The Insight: Conversations – European Credit at a Turning Point

0:29Hello, listeners of The Memo. Shemansky, Oaktree's senior financial writer. And today's episode is going to be focused on all things European credit, from liquid to private. So for this discussion, I'm thrilled to be joined by Armin Panosian, Oaktree's head of performing credit, Madeline Jones, portfolio manager of Oaktree's European high yield bond and senior loan strategies, and Niall Kutun, head of European private debt. Thank you all so much for joining me today. Thank you.

1:00To get started, I just kind of want to set the stage. What are some of the main ways to raise debt financing in European markets today? And how might they vary from what we see in the U.S.? Sure, I'd like to jump in on that and then Madeline and Niall could add. But in terms of corporate borrowers, there are a variety of different ways to borrow. Obviously, the banks are at times quite active in Europe. But coming out of the global financial crisis, banks in Europe and to some extent, the U.S. became quite conservative with the leverage that they were allowed to take on by regulators and by their risk managers.

1:33Away from the banks, the syndicated loan market is really an institutional asset class. CLOs, or collateralized loan obligations managed by investment managers like us, are the most active and prominent owner of syndicated loans. A lot of larger borrowers and private equity-owned businesses tap that market to finance their acquisitions. And then finally, there's high-yield bonds as well as investment-grade bonds. And in the case of high-yield bonds. It is also a very institutional asset class. There is really not a huge retail investor base in Europe. And then finally, I think away from the publicly traded markets, there's private credit, which Niall and team are very focused on.

2:10Generally speaking, there is a very active private credit manager universe in Europe. Every one of them has a different style, but the vehicles that those managers employ to raise capital from investors and then lend in the market are generally an institutional asset class. Again, there really aren't retail vehicles like you would see in the U.S. For example, in private credit in the U.S., business development corporations or BDCs are a heavily used retail vehicle that are distributed in U.S. as well as outside of the U.S. But I would say Europe in particular is not an appropriate regulatory framework for BDCs to be sold.

2:51And therefore, the retail investor base or the potential retail investor base in Europe, specifically in private credit, is really untapped at the moment. And look, I think it's fascinating to see how the market has evolved over the last decade. Ten years ago, Europe was dominated by banks. It was 80 % bank led, 20 % other. Today, it's 180 degrees the other direction. And private credit has really filled that gap in a big, big way. Now let's dive into today's credit market. So, Madeline, I'll start with you. on the liquid side. What are some of the main trends that have been driving activity over the last year?

3:28This has been probably a year of recovery from a terrible event-driven year last year. We had Ukraine, of course, the invasion there. And then we had the LDI issue at the back end of the year. So coming into this year, quite an interesting spread pickup, US versus Europe, very attractive, very compelling. But quite quickly, the market gaining confidence and realising that it can lend and it can find a risk spectrum it is happy with. And we've seen that kind of confidence continue to grow over the course of the year. A lot of this year has been light new prime issuance. A lot of it has been refinancing based.

4:08But what we found is if you're a good quality company, there is a receptive capital market for you. It may not be the spread or the yields that you might have wanted or seen a few years back. For us as lenders, it's fantastic. But for companies, it may present a different kind of yield context or coupon they have to pay. But if you find the right company, good quality companies, get the right yield on them, get the right structure, get good investor protection, it's a receptive market. And I would say at the tail end of last year, consistent with Madeline's point, there was the ultimate degree of pessimism about all things in Europe, that the war was going to spiral out of control, that the energy crisis was going to become quite acute in Europe and access to energy and heat was going to be a problem.

4:55And so spreads in the European market were worse than the US or wider than the US. And I think it really incorporated all the worst case scenario for all things Europe at that time. But I think coming out of it and the winter wasn't quite as cold as people expected and the energy situation wasn't quite as bad. The ability of the Ukraine military to defend itself was proven time and again. And I think that there's this growing perception that we don't need to assume the worst case in all things in Europe. And so we did see a spread tightening event in European high yield bonds and senior loans that was on top of or even outpaced the U.S.

