded to, we were actually at pretty much embargo conditions
Speaker 3: and we've now gone to you know, from embargo and
Speaker 3: potential kind of meaningful shock, meaningful non linear moment for
Speaker 3: the economy, and we've pivoted that to know, a rewiring
Speaker 3: of trade, and from that kind of more acute kind
Speaker 3: of you know, let's call it real shock, we're moving
Speaker 3: into a more sustainable, but longer duration potentially rewiring of trade,
Speaker 3: which will just be you know, very very costly for
Speaker 3: the global economy and certainly for the US manufacturing goods, importers,
Speaker 3: et cetera. So you know, we definitely see the likelihood
Speaker 3: of a fundamental impact to be setting in and setting
Speaker 3: in for the medium term. So you know, it's with that,
Speaker 3: I think obviously the markets have there are those technical
Speaker 3: forces and kind of you know, people were underweight and
Speaker 3: they sold a lot of risk and they had cash
Speaker 3: balances coming into this, but they've really bought into the
Speaker 3: idea that an all clear has been sounded. From a
Speaker 3: pricing perspective, I think that does provide a medium term
Speaker 3: opportunity to take to take the other side.
Speaker 2: Of it, and I think just following on from that
Speaker 2: on the on the macro side. You know, one of
Speaker 2: the things that I've seen in my coverage and Basic
Speaker 2: Materials is essentially we've been in an industrial recession for
Speaker 2: the past three years already, from around twenty twenty two,
Speaker 2: and you know, we've heard again and again about this recovery,
Speaker 2: you know, this H two recovery that never really materializes.
Speaker 2: You know, do you think this shock that you know
Speaker 2: might be materializing now is going to be the sort
Speaker 2: of catalyst to sort of trigger another leg down.
Speaker 3: I think it is more likely than not. Would definitely
Speaker 3: be how we're thinking about it. So you know what
Speaker 3: you mentioned there about the sort of we have been
Speaker 3: in relatively tough conditions for the last three years, so
Speaker 3: we would absolutely agree with what we see. You know
Speaker 3: right now is obviously your market very very focused on
Speaker 3: sort of the next piece of information, the next piece
Speaker 3: of news, whether it's tariffs, whether it's you know, US
Speaker 3: rateing downgrades. But what it all really is is the
Speaker 3: end of a fifteen year cycle, and this is a
Speaker 3: late cycle. This is a late cycle time at the
Speaker 3: end of you know, ultimately a pretty long period in
Speaker 3: the most drawn out cycles that's been unsustainably and in
Speaker 3: many ways artificially sustained for a few extra years. And
Speaker 3: you know, is with that we do see as you say,
Speaker 3: kind of that industrial recession. Yeah, you know, they have
Speaker 3: been there have been various sub sectors that have been
Speaker 3: struggling for the last few years, which is what you
Speaker 3: get at the tail end of the cycle. You know,
Speaker 3: we've been told about the restocking that was coming in
Speaker 3: chemicals right for quite a while. There's obviously the early
Speaker 3: losers at the tail end of a cycle, which you know,
Speaker 3: if you're looking at basic materials, building products, and that
Speaker 3: exposure to the housing market which has been lackluster, you
Speaker 3: know since twenty twenty two, and the rise in interest
Speaker 3: rates globally. So there have been a number of sectors
Speaker 3: which have been stuttering. And you know what is actually
Speaker 3: the most interesting, to be honest, is over that three years,
Speaker 3: how you know we have avoided major issues already, right,
Speaker 3: I mean I think that this, you know, our characterization
Speaker 3: of the market, well the economy in a late cycle
Speaker 3: period really does suggest that, you know, we are to
Speaker 3: some extent on borrow time and you're really looking for
Speaker 3: kind of what is the catalyst that tips it over
Speaker 3: the edge in the end. And I think those kind
Speaker 3: of very heavy goods associated sectors that you mentioned, which
Speaker 3: are have interest rate sensitive end consumer demand are clearly
Speaker 3: the ones which have been the weaker since twenty two
Speaker 3: because those are the places where you know, end demand
Speaker 3: was more constrained by the traditional interst rate function and
Speaker 3: how it impacts consumer spending. I think kind of so
Speaker 3: for us, you know, we really do feel that for
Speaker 3: whatever shot comes down the pipe, we do think most
Speaker 3: likely tariffs, but you know, it could equally be sovereign funding,
Speaker 3: et cetera. There are several there are several things that
Speaker 3: are kind of available at the end of this economic
Speaker 3: cycle to be the ultimate one that breaks this breaks
Speaker 3: the camera's back, as it were. But you know, they
Speaker 3: all sit within a context of, you know, credit wasn't
Speaker 3: that credit worthy over the last couple of years. You know,
Speaker 3: we are looking at very very high debt to cash
Speaker 3: flow statistics. We're looking at extremely high amounts adjustments of
Speaker 3: adjustments to earnings, and none of these things can really
Speaker 3: pay your debt, you know. So that's why the market
Speaker 3: is somewhat more fragile in the credit sector is somewhat
Speaker 3: more fragile in the lower rated spectrum to these forces.
Speaker 1: I feel like we've been talking about this scenario for
Speaker 1: years though, in terms of, you know, the end of
Speaker 1: the cycle and a big distressed cycle coming, and there's
Speaker 1: all this money been raised for that strategy, and yeah,
Speaker 1: it just never happens, you know, certainly on mass. I
Speaker 1: mean there's there's specific situations. You see, there's companies that
Speaker 1: you kind of see dropping into trouble and you know
Speaker 1: that they're going to get into worse trouble. But you
Speaker 1: know the size of that that opportunity just seems so
Speaker 1: small relative to the whole market. So so why should
Speaker 1: we worry? Now, what's the tipping point that we're really
Speaker 1: focused on. What are the signs that you're seeing to
Speaker 1: show that's coming.
