This article is sponsored by Ares Management
The pandemic may have caused significant economic disruption, but swift monetary policy and government stimulus interventions have kept many businesses afloat through lockdowns. There is bound to be distress stemming from covid-19’s fall-out, but which markets and deal types will be the most attractive and why? We spoke to Scott Graves, co-head of private equity and head of special opportunities at Ares, to find out where his firm is sourcing deals and where we will see future volatility.
Why do you see private equity as well suited to distressed investing opportunities?
Private markets in general have a lot of advantages in distressed investing over public markets, in our experience. Back when I started in the 1990s, there were a lot of opportunities in public markets, where the roots of distressed investing really began. We used public information to purchase debt claims at a discount and you needed a deep knowledge of intrinsic value, restructuring and turnarounds. It was an inefficient market then and you could historically produce healthy mid-teens returns in even the more benign parts of the economic cycle.
Yet the dynamics have changed since the Global Financial Crisis, with the rise of alternatives generally and the outperformance of private equity during more difficult economic periods, together with the increased supply of capital and competition in public markets. These factors have shifted the balance so that distressed investing in private markets has become more comparatively attractive.
In what respects are private markets more attractive?
In public markets, a low barrier to entry combined with the arrival of increased demand, more capital and a deeper pool of competitors in distressed situations has resulted in worse covenant protections in documentation, lower quality of earnings definitions and therefore materially eroded the control and downside protection once enjoyed by distressed investors.
In private equity and traditional direct lending, by contrast, you typically see stronger documentation and can conduct more thorough, private due diligence. There are also higher barriers to entry, and we believe you can create advantage through relationships, speed of execution, reputation, restructuring expertise and industry knowledge. In assessing new opportunities, Ares can draw on its product, industry and portfolio management teams – a group of former operating executives – to help companies with the challenges they may face with strategy, cost structure or navigating through transformational change and over-leverage. In these situations, we are typically on the management team’s side – we try to position ourselves as a valued resource that can help companies and management teams improve their business.
Do you see distressed opportunities as more of a private equity or private debt strategy?
It is both. We are targeting the inefficient parts of the market and, at Ares, we have significant strengths and firepower as a private debt investor and our view is that gives us an advantage in special situations and rescue finance markets. Yet we also have a well-heeled and proven private equity platform. That means we can manage our private equity strategies on a hybrid basis. We can target both more traditional healthy markets, buyouts and growth finance, but we can also pivot in more difficult environments to distressed and transformational change.
We see a lot of opportunity in marrying private equity and private debt. We have two private equity strategies with different levels of corporate influence; one takes non-control private equity positions while the other primarily makes influence and control investments – and they both are managed by overlapping teams, offering different but complementary solutions. We are utilising a platform that integrates private equity and private debt to invest in mid-market companies where there are typically more inefficiencies and frequently direct bilateral discussions.
How have opportunities emerged through the pandemic?
Today, we are finding excellent opportunities in private markets for the reasons discussed. Yet, just as we saw in 2001 and the Global Financial Crisis, markets can change quickly. There was a shock and significant change in relative value between March and July 2020. Driven by the pandemic, a window emerged where we saw more attractive investments were available in public markets. Now, we are back to a situation where we believe private mid-market investments are more attractive on a relative value basis – we believe this part of the market typically enjoys lower competition than further up the deal size spectrum and the individual circumstances tend to be more complicated and targeted, which allows private capital providers to negotiate and structure debt and equity solutions that fit the circumstance and provide appropriate control and documentation protections.
Within this space, there is a significant backlog of companies seeking finance and they tend to fall into two business purposes: offensive and defensive. Companies on the offence are looking to take advantage of the pandemic’s disruption to launch new products and services, make acquisitions, or both. Yet their cashflows tend to be depressed and they cannot borrow capital on standard measures. These are classic special situations investments. Companies on the defence are experiencing a need for liquidity, capital structure flexibility or both. They are seeing a material gap between their fundamental earnings and cashflow and the attractive debt and equity prices available in the mid-market, which are being sustained by monetary policy and fiscal stimulus.
What comes next?
Right now, the market is entirely focused on stimulus and the near-term pandemic outlook: the speed of opening up economies and the extent of pent-up demand. There is clearly optimism here since S&P 500 earnings are projected to be back at all-time highs before too long. Either earnings and the fundamentals will recover to warrant the increased market pricing we are currently seeing – multiples have moved from historical averages of 16x to 17x up to 22x today – or they won’t, and pricing will need to come down.
Looking at the intermediate and long term, we expect increasing volatility, rising taxes and a real risk of inflation. The stimulus for the pandemic has been significant and rapidly deployed. If taxes and interest rates rise and stimulus wanes, there is a big question around what happens to companies and consumers. In the US, there were 3.6 million 90-day mortgage defaults in 2020, which is the most since 2009. Moreover, there were 2.1 million homeowners seriously delinquent on their mortgage payments as of the first quarter of 2021. These kinds of numbers suggest the mid-market may not be as healthy as many are expecting.
And, of course, no-one knows what the next black swan event will be. Right now, there is abundant liquidity in the system – when you have this, the conditions are ripe for bubbles that then pop. Overall, the short term feels bullish, but the medium term looks more volatile.