5:32market at times for most of this year so far because it was wider and more pessimistic. And now it's, I would say, on par. And there is a belief that, again, to Madeline's point, in terms of the high quality part of the European market, that the high quality part of high yield bonds and senior loans are actually higher quality than the U.S. in that they're less levered, very non-cyclical businesses. There's a lot to like and a lot to buy in Europe. Well, look, in private credit, I think we've seen much of the same themes. This idea about flight to quality, I think, is central. You know, last year, you were averaging 1 ,000 transactions a year in private credit.

6:09At this point, you're probably 30%, 40 % down on volumes, maybe even more. And so you have seen this flight to quality. But you've also seen the defensive positioning has become a really, really strong theme. So in a bizarre way, those industries that have traditionally been resilient, so take healthcare, business services, software, you've seen actually even more competition for those particular deals than you have done before, even though the volumes are significantly down. Now, I know a lot of the trends that we've seen in both European and U.S. markets have been driven by macro forces in the last few years.

6:42But obviously at Oaktree, we're bottom-up fundamental investors. And I'm curious what the fundamental work that you've been doing, the conversations you've been having with companies, how that's informed your insights about some of these macro themes. And also, have there been any instances where what you've seen on the ground has differed from what you've seen in broad indicators? Yeah, I mean, I can have a go at that. We're privileged in that we look at hundreds of different companies. So we are getting reads on industries and granular feedback on what is really happening out there. And for the most part, I would say in traditional concerns about recessions, you start to worry about the consumer and unemployment and the slowdown of spending.

7:27And this environment hasn't really shown that to date. The consumer has been really robust. That, I would say, is the difference with what you read in the press sometimes about concerns on the consumer. You just haven't seen it yet. They're sitting on quite a lot of cash still. But we all fear that will come and maybe we're starting to see a little bit of it around the edges of consumer pulling back, even around leisure now, a little bit pullback, a little bit of down trading in food. But what I think is more dramatic is the intermediary companies who are de-stocking ahead of that. So they're getting quite conservative, getting quite defensive and just not keeping as much inventory, really right sizing their cost bases and retrenching.

8:14So you've seen the impact of that on places like cyclical chemical companies, very significant volume reductions on their top line because their customers are just becoming quite cautious. So although it's not the traditional consumer-led recession, you're seeing something happening around the cyclical end of the market. Also in residential building construction, building construction material suppliers, they've seen a lot of retrenchment as well. So you're seeing pockets where there is clearly recessions within industries. And that's what we're paying very close attention to. But this may be just a question of timing, because if you think about historic periods of time where rates suddenly rose, you really didn't see a recession or recessionary pressures until 12 or 18 months thereafter, until after the peak rate was hit.

9:02And we are not 12 or 18 months since the peak rate has been hit in global markets. And so in the short-term indicators, especially those that are backward looking, how did a company perform last quarter or the quarter before or the quarter before, it's not necessarily indicative of how it will perform in three quarters or two quarters. So as a result, when we look at those fundamental performance indicators of businesses, they look shockingly resilient. The consumer is shockingly strong. Companies are able to pass through some level of cost increases from inflation. At this point, inflation is heading in the right direction.

9:35However, I think the question becomes, at least for Oak Tree, even though we're not macro forecasters, we do need to think about where we are in terms of likelihood ahead of a recession and what could cause that to tip over. From my perspective, it is fairly clear that we've had 10, 15 years of easy money. And as you suddenly turn that off and access to capital dries up and the cost of that capital rises, it's natural to think that cracks will develop. And in the short run, we're going to see minor cracks or maybe no cracks at all. And that's kind of a head fake. But if you think about the market, the economy, access to capital in a few quarters from now in a higher rate environment and you say, okay, well, what's going to happen between now and then?

10:17Between now and then, it looks like GDP is fine. It looks fairly positive. Maybe it's not quite strong in terms of economic growth, but at least it's positive. And if inflation is under control or becoming under control, well, then central banks don't really have a reason to either raise rates or to let them decline. And that second part is a critical piece to predicting dislocation. Because if a bunch of the market and capital structures were put in place at a time of easy money, and therefore very debt heavy, and this is a global statement rather than a Europe centric statement. But if that capital structure in light of today's rate environment looks top heavy in terms of debt, well, give it another two or three quarters and higher cost of borrowing, you will have a default and loss experience with or without a recession occurring.