Speaker 3: Yeah, Look, it's the process, right, The creation of of
Speaker 3: of excess misallocated credit is very much a process, and
Speaker 3: it takes place over a sustained period of time, and
Speaker 3: that you know, that was really the build up of
Speaker 3: debt through that low interest rate period that we've had
Speaker 3: since the GFC. So you know, the statistics really are
Speaker 3: that we have seen that incredible pick up in just
Speaker 3: the amount of the volume of sub investment. Great credit.
Speaker 3: You know, we're not worried about credit in general. Investment
Speaker 3: grade balance sheets are very strong, and you know, there
Speaker 3: was a corporate windfall from effectively the pandemic and the
Speaker 3: pandemic in era stimulus. So investment grade companies are about
Speaker 3: as about as good as they have been. Yeah, they've
Speaker 3: they've maybe overspent a little bit on buybacks, right, you know,
Speaker 3: ultimately and kind of left a bit of leverage on
Speaker 3: balance sheets. There are, of course a few exceptions which
Speaker 3: are a little bit weak, but you know, by and
Speaker 3: large igs okay. But high yield went from being that
Speaker 3: niche asset class to you know, very much mainstream post
Speaker 3: to GFC maybe five hundred billion dollars of loan and
Speaker 3: high year bonds outstanding, which is now five trillion dollars. Right,
Speaker 3: ten x the number of names, you've ten x the amount.
Speaker 3: But in that period of time, actually a lot of
Speaker 3: the sort of number of eyeballs looking at things has
Speaker 3: been outsourced to passive you know, passive purchasing. So the
Speaker 3: the kind of that has a lot the kind of
Speaker 3: a man of scrutiny on a lot of the single
Speaker 3: names to be reduced. So we definitely have kind of
Speaker 3: through that process. You know. My point here is really
Speaker 3: that we have been building up this misallocation as a
Speaker 3: process and then kind of you know, credit always gets
Speaker 3: to the same tipping point at the end of a cycle,
Speaker 3: which is what is the point where you sort of
Speaker 3: compare your growth rate the G, with your financing costs,
Speaker 3: your interest rate the R, and what matters to servicing
Speaker 3: credit is you kind of need a bigger G and
Speaker 3: a smaller R. And obviously, through the period of low
Speaker 3: interest rates the reason why credit was misallocated. Then you
Speaker 3: can see that from kind of how much credit grew
Speaker 3: relative to GDP, right, you know, so much more credit
Speaker 3: growth than there than there was GDP growth. And you
Speaker 3: get to the end of that process where you didn't
Speaker 3: need much G. Right, you didn't need to be producing
Speaker 3: much G you know, pre pandemic because because the R
Speaker 3: was so low. Come out of kind of the pandemic era,
Speaker 3: you know, twenty twenty two onwards, and we've seen kind
Speaker 3: of the R, the financing costs, the risk free rate
Speaker 3: for the economy pick up, but we haven't really seen
Speaker 3: a ton of real growth. And then the thing that
Speaker 3: kind of obviously everyone who was said, have said, well, look,
Speaker 3: the moment where your our versus G mixed, your ORE
Speaker 3: rises quickly and your G is constrained because you know,
Speaker 3: the economy is ultimately interest rates sensitive, was when we
Speaker 3: went into the hiking cycle of twenty two, And I
Speaker 3: think it's pretty fair to say that would be attributed
Speaker 3: to be a pretty good, you know, kind of starting
Speaker 3: bell for the the the unraveling of what at the
Speaker 3: time was a sort of twelve or thirteen year period
Speaker 3: of pick up in debt. The reason why it didn't
Speaker 3: is not, in my view, because the economy is no
Speaker 3: longer interst rate sensitive or as interest rates sensitive as
Speaker 3: it was, is actually that it was a very unusual
Speaker 3: period where that monitor tightening came with an enormous fiscal loosening,
Speaker 3: so the monasary tightening didn't bite as much as it
Speaker 3: otherwise would have done, not only the fiscal loosening that
Speaker 3: we saw twenty two to twenty three, twenty four, but
Speaker 3: also kind of the legacy unspent fiscal funds from twenty
Speaker 3: to twenty one. So really it has to be thought
Speaker 3: of as a stock flow impact, which is ordinarily you know,
Speaker 3: twenty two's interest rate cycle and the aftermath of it
Speaker 3: would have created those higher interest rates, higher financing costs,
Speaker 3: which would have you know, really started the pinch on
Speaker 3: corporate credit balance sheets. But the economy was just awash
Speaker 3: with fiscal money and then got more physical money, and
Speaker 3: that did kind of that unsustainable element did did draw
Speaker 3: out this tail end of the cycle. But you know,
Speaker 3: the forces of physics and the forces of finance, you know,
Speaker 3: they don't change, right, This is just a stock flower,
Speaker 3: and we went into the usual kind of bad flow
Speaker 3: piece of lower growth and higher financing costs, but with
Speaker 3: a much larger stock, much larger buffer for the economy
Speaker 3: to take it. But you know, we call this time
Speaker 3: under tension, right, which is also the corporate don't. They
Speaker 3: don't roll over at the first moment of a higher
Speaker 3: interest rate. You kind of have to leave in place
Speaker 3: that period of higher interest rates and lower growth for
Speaker 3: a longer period. Is the time under tension, not just
Speaker 3: the existence attention. And that time is a little bit
Speaker 3: drawn more drawn out this time because of because of
Speaker 3: the support that offset the monetary tightening that we had.
