PSP Bolsters its Private Debt Arm?
The Public Sector Pension Investment Board, one of Canada’s largest pension funds, is expanding its private debt team to focus more on investments in distressed companies.Now, before we begin, it might be worth reading this Mercer paper on high yield and distressed debt, this paper from M&G Investments on unlocking value in debt opportunities and this research paper on the performance of private credit funds to get a sense of this market, the different funds in the space and how they are performing.
Montreal-based PSP hired Francis Blair to broaden the fund’s capabilities to include rescue financing and other solutions for companies with capital structure challenges. Blair most recently worked as a partner and senior credit analyst at Milford Sound Capital LP and earlier as a managing director at Solus Alternative Asset Management, where he was involved in some of the fund’s largest distressed investments.
PSP’s private debt investments have been largely focused on revolving credit facilities, first and second lien term loans, as well as secured and unsecured bonds. Blair’s hire will let the pension plan get more involved in distressed debt and rescue financing by capitalizing on its relations with the world’s largest private equity funds seeking financing for their portfolio companies.
“PSP is one of the go-to people in preferred equity solutions, because there is a more limited number of players in this space,” said Jeff Rowbottom, managing director at PSP Investments USA, in a phone interview from New York. “We are very happy to structure, put together and speak for the entire deal, but often times the private equity firm will desire to have other players and we play well with other investors.”
Private Debt
PSP’s private debt arm had C$8.9 billion ($6.8 billion) in assets under management at the end of March, with 75 percent of them located in North America, and the bulk of the remainder in Europe. Healthcare, technology and industrials were the sectors that dominate its portfolio.
Pension funds around the world have been increasing investment in private debt in recent years as it gives them the opportunity to deploy cash in long-term assets. Although it’s less liquid than public assets, private debt generally offers higher returns, a crucial incentive at a time of near record-low interest rates.
While the Federal Reserve and the Bank of Canada have been gradually tightening monetary policy, rates are still relatively low by historical standards. And as the move into private debt is become more widespread, some areas like middle-market corporate lending get overcrowded, according to advisory firm Willis Towers Watson.
In distressed debt, rival firms have been hindered by a shortage of troubled companies, which have been kept afloat by cheap interest rates and lax lending standards. At midyear, performing distressed debt was at its lowest level since 2014, according to a Bloomberg Intelligence tally.
“There’s still a lot of room to run in private credit,” Rowbottom said. “There’s a lot of capital that is being raised right now, and there’s going to be a lot of transactions, so we think we have a lot of tools to be relevant.”
Debt Solutions
Blair’s work from New York will be focused on providing solutions rather than actively trading distressed assets because that’s where long-term capital can be best deployed, said Rowbottom, who was the head of capital markets for North America at KKR & Co. before joining PSP in February 2016. The pension fund will be looking for deals ranging from $75 million to $1 billion.
Some examples of PSP’s activity in this space include investments in video telematics company Lytx Inc. and a subsidiary of Stone Caynon Industries LLC. It also supported USI Insurance Services in acquiring a rival brokerage from Wells Fargo & Co., Rowbottom said.
PSP’s private debt arm has offices in New York, London and Montreal, which employ 30 investment professionals. It has already worked with more than 40 private-equity firms, including almost every major entity in that space, Rowbottom said.
“Most pension funds are not as well known for being creative and solutions-oriented,” Rowbottom said.
PSP, which invest funds for the pension plans of the Canadian public service, the armed forces and the Royal Canadian Mounted Police, had C$153 billion in net assets at the end of March.
From the third paper:
Distressed debt funds are closed-end or open-end vehicles that invest in debt securities of mid-to large-sized companies that are experiencing financial distress. Investments are made either by purchasing at steep discounts in the open market or from existing creditors.As the article above states, distressed debt funds have been hindered by low rates, lax lending standards, and a shortage of troubled companies given the strength of the US economy.
Distressed debt managers can pursue a variety of strategies including control (loan-to-own), non-control and restructuring (or turnarounds), among others.
But the US Markit Manufacturing PMI fell to 9-month low this morning (54.5 vs. 55 expected) and as I've been warning my readers, the flattening yield curve is signalling a slowdown ahead.
What we don't know yet is whether this is going to be a soft patch or rough patch.
Interestingly, Myles Zyblock, Chief Investment Strategist at 1832 Asset Management, posted this chart on LinkedIn showing that the 2020 recession scenario is now consensus (click on image):
You can also read my comment in the image above. Basically, I think the slowdown is already underway, so if I had to bet, I'd say the recession will hit us sooner rather than later.
However, it remains to be seen how bad things get because if the Fed makes a serious policy mistake and continues tightening in spite of mounting evidence of a slowdown, then you can expect more of a rough patch ahead. That remains to be seen.
Either way, PSP getting into distressed debt now and hiring Francis Blair and others with expertise in this space is a very good long-term move.
As Jeff Rowbottom states, Blair's focus wil be on providing solutions rather than actively trading distressed assets because "that’s where long-term capital can be best deployed."
Think about it. What is PSP's edge in distressed debt? Four things:
- Very deep pockets
- Long investment horizon
- Great relationships with top private equity funds
- And now they have internal expertise in the field
What else? Last October, Michael Zupon, CIO of US Private Credit Solutions at Allianz, wrote a great paper, Private Debt Investing in the Late Stages of the Credit Cycle. You can read it here and his key takeaways were the following (click on image):
Still, there are concerns. In May, Sally Blakewell and Lisa Lee of Bloomberg wrote an interesting article, Leveraged Loan Safety Net May Prove Frayed for Investors:
It was enough to set investors’ teeth on edge.This gives you the backdrop for distressed investing because when the economy heads south, it will prove a more challenging environment for distressed debt investing.