11:07And that's really just because of rates. And it's because of rate-sensitive asset classes having inflated so much over the last 10 to 15 years. Yeah. I mean, companies that put on debt two or three years ago, they were half the cost of debt they are today. And they didn't predict that in their... And they didn't hedge. And they didn't hedge. And what's interesting is in the UK, certainly the biggest impact on the consumer by far is going to be when all these medium-term five-year fixed mortgages roll off and suddenly the consumer has to refinance onto a floating rate significantly higher. I mean, forget inflation and food prices.

11:44This is going to be the single biggest impact on discretionary spend. And it's still coming. As you talked about, Armin, this is coming in three, six, nine months, not today. Yeah, the UK is particularly challenged with that. Fixed-rate mortgages, not long-term, And like the US has very long term structures, ours are much shorter. So to be careful about the UK consumer and the pockets that they have. However, employment is still very, very tight. So there might not be a reason for central banks to continue to raise interest rates. But also, if employment is still pretty strong, also not a reason to lower them.

12:22Yeah, I agree with that. If the unemployment picture is relatively stable, central banks look at that and say, well, it's okay to have a little bit of a recession or a little bit of a washout or some deflation of asset bubbles. That's natural. That's okay. And as long as we don't have systemic risk, as long as we don't have banks failing and deposit risk, then having a natural, not a very deep recession is a completely acceptable outcome, I believe, for central banks in this next kind of two-year period. Yes, a clear out of some weak, over-levered parts of the market. We absolved the market of that issue after the global financial crisis by just drumming in a whole lot of liquidity.

13:05Maybe now this is the time where they let some things fail. But now this higher for longer scenario that you're outlining, would you say that most people in the market are predicting that or people still thinking that, okay, rates are high, but they will trend back towards what we saw in the last 10, 15 years? I think there's a bit of hope, especially the company that sits on a heavily indebted balance sheet that maybe doesn't mature for a couple of years. Maybe they just want to play it out a bit to see where the rates come down, they can refinance it. But the reality is this might be as good as it gets for them and they probably shouldn't wait too long if the capital markets are receptive today.

13:47I hope is not a strategy, but when the short-term indicators are, oh, the world isn't so bad, then you stop thinking about the world in three or four quarters from now. And I think CFOs of these businesses that have a lot of leverage, if you were to ask them why they're awake in the middle of the night, it's because they didn't hedge two years ago. It's because their cash balances are shrinking. They are being impacted in a negative way by inflation. They're not able to pass through all of those cost increases within a short enough period of time. And I think that some of them understand that their equity support may not be there for them in the scale and quantum that they need.

14:26They should expect, if they don't already, some challenges and need for capital and concessions from lenders. And I think we're just very early in that phase. I think there are rating agencies now that are downgrading highly levered credit at a faster rate than they're upgrading them. That should be a sign that at least some Some third parties are looking at that imbalance in the capital structures and making moves that would indicate some stress coming along the way. But for now, there's a little bit of euphoria because it looks like the economy is growing. Inflation is coming in the right direction.

15:00Corporate earnings are okay. Consumer is spending money. It feels to me a little bit like a head faker of the calm before the storm. The immaculate disinflation. Yes. Madeline, you touched on this a little bit before. We're talking about overarching risk, but I'm interested more in sector-specific risk. I'm also curious if there are differences between these sectors that are areas of concern in liquid markets versus in private markets in Europe. Yeah, that's really interesting. Niall, you were talking about a couple of the sectors, healthcare, I think you mentioned software. Software, business services.

15:32Yeah. And these are the pockets of concern. The names within the existing, particularly the loan universe, where balance sheets were put on a few years back, because of that very same desire to lend, they got given a whole load of debt. lenders were very happy to really lever up seven turns of leverage on a good quality healthcare name hospital company care home whatever it may be and they got given good debt floating rate and now they've got double that interest burden coming on and for us those are the areas despite their good top line characteristics because of that amount of leverage they just look very vulnerable to us to any operational issue that may happen.