Speaker 3: But it is real, right, and you do see kind
Speaker 3: of it's more of a niche practice, but obviously you've
Speaker 3: been a massive pickup in liability management distressed exchanges, and
Speaker 3: we've had a pretty meaningful sort of default rate across
Speaker 3: leverage loans and high yield right you know, for a
Speaker 3: robust part of the cycle, it's been non zero, which
Speaker 3: is which is unusual and is now being followed up.
Speaker 3: What's super interesting right now when you think about that
Speaker 3: kind of the impact that interest rates have. You know,
Speaker 3: we're now starting to see that pickup in delinquencies, you know,
Speaker 3: certainly in the US across credit card, auto loan, obviously
Speaker 3: the end of student loan for bearns, the impact that
Speaker 3: that has an f A h A mortgages. So I
Speaker 3: think a large part of kind of that delayed reaction
Speaker 3: coming through from from interest rate hikes is starting to
Speaker 3: be seen in the data in the in the US consumer.
Speaker 3: We're going to have it in Europe as well, with
Speaker 3: a kind of moderate upwards drifting NPL. So you know,
Speaker 3: think about it. We think about it as kind of
Speaker 3: you know, the foothills before the mountain, as you can
Speaker 3: kind of go on the slower sent and then and
Speaker 3: then it kind of picks up more broadly after that.
Speaker 3: So you don't always need a shock. I think like
Speaker 3: the financial markets love to look for that one shock,
Speaker 3: and it could actually just be a set of things
Speaker 3: building in the background. If you allow me to the
Speaker 3: labor my R versus G thing for a little bit longer,
Speaker 3: I would say that, Well, the reason why tariffs are
Speaker 3: a really interesting one is because they in it as
Speaker 3: a supply shop for the US and a demand shock
Speaker 3: for everyone that exports to the US, so simultaneous supply
Speaker 3: demand shop. We don't see many simultaneous supply demand shocks,
Speaker 3: So that's you know, highly likely to be a lower G,
Speaker 3: and for every unit of lower G, you're going to
Speaker 3: have a slightly stickier R. As we know sort of
Speaker 3: central banks should be it should be slightly harder for
Speaker 3: them to react to slow down in growth because this
Speaker 3: is something that raises prices, even if it's only on
Speaker 3: a one time basis. I dispute that, but you know,
Speaker 3: because it's a supply shot. But you know, the you know,
Speaker 3: you will make the G versus our mechanic harder. So
Speaker 3: the interesting thing about about tariffs is you stop. You know,
Speaker 3: My view would be we are starting with a difficult
Speaker 3: starting point for the end of a cycle. Big pickup
Speaker 3: in debt it has been sort of artificially extended by that,
Speaker 3: by that fiscal policy, which is effectively allowed kind of
Speaker 3: three years of additional poor management for those corporates to
Speaker 3: stick into place, and then you're hitting it with you know,
Speaker 3: what should be a credit negative shock at the end.
Speaker 3: So it's very difficult time to be a kind of
Speaker 3: highly levered corporate because obviously it is a companies do
Speaker 3: have the ability to react to some of these things.
Speaker 3: But if you've got a lot of debt than your
Speaker 3: ability aware with all an effect of deep degrees of
Speaker 3: freedom to act are meaningfully lower. And so I think
Speaker 3: kind of, you know, leverage is really the enemy for
Speaker 3: a corporate at this time.
Speaker 2: And in terms of your strategy, you know, how are
Speaker 2: you how are you positioned to take advantage of that view?
Speaker 2: You know, you mentioned perhaps US markets might see more
Speaker 2: opportunities there. You know, I think that's interesting, you know,
Speaker 2: covering chemicals, the US has actually been until recently one
Speaker 2: of the stronger markets and Europe's been the weak one.
Speaker 2: But perhaps with the tariff shock that's now going to reverse.
Speaker 3: Yeah, yeah, I mean, how we're positioning for it is
Speaker 3: we do have a more substantial book of single name
Speaker 3: high your credit shorts. So we have increased the let's
Speaker 3: call it the percentage exposure of the fund as well
Speaker 3: as the number of names that we're exposed to, because
Speaker 3: you know, as I mentioned, if you came into if
Speaker 3: you came into this year, you know, we were certainly thinking, well,
Speaker 3: there is that general misallocation in credit, right, and there's
Speaker 3: obviously kind of those misallocations could be poor quality yearnings,
Speaker 3: weaker businesses from a cyclical or secular basis, then you
Speaker 3: impose on it. Additionally the tariff issue. You understand, there's
Speaker 3: kind of our number of different sectors at play. Challenges
Speaker 3: for consumer discretionary businesses as there's just less real link
Speaker 3: and that impacts lots of different service and goods businesses.
Speaker 3: As I mentioned earlier, the housing cycles being struggling, so
Speaker 3: there's a lot of different sectors that are actually impacted here.
Speaker 3: So really what we're we've been looking for is week
Speaker 3: company with high leverage. We obviously like subordination as well
Speaker 3: in shorts, because if someone sits ahead of you in
Speaker 3: the queue in one of your restructurings, then the recovery
Speaker 3: is clearly likely to be lower. Right, Because we're obviously
Speaker 3: selecting for high loss given default, looking for those low recoveries.