When KKR & Co. tried to sell money managers pieces of a $1 billion loan to fund its buyout of Heartland Dental, it included a bold ask: it wanted credit now for earnings the company expected to get in the future from offices it had just opened. That helped nearly double a measure of income that will be used to test whether the dental-office services company is making enough money to keep borrowing, according to people with knowledge of the matter.
Heartland Dental got what it wanted in the end and sold its loans late last month. Its success underscores how money managers can’t get enough loans to junk-rated companies now, and how that strong demand is allowing borrowers in the $1 trillion market for leveraged loans to push the envelope and make the debt riskier.
It’s a surprising outcome because the money managers that are piling into loans are seeking investments that offer safety compared with junk bonds. Loans are usually first to be repaid when a company goes under, so they tend to perform better in a downturn than bonds, which are often second or third. As the loan trade becomes more crowded, the peace of mind that investors are looking for may prove illusory, said Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott LLC. Eventual losses could be high by historic standards.
“The selling points made to buyers are remarkably similar to those made to buyers of subprime mortgages,” LeBas said referring to the securities that helped bring trillions of dollars of losses to investors during the 2008 financial crisis. “Low default rates justify weaker documentation and covenant structures deteriorating, and there’s not a lot of pushback against it. Those are yellow flags.”
When the credit cycle does turn, investors used to recovering around 77 cents on the dollar from first-lien loans to failed companies may find themselves with closer to 60 cents, Moody’s Investors Service forecast in March. For second-lien loans, 43 percent historical recoveries may fall to 14 percent, Moody’s said.
Growth, Risk
The market for loans to highly indebted companies has grown almost 50 percent since 2013, making it almost as big as the U.S. junk bond market. There have been 11 straight weeks of inflows to U.S. leveraged loan funds, according to data from Lipper.
That growth has allowed corporations to take on more debt. The average company in a leveraged buyout had borrowings equal to 6.4 times a measure of income known as earnings before interest, tax, depreciation, and amortization in 2018, according to Fitch Ratings. Last year it was 6.2 times and in 2016, it was 5.9 times.
Amid that growth, investors have become more willing to accept weaker protections known as covenants. One such safeguard measures how easily a company can afford to pay interest by comparing its Ebitda to its interest expense. When that ratio gets too low, lenders can demand repayment.
Companies have been getting more aggressive in monkeying with how Ebitda is calculated, often by adding future revenue or subtracting current expenses. While such add-backs have long been done to factor out one-time events that might distort a metric of a company’s health, over time the adjustments have grown more aggressive.
“Battle lines are being drawn between the aggressive versus the reasonable in both add-backs and covenants,” said Christopher Remington, an institutional portfolio manager at Eaton Vance. “We are increasingly digging in on covenant issues.”
With Heartland Dental, the company’s add-backs included assumptions that new business would be as profitable as longer-term clients, and that opening and closing offices would incur no expense, the people said. While the company has included these add-backs in its lending agreements since 2012, the adjustments had never had such a big impact on Ebitda.
Representatives for Heartland Dental, KKR and Jefferies Group, which led the financing, declined to comment.
Lax Covenants
Other safeguards for borrowers have been getting weaker too. A higher percentage of loans are "cov lite," meaning they have the more lax covenants typically seen on high-yield debt instead of the more stringent ones that were historically baked into leveraged loans. Covenant-lite loans comprised almost 80 percent of the U.S. market in 2017, a record and up from 75 percent in 2016, according to Moody’s.
And while loan lenders are first to be repaid if a company goes under, a growing percentage of borrowers have loans as their only form of debt, which can force these creditors to take more losses.
Investors that do look to shed their holdings will find it takes on average 17 days to settle a loan trade, according to IHS Markit, compared to three days for a bond. That slowness could strain loan mutual funds and exchange-traded funds, which promise their own investors that they can sell out of the fund on short order. These funds hold about 15 percent of leveraged loans.
There are still reasons for investors to be sanguine about the loans. The economy is growing at a solid pace, and unemployment in April fell to its lowest level since 2000. The biggest buyers of loans, known as collateralized loan obligations, tend to hold their loans long-term, so any turn in the economic cycle may not impact them much if they wait it out.
“The most important thing is that fundamentals and the broader market are very much in check. Companies are on a solid footing and the economic backdrop is good,” Eaton Vance’s Remington said.
But at some point, companies and the broader economy will face strain. More companies might feel that pain as the Federal Reserve readies to increase rates at two or three more times this year.
“It all works until rates get too high,” said Ethan Lai, an associate portfolio manager at Leader Capital Corp. “Then that wall hits.”
Nevertheless, there will be plenty of opportunities and I'm sure PSP and its partners will capitalize on them as they arise.
In other related PSP new, Kirk Falconer of PE Hub reports, PSP Investments partners in buy of Australia’s Bengerang:
A joint venture that includes Public Service Pension Investment Board (PSP Investments) has agreed to acquire Bengerang Ltd, an owner and operator of agricultural land and water assets in Australia.You can read details of this private equity deal here.
The joint venture, called AFF JV, is buying the business from Webster Ltd for about A$132.7 million ($126.8 million).
As part of the deal, PSP Investments will become the largest shareholder in Webster, an Australian agribusiness, acquiring a 19.15 percent stake and the right to a board seat.
PSP Investments’ partner in AFF JV is the holding company of Australia’s Robinson family.
Below, an older interview and Q&A with billionaire debt investor and founder of Oaktree Capital Management, Howard Marks, and managing director at Oaktree, Rajath Shourie. In this interview, they discuss investing in distressed debt and how they think about capital allocation versus time.
Great discussion, listen to Howard Marks, he's an exceptional investor and very bright guy.
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