16:18They've got rising labour costs, they've got labour shortages. How to pass that through and still service that increased debt costs, they look more vulnerable to us. And perversely, some of the areas where traditionally we don't like to lend to, some of the cyclical parts of the market, even the commodity chemicals parts of the market, they are used to being in cycles and they have levered themselves very, very conservatively. It's all about balance sheet today. Can you afford your debt? And we'll gravitate towards those just as you do a good quality consumer, you gravitate to provide your lending to someone who can afford it and afford it very healthily.

16:55But quite different, I think, from the new structures you're seeing. Yeah. And certainly, I think my comment was with reference to new issuance, as opposed to as you look at infrastructure deals, especially historically, they will have it sometimes in double digits. And so as they look to refinance, they're really struggling. But I think that there's a really interesting wider point around private versus public market valuations. And certainly as we look at refinancing a corporate, it's sometimes hard to get around that discrepancy between the two sides of the spectrum, because on the one hand, we look at it and we struggle to see how the private marks really reflect today's valuations.

17:34And that's the challenge you have in that private marks are set by GPs that have total discretion, particularly when they go fundraising, as you can imagine. And so they tend to be quite sticky. And so you struggle sometimes to get to any form of understanding or comfort with the numbers because the valuations just look out of whack. And one of the interesting data points to look at is the share price of publicly listed private equity funder funds. And what you'll see if you look at these share prices. Over the last six months, we've seen really moderate movements in NAVs, but on average, they've all traded at a 30 to 40 % discount to NAV, which basically tells you the public market thinks that these things are way overvalued.

18:15And that's part of the challenge we have when we go and have a private credit conversation, which is there's just that wide gap between expectations of value and what we think they truly are. I think that point about private equity is important in that private equity funds over the last 10 years were very accustomed to buying a company at a very healthy multiple. That multiple would generally go up over time because the cost of borrowing was stable or declining over time. And access to capital markets allowed them to do dividend recaps, return capital to their LPs. There was a liquidity that was quite attractive for LPs that were invested in private equity funds.

18:50But now over the last two or three years, we've seen a decline in valuation multiples. And those businesses that were bought in 2018, 19, or even 2021 are now underwater from a valuation multiple standpoint. And that's why those stocks are trading at a discount to NAV. It's also created as a new market opportunity. And that market opportunity is created by the fact that LPs want capital back before they invest in new private instruments. And as a result of that, things like NAV finance to private equity sponsors, it has grown. The size of the transactions have grown. The frequency of the transactions have grown.

19:28The desire for LPs to have that type of financing at the fund level has opened. We're seeing a lot of those types of transactions now starting to develop both in Europe and the U.S. because of the need for liquidity to return back to LPs. Similarly, there is a very well-known market in private equity secondaries, and we're seeing the emergence of a new credit or private credit secondaries activity where investors, institutional investors and private credit funds and private equity funds are now looking to trade their limited partnership interest to other institutional clients or managers. And again, it is because there's a certain cadence of return of capital that they were expecting.

20:09They had made commitments to new funds predicated on that cadence, and that is not playing through. So at the end of the day, there's both risk and opportunity in the markets. And it really depends on the vintage. If you look at the old vintage, the healthcare companies that were and continue to be quite stable performers, well, they were levered to the hilt. And now with elevated cost of borrowing, they're in trouble. New vintage in the same healthcare industries or sectors are more appropriately structured. The capital structures are put in place in contemplation of 11%, 12%, 13 % cost of borrowing in the case of the private context.

20:45and therefore the equity checks that we're seeing from private equity firms in these really attractive sectors are now north of 50 percent whereas they used to be more like 40 percent and routinely in tech healthcare we're seeing 60 70 equity checks in these types of private equity deals it's both risk and opportunity well it's interesting and i'd throw it out to the group for their thoughts but there is a debate as to whether or not you would actually take on that higher cost of financing today just because of buying opportunities in the market are tremendous i I mean, would you argue potentially that the equity returns you could potentially generate at today's valuations more than offset the dilution of higher borrowing costs?