Speaker 3: We're selecting for a high probability of default. The company
Speaker 3: has leverage. We business cyclically challenged because of the because
Speaker 3: of the particular dynamics in the end markets that might
Speaker 3: be unfolding. So you know, basically expanding by number the
Speaker 3: set of situations that we have, but also increasing the
Speaker 3: number of them that we have Paris would draw in
Speaker 3: a larger larger set of names, clearly, But as I
Speaker 3: mentioned earlier, you know, we are talking to several thousand
Speaker 3: names in the high yield market. So if you were
Speaker 3: to say we focus on the bottom ten or twenty
Speaker 3: percent of names by quality, that's still one thousand names
Speaker 3: that we could be looking at and pouring over to find,
Speaker 3: let's say the weakest one hundred and fifty or two
Speaker 3: hundre hundred. So it's really mean about kind of screening
Speaker 3: and looking for more weaker situations, trying to understand what
Speaker 3: would a cyclical slow down globally mean for that business,
Speaker 3: what would the tariff cost mean for that business. I mean,
Speaker 3: we've seen kind of a lack generally of commentary from
Speaker 3: companies and therefore you know they have not been educating
Speaker 3: analysts on the exact costs right of tariffs to them.
Speaker 3: Obviously a lot of them will hide behind well, I'd
Speaker 3: buy my things from a US based distributor, right, You're like, yes,
Speaker 3: in the US based distributor probably purchased it from somewhere
Speaker 3: else that wasn't in the US. Right, So you know,
Speaker 3: the clarity of the information there isn't super clean. But
Speaker 3: ultimately an enormous amount of intermediate products do you come
Speaker 3: into the US from other countries, So there's a lot
Speaker 3: of analytical work to do there. We would spread our
Speaker 3: bets these days in terms of kind of the number
Speaker 3: of situations we would look at quite simply because the
Speaker 3: nature of restructurings has changed, Right. You know, we see
Speaker 3: a lot of distress exchanges in lmes, and what those
Speaker 3: really are is sort of, you know, in the nicest
Speaker 3: possible way, is you know, avoiding a default that should
Speaker 3: have happened now and almost always pushing into the future. Right.
Speaker 3: You know, the majority of these companies do not make it.
Speaker 3: You're buying time, but ultimately buying that time doesn't actually
Speaker 3: generate success for the equity owner of the business. And
Speaker 3: it's because of that kind of appetite to pursue those transactions.
Speaker 3: You're seeing a lot of you know, the definition of
Speaker 3: zombie has widened, right from something that's sort of looked
Speaker 3: like it might not have been able to pay the
Speaker 3: interest and principle on its debt to literally one where
Speaker 3: the creditor said, you don't have to pay me anymore.
Speaker 3: Let's just pretend that you know, we're still with you know,
Speaker 3: this is still a performing credit. So it's because of
Speaker 3: that kind of dynamic in the market that we like
Speaker 3: to kind of shield ourselves maybe from what we see
Speaker 3: as as those sort of not full restructurings.
Speaker 2: Yeah, I'd actually like to push a bit further on
Speaker 2: the on the ownership and kicking the can down the
Speaker 2: road theme. But before we do that, I think it
Speaker 2: would be quite interesting to hear a little bit more
Speaker 2: about the mechanics of how you shot these names. Are
Speaker 2: you looking to do it physically synthetically? Can you talk about,
Speaker 2: you know, how you manage some of the risks, you know,
Speaker 2: they're quite expensive short sometimes, you know, the liquidity can
Speaker 2: be an issue. You know, perhaps even any examples you're
Speaker 2: able to share.
Speaker 3: Well, to be honest with you, I think the biggest
Speaker 3: the biggest way of managing your risk there is is
Speaker 3: to leave as few footprints as you can. Right. So
Speaker 3: one of the reasons why we have you know, a
Speaker 3: lot of shorts, so you know, hundreds, is so that
Speaker 3: we're not exposed to any single name and the instability
Speaker 3: of repo or the ability to borrow bonds in any
Speaker 3: one of those names. We don't tend to use a
Speaker 3: lot of synthetic, so we don't tend to use a
Speaker 3: lot of CDs. I think both sides of the Atlantic
Speaker 3: have obviously seen lots of high profile examples over the
Speaker 3: years of CDs not really being a particularly efficient tool
Speaker 3: for taking a view on on credit. You know, plenty
Speaker 3: of high profile examples where company went bust but CDs
Speaker 3: was uphaned or you know, engineered default or what have you. So, yeah,
Speaker 3: we stick to the physical market, but leave no footprints. Really,
Speaker 3: So if we if we have you know, if we
Speaker 3: spend the effort analytical time, research, you know, research time,
Speaker 3: research expense on finding as men of the weak names
Speaker 3: as possible, we can have a smaller position in each one.
Speaker 3: Therefore there isn't going to be crowded repo in them,
Speaker 3: and and and as a result, you know, the cost
Speaker 3: tends to be lower, the availabilities higher, the liquidity risk
Speaker 3: is lower, so we kind of manage around that, to
Speaker 3: be honest with you, just but what it requires is
Speaker 3: to have looked at a lot of names, because if
Speaker 3: you're going to assured one hundred and fifty names, you
Speaker 3: have to have looked at one thousand, and you have
Speaker 3: to have looked at them properly, you know, I would
Speaker 3: say that kind of in this very very low volatility
Speaker 3: period that we've been in for a while, excluding April
Speaker 3: and May twenty five, the availability of repo for high
Speaker 3: year bond has been very very high because it was
Speaker 3: a good source of financing revenue for low fee, low
Speaker 3: fee funds, and you know, there wasn't really a market
Speaker 3: or appetite for shortening any of the debt, so you know,
Speaker 3: it was just ultimately for the end owner of the bond,
Speaker 3: quite good way of generating extra income. So the availability
Speaker 3: and depth of the repay market is higher than it
Speaker 3: ever has been. I think what we would expect as
Speaker 3: times get slightly tougher for these credits, we'll see more,
Speaker 3: we'll see more kind of you know, instability in that market,
Speaker 3: and we'll probably see more regulator reinforcement action as a result, right,
Speaker 3: you know, because sort of the easy way to generate
Speaker 3: a bid for a weak position is to try and
Speaker 3: engineer a repost squeeze by the end owner, and you know,
Speaker 3: obviously you're not allowed to do that, so you know,
Speaker 3: it is something that the regulator knows to look out
Speaker 3: for at the end of a cycle. So a lot
Speaker 3: of the times the instability and the risk you're managing
Speaker 3: around is really around somebody doing something they're not supposed to.
Speaker 3: So fortunately we have regulators for that.
Speaker 2: So would you see opportunities in some of these more
Speaker 2: creative lem examples we've seen over recent years. I mean,
Speaker 2: Federick Gourney had a toggle pick that came out last year.
Speaker 2: There's been a number of other picks or partial picks
Speaker 2: from you know, highly levered European names over the last
Speaker 2: year or so. You know, is that the sort of
Speaker 2: thing that interests you as well?
Speaker 3: In a word, no, the look, you can make money
Speaker 3: on them here all there. But I think as a strategy,
Speaker 3: I buy credit and the goal with credit is I
Speaker 3: you know, when you're buying it, you want to make
Speaker 3: a yield, right, and the yield requires that I get
Speaker 3: paid a coupon, and I also get my money back
Speaker 3: at the end, and that, unfortunately, is one of the
Speaker 3: reasons why I don't think lms in distressed exchanges, et
Speaker 3: cetera work particularly well, which is, if I'm picking and
Speaker 3: rolling out maturities, then I'm not getting paid either the
Speaker 3: principle or interest, and therefore I'm kind of left wondering
Speaker 3: how if I have to be the end owner of
Speaker 3: that credit, right, if I cannot find a way to
Speaker 3: recycle that risk, I'm left wondering how I'm going to
Speaker 3: make a profit, because the reality is I'm probably taking
Speaker 3: a corporate that has been struggling recently. I'm leaving the
Speaker 3: current management team in to continue running it in an
Speaker 3: otherwise difficult It's obviously a difficult cyclical or secular environment
Speaker 3: with the same amount of debt and presumably relatively constrained
Speaker 3: cash flow. Because if they can't pay me as a creditor,
Speaker 3: presumably they're they're under investing in R and D, CAPEX,
Speaker 3: they might actually be underpaying staff, you know, all of
Speaker 3: those things. That doesn't strike me as kind of a
Speaker 3: situation where I would be saying, Okay, well, I'm going
Speaker 3: to get my money back as the person who ends
Speaker 3: up holding these because this company's going to recover because
Speaker 3: it just doesn't have Like you just statistically, if you're
Speaker 3: short on cash, you can't pay your debt. You haven't
Speaker 3: got less debt and your cash flow constrained, and you
Speaker 3: left the same management team in and you had a
Speaker 3: bad starting point. I don't see how I underwrite the recovery.
Speaker 3: So you know, ultimately, when we're looking at these situations,
Speaker 3: we want to be the top of the stack. We
Speaker 3: want asset based situations. I want them to be free
Speaker 3: cash flow positive before debt service, so that I know
Speaker 3: that the thing I'm buying actually has some cash flow
Speaker 3: coming into that box. And and and you know a
Speaker 3: lot of these lems the issue is they are burning cash, right,
Speaker 3: you know that it's not they're not generating cash, and
Speaker 3: therefore they're very, very difficult to do from a stress
Speaker 3: and distress perspective.
Speaker 2: Yeah, so I think I'll sort of pivot onto the
Speaker 2: private equity side of it now. Then, you know, you
Speaker 2: mentioned you're seeing a lot of kicking the can down
Speaker 2: the road, you know, with these lemis. I totally agree
Speaker 2: private equity firms huge driver of issuance in the sector,
Speaker 2: but the exit market seems largely closed. You know, I'm thinking,
Speaker 2: especially in the industrial sector, multiples that come down earnings
Speaker 2: are you know, troughing. You know, so we've heard talk
Speaker 2: in the past of sort of there being dry powder
Speaker 2: and you know, they can sort of continue propping up
Speaker 2: these these companies. I think, you know, anecdotally, we might
Speaker 2: have seen a bit less of that dry powder being
Speaker 2: deployed and a bit more of these more creative financing
Speaker 2: opportunities or solutions rather. You know, how do you view
Speaker 2: the ownership structure of the you know, the positions you're
Speaker 2: taking on the on the short and the alongside. Is
Speaker 2: there sort of specific you research you do into pe
Speaker 2: funds that you know may have been fully deployed and
Speaker 2: you know are limited on the on the drive powder.
Speaker 3: Yes, so you're definitely looking for that as one of
Speaker 3: your pieces of due diligence. Is the likelihood of a
Speaker 3: company to be supported by by the owner. It's worth
Speaker 3: remembering there's an awful lot of debt is on non
Speaker 3: sponsor businesses as well, especially in the US market. But
Speaker 3: it is true that kind of there is a lot
Speaker 3: of sponsor There are a lot of sponsor businesses. You know,
Speaker 3: it's not a surprise to anybody that exits have been lower,
Speaker 3: right in terms of frequency. There's obviously, you know, lots
Speaker 3: of high profile news out there about the discomfort that
Speaker 3: private equity investors have about the lack of return capital,
Speaker 3: and it looks like it should continue, right, you know, ultimately,
Speaker 3: which is it is hard to see what really brings
Speaker 3: about a wave of exits, right. You know, so private
Speaker 3: equity activity is easier to envisage in a decent economy
Speaker 3: with low rates right and low finante costs. So you know,
Speaker 3: we don't have the low enough rates and we don't
Speaker 3: have a decent enough or stable enough economy right now,
Speaker 3: so it is difficult to imagine being able to monetize
Speaker 3: at the multiples that the would effectively get private equity
Speaker 3: out at their now. So you know, obviously, with that,
Speaker 3: the idea of dry powder is key. Now, there's two
Speaker 3: types of dry powder, right. The dry powder in the
Speaker 3: private equity firms is also dry powder in private credit.