21:21Funnily enough, we have this dilemma in CLOs, right? Because we are a CLO manager. We like to accumulate portfolios of loans and then we find some debt financing to level that up and we can potentially generate a healthy equity return. Today's market, the cost of that debt is high, but so are the primary loan yields we're getting. some of the best primary you will see is after some very challenging events are revealed you've seen that after the global financial crisis you get excellent yields you get better structured documentation so this is a wonderful time to be harvesting that kind of quality of loan at those yields but your debt cost on your clo liabilities has gone up but i think if you marry the two up you can still generate a very very compelling equity return because you have that underlying pool, which we don't often get.

22:13And you also have a market, a secondary market for loans, which is dislocated, trading at below par levels for high quality. So you have a discounted price level, which you hardly ever get. So the marrying of the two, to your point, your opportunity set is much better than it was before. Yeah. I mean, a lot of investors say you make money on your buy. And with respect to private equity, that's true. If you're able to buy a company that used to trade at 15 times EBITDA, and now you could buy it at 12 times or 11 times. If you can convince yourself that in three, four or five years, the valuation multiples will revert to something between 12 or 15, then you could make a lot of money through multiple expansion.

22:53And you're able to buy a business that's very high quality that just wasn't even available for sale in the last five or 10 years. So buying that business and yes, paying 60, 70 % in equity to buy that business can make a lot of sense. Similar for CLO equity. I think a lot of equity investors in CLOs think about the arbitrage between the return on the assets of a CLO and the cost of the liabilities of the CLO. And they look at that and say, well, is that attractive or is that not attractive? But the reality is you make money on the buy in CLOs. If you could buy a portfolio of CLOs that's highly diversified, high quality, low default risk, and with a manager that has experience navigating through many, many cycles, well, then you are buying a portfolio at a discount and there is no substitute to buying CLO assets at a discount.

23:41The reason is this, if you buy a portfolio at a five point discount and it recovers to par over time because these are good assets and they don't default. Well, your liabilities, while they might be more expensive than you otherwise would have liked, at some point when the dislocation fades and it becomes a more normal market, you will be able to refinance your liabilities into much tighter spreads and much lower cost. But you will never be able to recreate that portfolio that you bought at 95 cents on the dollar. And with the leverage implied in CLO equity, that recovery to par has multiple impact on your equity.

24:17It's a very attractive time. And I know Madeline and I talk about this all the time, which is it is conversely to what popular opinion is about the way CLOs work and what makes them attractive. This is actually a far more interesting time to invest in CLO equities than in balanced par markets. because we did backtesting and we looked at the best performance of CLO equities was actually during those periods of market dislocation, not during the periods of par markets. We're thinking about opportunities, risks in Europe. Obviously, jurisdiction plays a big role. I'm curious, now I'll give this to you.

24:52What do you think the differences are between jurisdictions in terms of opportunities, maybe risks? Very significant. And the reality is there It isn't a single answer because it's constantly changing. And there's so many facets to it. I'll name a few. The first, obviously, is political. So take Brexit. How do you underwrite the UK as it goes through Brexit? It's virtually impossible to underwrite the exit at that point. Some of it is as simple as macroeconomic. Germany was the powerhouse. Now it's going through a really, really tough period. And so any private credit investor looking to underwrite Germany at this point can ask for a bit of a premium to take on German risk.

25:25And some of it is just simply structural, historical issues in law or jurisdictions that have never changed. So take Italy, Italian legislation prohibits the issuance of non-amortizing term loan fees. And of course, that's much more high in demand today. But also, there's just a lack of banks that operate in the middle market. And that creates a vacuum for private credit and alternative lenders to come and fill the gap. So there isn't a single answer, unfortunately. And it's one we monitor the whole time because we're trying to balance at any single moment where the best risk reward lies in Europe and try and pick and choose.

26:00It's one of the wonderful things about European investing is there's always something going on. If not today, it will invariably come quite soon because it's not a uniform landscape. The political environment is so different and the cadence of political events is so different. And with Europe, you can wait and be patient because there will be an event which will blow out the spreads and make it look compelling again. And it's just, as you were saying, it's lots of different things which make it always worth looking at for an opportunity because there will invariably be one of mispriced risk. And talking about pan-European is easy in concept.