Speaker 3: So you have to take both of those things into
Speaker 3: account as a potential source of capital into your lungs
Speaker 3: and shorts. And you know, candidly, if you're long, you're saying,
Speaker 3: I wonder how I can get some of that dry
Speaker 3: powder into this business. And that absolutely happens. Not every
Speaker 3: company that enters stress or distress is insolvent. Some of
Speaker 3: them are just over levered. So effectively, we would push
Speaker 3: the equity owner of the business, you know, or sometimes
Speaker 3: of a sponsor, you know, if you want to keep
Speaker 3: this asset, support it with some equity, and that goes
Speaker 3: to pay me down and de levers me. And I
Speaker 3: feel like I'm in a better place, and I will,
Speaker 3: you know, make some compromises to you, maybe on kind
Speaker 3: of the duration of I'll leave the capital with you, you know,
Speaker 3: in return for that. So we really would ask that
Speaker 3: if we were a long something that the private equity
Speaker 3: company does step in with cash. What has been interesting
Speaker 3: has been that in a lot of l and ees
Speaker 3: that the owners of the debt have not pushed for that.
Speaker 3: They've basically given the private equity firms a free option
Speaker 3: on holding the business and running it into the future.
Speaker 3: And you know, which is odd in situations where it's
Speaker 3: not working right now, right there is stress and distress
Speaker 3: because you know, maybe it's the governance of the business,
Speaker 3: maybe it's the capital structure, maybe it's the business itself,
Speaker 3: but it's not working. You do need to change something,
Speaker 3: and you know, that does strike me as odd that
Speaker 3: that hasn't happened. It's worth noting that the kind of
Speaker 3: private credit dry powder. You know, sometimes they could come
Speaker 3: in as a refinancier if they're very friendly. You know,
Speaker 3: you've bought something as a stress debt, but they're very
Speaker 3: friendly with a private equity sponsor and they come in
Speaker 3: and do some refinancing, sometimes as a second lean, and
Speaker 3: we might have been a first lean, so they've kind
Speaker 3: of taken the role of putting that extra cash into
Speaker 3: Deleverers as the first lean. But in general, you know,
Speaker 3: I would say that your goal has to be well,
Speaker 3: there is dry powder out there, so if you long something,
Speaker 3: you should be finding a way to get that capital
Speaker 3: into the business. And when we're short something, it is
Speaker 3: you know, just ultimately it is a risk that that
Speaker 3: that capital comes in, but it frequently hasn't, right, And
Speaker 3: the reason why it hasn't is because the capital from
Speaker 3: your investors is absolutely precious, right, you know, it is
Speaker 3: it is you know, and it has to be used
Speaker 3: for you know, it has to be used for the
Speaker 3: right purpose. Your fiduci you duty to be a good
Speaker 3: custodian of that capital. And if and if the business
Speaker 3: isn't working and you're not achieving any deleveraging, then you know,
Speaker 3: really you're not doing the right thing for your investors.
Speaker 3: And if that is what ends up happening as a
Speaker 3: private equity firm, just dropping some money into a into
Speaker 3: a failing business that you kind of knew you were
Speaker 3: going to burn, then it starts to taint your reputation
Speaker 3: for future future capital raising, and that that is effectively sacrificing.
Speaker 3: You know, that's the one thing that you would never
Speaker 3: want to do. So I see why they've been cautious,
Speaker 3: which is why would they put the capital into some
Speaker 3: of these situations. Like you know, if you imagine a
Speaker 3: business has you know, two billion dollars of debt and
Speaker 3: it's got a sustainable debt capacity of one billion dollars,
Speaker 3: which is probably about the right maths for a lot
Speaker 3: of these credits. Well, you know, what can you put
Speaker 3: in there to achieve a one billion dollar debt right off?
Speaker 3: And it might be you know, no one's willing to
Speaker 3: take that. They'll only do that if you hand the
Speaker 3: business over. You can't really put in fifty million of
Speaker 3: new equity and hope that people are going to ride
Speaker 3: a billion off. So the kind of maths hasn't really
Speaker 3: been working. And then kind of saying, well, we've got
Speaker 3: a pretty high nave on this asset. You know, how
Speaker 3: do we sell this twelve times leathered business at sixteen times?
Speaker 3: You know that's difficult as well. We need to deliver
Speaker 3: it at six to six before we could, and you know,
Speaker 3: the math doesn't really work. So they're keeping the dry
Speaker 3: powder safe.
Speaker 1: I me, but some of the distressed investors out there,
Speaker 1: I mean, there's so much cash that they've raised over
Speaker 1: the years for not a lot of opportunity in relative terms,
Speaker 1: there seem to be under pressure to deploy, and in
Speaker 1: some cases they're lending new money to these stressed companies
Speaker 1: that seems to be more, you know, more of a
Speaker 1: popular strategy. How do you see that? I, well, we don't.
Speaker 3: Do that because I'm old fashionate enough James to think
Speaker 3: that a company that's struggling with too much debt might
Speaker 3: not need more of it. So look the way that
Speaker 3: I think the way the industry is it has proceeded
Speaker 3: to say, in the absence of interesting secondary distress purchases
Speaker 3: right of buying somebody else's mistake. They pushed towards kind
Speaker 3: of primary stress and to stress. So lend money into
Speaker 3: a struggling situation. And I suppose the capital solutions industry
Speaker 3: has evolved from doing into doing that in an effectively
Speaker 3: subordinated format. Now I can't imagine taking a stressed company
Speaker 3: and wanting to put subordinated capital into that, right, but
Speaker 3: I know it happens. I think that you know that
Speaker 3: the turnaround that would be required in that situation in
Speaker 3: terms of the operation of the business, the quality the
Speaker 3: business would just be enormous that you would have to
Speaker 3: underwrite two to feel that you were definitely going to
Speaker 3: get that money back. You know, we would obviously do
Speaker 3: senior rescue financy, but that's not really what's been happening
Speaker 3: out there, right, You know, a lot of it is
Speaker 3: really sort of stressed subordinated. So you know, rule number
Speaker 3: one never subordinate yourself and the other is never pick yourself.
Speaker 3: So if it breaks the the cardinal rules, then I
Speaker 3: wouldn't do it. So, yeah, we're not really into that.
Speaker 3: I think kind of more broadly, for your investors, you
Speaker 3: also have to think about, well, what am I really doing? Right?
Speaker 3: The reason why we stick to only secondary purchases the
Speaker 3: average purchase price on our distress debt. So we've done
Speaker 3: our one hundred and thirty five transactions in nearly twelve years,
Speaker 3: the average purchase price has been fifty five cents on
Speaker 3: the dollar. So the thing about entering the debt via
Speaker 3: the secondary at a discount, they have to be able
Speaker 3: to find it right, and that's a whole new thing.
Speaker 3: You know, we have managed to sustain a franchise for
Speaker 3: purchasing that secondary distress debt. But if you buy the
Speaker 3: right stuff, you have gone into a situation where you
Speaker 3: kind of feel like the worst thing has already happened, right,
Speaker 3: You've gone bankrupt. And therefore, kind of if you think
Speaker 3: about the conditional probabilities of this, what's the probability wants
Speaker 3: a really terrible thing has happened, then another really terrible
Speaker 3: thing happens afterwards, and also it is clearly much lower. Right,
Speaker 3: the bad thing has already happened. So, you know, we
Speaker 3: got in there at fifty five cents on the dollar
Speaker 3: feeling like, well, if we can get the assets or
Speaker 3: cash flows, maybe get forty five or fifty back but
Speaker 3: if we get it right, there's a potential equity like
Speaker 3: return available here. The problem with giving the company fresh
Speaker 3: new capital on a primary basis is you basically given
Speaker 3: them one hundred. You said, well, keep paying me my
Speaker 3: twelve of coupon that you're going to afford. But if
Speaker 3: I get it wrong, I get zero. Right, So you know,
Speaker 3: if you think about the skew on ours, we've paid
Speaker 3: fifty five to try and get somewhere between fifty and
Speaker 3: one hundred, and you know if you but if you've
Speaker 3: done the primary example that new money capital solutions is money,
Speaker 3: you've given them one hundred. Your best case, you get
Speaker 3: one hundred. In your worst case you get zero. But
Speaker 3: you subordinated yourself, so the probability of the zero is
Speaker 3: much higher. So you have to charge a pretty substantial coupon.
Speaker 3: But then theblem is that the company's probably struggling. If
Speaker 3: it's struggling with debt, then it's going to be picking
Speaker 3: your coupon presumably, So it kind of falls a little
Speaker 3: bit down on the common sense thing, which is, you know,
Speaker 3: if you were talking to your grandma about that, what
Speaker 3: would she say, you know, when you'd sort of you
Speaker 3: know her neighbor wasn't paying their mortgage, so you said, well,
Speaker 3: i'll give you, you know, I'll give you another twenty
Speaker 3: five percent of your house value. You don't have to
Speaker 3: pay me a coupon, and I'll sit behind the bank.
Speaker 3: You know. She would say, well that now, I'm not
Speaker 3: sure that makes a ton of common sense. And I
Speaker 3: think you know, that's why we would describe maybe that
Speaker 3: primary Cap solutions as an innovation as we call it
Speaker 3: in finance, which isn't a real innovation. It might just
Speaker 3: be a fad.
Speaker 1: So when you're pitching this rob to you investors out there,
Speaker 1: you know, in terms of a strategy, what's the upsite
Speaker 1: right now? What's kind of questions they asking you? In
Speaker 1: you know the context? Also, you know they can get
Speaker 1: five and a half percent on an investment grade by
Speaker 1: with zero likelihood of default, So why should they stick
Speaker 1: their necks out and really you know, jump into distress
Speaker 1: right now?
Speaker 3: Well you can definitely make more than that on good distress,
Speaker 3: you know, so it really forms part of a you know,
Speaker 3: balanced portfolio, right you know. And and what I think
Speaker 3: you're really saying to investors is, look, that becomes a
Speaker 3: time each cycle, right, we have these micro distress cycles
Speaker 3: and we have a macro distress cycle. You know, ultimately
Speaker 3: also insues and what they provide you is the opportunity
Speaker 3: to create assets at the meaningful discount to their intrinsic
Speaker 3: value via the debt. And so you can actually make
Speaker 3: equity like returns from you know, being senior in a
Speaker 3: capital structure, right, so you can actually be in the
Speaker 3: in the lower risk part of it, and you can
Speaker 3: make equity live returns from that top of the cap
Speaker 3: stack position in really really great assets, right. You know,
Speaker 3: it could have been done in realists day, or aviation
Speaker 3: or hotels or yeah, some operating businesses, infrastructure, you name it.
Speaker 3: So you can get these brilliant businesses and you can
Speaker 3: actually take the kind of thin slices at the top
Speaker 3: and generate equity like returns from that. But you only
Speaker 3: get that every so often, and it's in these periods
Speaker 3: where you've kind of kind of the misallocation has has
Speaker 3: built up over the years, and you get to a
Speaker 3: position where when we get the market clear and you
Speaker 3: you absolutely get kind of a brilliant opportunity for that.
Speaker 3: I think investors have been really receptive over over the
Speaker 3: over the last couple of years. I think they they
Speaker 3: have have a couple of perceptions. One of one of
Speaker 3: them is we also we have kind of a real
Speaker 3: business for doing this, right. It's not just waiting for
Speaker 3: the things to kind of turn up and jump jump
Speaker 3: out at you off the screen. We have had to
Speaker 3: kind of find a way to keep sourcing the really
Speaker 3: interesting risk that fits that top of the capital strut
Speaker 3: a big discount against asset based situations, right, and having
Speaker 3: built that infrastructure has been really key for investors to
Speaker 3: understand that, well, we can find things when there isn't
Speaker 3: a big macro cycle, then when it turns up, hopefully
Speaker 3: will be a safe custodium for their capital when when
Speaker 3: one does turn up. I think the other thing that
Speaker 3: one centers from investors is they're absolutely not kind of
Speaker 3: entirely comfortable with the current setup of of of market
Speaker 3: prices and fundamentals because you know, I think it's one thing,
Speaker 3: you know, investors don't have an other people's money mindset, right,
Speaker 3: It is absolutely their money that they manage and that
Speaker 3: you know, they have been entrusted with, certainly our end investors,
Speaker 3: and therefore they're trying to come up with what the
Speaker 3: right thing to do is and it's quite hard to
Speaker 3: find kind of that fundamental justification, you know, is a
Speaker 3: high and fundamentals a week for just sort of you know,
Speaker 3: you know, just plow on and keep the faith and
Speaker 3: sort of diamond hand at whatever. So you know, I
Speaker 3: think what what you send is that trepidation that they
Speaker 3: have and sort of meet more and more people with
Speaker 3: with grady degrees of anxiety, you know, on behalf of
Speaker 3: you know, if it's a pension fund, you know, the
Speaker 3: trustees of that pension fund, or it's an endowment, it's
Speaker 3: the maybe some of the important programs that they're doing
Speaker 3: with the funds that are available. The sovereigns kind of
Speaker 3: you know, the longer dated you know, a wealth of
Speaker 3: their countries, so they don't necessarily really want to just
Speaker 3: be yoloing it. So you know, it's with that that
Speaker 3: they kind of you know, maybe also what can appeal
Speaker 3: is these more balanced portfolios where you're not just running lot.
Speaker 1: I've got to answer that because you mentioned it. If
Speaker 1: you don't equity like returns, you know, in the US
Speaker 1: for some people that only remember last year, that's you know,
Speaker 1: in excess of twenty percent, So what does it mean to.
Speaker 3: You, well, yeah, and then in twenty twenty two, I
Speaker 3: guess it was down about that much. So you know, yes,
Speaker 3: I think I think you have to think about it
Speaker 3: through the cycle. But I mean, equity like returns is
Speaker 3: you know, maybe a bit of a glib phrase, James,
Speaker 3: but you know, credit like returns is four to ten
Speaker 3: and equity like returns is kind of you know whatever,
Speaker 3: twelve to twenty and and you know that that is
Speaker 3: that is just kind of broad bucketing as much as anything.
Speaker 1: So what's the edge then, where's the best relative value
Speaker 1: right now?
Speaker 3: On the long side? Is really mining for you know,
Speaker 3: what we're looking for is European bank owned risk that
Speaker 3: tends to have been more conservatively underwritten in the initial
Speaker 3: you know, in the initial underwrite and actually has the
Speaker 3: hard asset backing. But what I would say is more broadly,
Speaker 3: you know, it's a time for caution. There's a lot
Speaker 3: it's difficult to underwrite longs because you don't necessarily know
Speaker 3: what's going to happen next. But I think that sort
Speaker 3: of where we're finding the best value is is in
Speaker 3: things that were more conservatively underwritten initially on the long side,
Speaker 3: which therefore pushes us to buy in bank non performing loans.
Speaker 3: But you know, I think the you know, I think
Speaker 3: the I think the bigger miss pricing lies still in
Speaker 3: the lower rated parts of credit and utilizing those as
Speaker 3: are short because they do imply a pretty low probability
Speaker 3: of default and loss given default, which in these kind
Speaker 3: of unusual circumstances may well not transpire.
Speaker 1: One more question from me, Rob, Bloomberg News has reported
Speaker 1: that your firm is up for sale. What can you
Speaker 1: tell us about that.
Speaker 3: I'm afraid that's something I can't comment on, but thank
Speaker 3: you for asking.
Speaker 1: I'm sure you'll tell us first when it happens. Great stuff,
Speaker 1: Rob Daforon, Chief investment Officer at Polist Capital Management. It's
Speaker 1: been a pleasure having you on the credit edge.
Speaker 3: Many thanks, Thank you much appreciate it.
Speaker 1: And Tim Riminton with Bloomberg Intelligence, thank you very much
Speaker 1: for joining us today.
Speaker 2: Thanks, it's been a pleasure.
Speaker 1: For even more analysis, read all of Tim Riminton's great
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Speaker 1: I'm James Crombie. It's been a pleasure having you join
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