This article is sponsored by Ares
For a few years now, seasoned investors and lenders have been on the lookout for events that would trigger the next economic downturn. Few might have predicted the arrival of a pandemic as the cause and, while many of our lived experiences have been markedly different from the past, some elements of the financial and economic fall-out look and feel very familiar to those that have worked through a number of cycles.
We caught up with Joel Holsinger and Keith Ashton, portfolio managers and co-heads of the Ares alternative credit strategy, to find out their views of where the risks and opportunities lie in today’s market and how the industry will change over the coming years.
What would you say have been the greatest effects of the pandemic on your part of the credit market?
Keith Ashton: Alternative credit at Ares is where we conduct asset-focused investing. Ares is one of the leaders in direct lending and liquid credit, and alternative credit fills the gaps outside of direct lending and liquid credit with flexible capital in size with a diversified asset focus. A little-known fact is the “gaps” are bigger than the defined institutional markets. Like other credit markets, the pandemic has been the catalyst that triggered a traditional economic cycle. At the turn of the year, we said we were late cycle; since March, we’ve moved to the beginning of a new cycle. The pandemic triggered the initial phase of volatility and market dislocation that has resulted in liquidity stresses in traditional markets.
This stress is also apparent in alternative credit markets, in asset markets – and, in fact, the effect is amplified as the magnitude of capital dislocation is greater and stresses continue for a longer period. Liquid parts of our market become illiquid as access to credit is curtailed, which means more opportunities shift away from traditional markets and into the private markets we focus on – it’s a sequential event.
Joel Holsinger: The market consists of the haves and the have-nots. When a shock occurs, the have-nots grow dramatically. While the haves may continue to have access to the securitisation markets, the have-nots fall into gaps in the market. That’s where we “create” credit investments.
What do you mean by gaps in the market?
KA: The gaps in the market are the places where traditional capital doesn’t reach. Efficiency-seeking behaviour in liquid markets leave a lot of folks out. The haves are those who can access the securitisation markets, but for every one of these, there are hundreds more have-nots who are shut out because they do not meet the criteria required to fit into the box that traditional capital markets require.
Since March, that box has become much smaller leaving more without access to traditional capital and creating a gap. Our platform is there to fill these kinds of gaps. With a global strategy, this is an exciting time and place to invest. Yet, I believe success relies on being able to provide the right kind of capital so you can offer real solutions that address those gaps.
What do these kinds of opportunities look like?
JH: We are always credit and asset-focused, but the breadth and depth of our team, and our relative value orientation, means we can pivot or rotate as cycles change. For example, before March we were mainly looking at plain vanilla lending against assets in a quantum of about $50 million and $150 million. Since March, however, we’ve pivoted to opportunities arising from capital dislocation, with the vast majority of these investments in performing asset portfolios. A common theme in the current market is that we’re spending a lot more time on larger, $200 million-plus deals where flexibility is needed to structure capital so that it works for specific situations. Here, dealflow tends to be defined by those looking for truly non-traditional solutions – they are not just looking for a big cheque but also flexibility and creativity in structuring.
Can you give us any examples of these kinds of deals?
JH: Our recent $400 million transaction to mortgage REIT Chimera Investment Corporation typifies our approach in the current market. The solution was structured specifically for Chimera and gives it the opportunity to go on the offensive at a time of high spreads and market turbulence. We also recently provided a $250 million revolving asset-backed credit facility to Affirm, an established consumer credit finance company, to help it scale.
KA: The point about these and other deals we’re doing currently is that you need to be able to provide flexibility in structure. That means the ability to offer preferred or structured equity, first lien or unitranche debt, sale leasebacks or even acquire portfolios, as well as to understand the dynamics of different sub-asset classes. For example, one recent transaction had over 130 underlying securities across 16 different asset sectors. You need to be able to underwrite and diligence all these elements and then structure an investment accordingly.
You also provide fund finance. What’s happening in that part of the market?
JH: I believe that this is a very exciting market currently. Before March, this was a relatively quiet space for us where we would pursue around a deal every quarter; since May, we’ve seen around 30 fund finance opportunities. Appetite has grown dramatically such that the players we used to see in the space – the small, niche funds, some banks and secondaries players – can no longer keep up with the demand or scale of deals.
With a step-up in scale, fund finance is now enabling private equity, real estate and other private funds to protect existing investments and make new ones at a time of low liquidity. The opportunity set there has grown significantly.
Where do you see risks emerging in today’s market?
KA: Much of the risk stems from the combination of the way that quarantine measures have affected the economy and the unprecedented fiscal actions taken to stabilise and support the economy.
While necessary, these fiscal actions have obfuscated the picture. So, for example, it’s very difficult to determine how consumer and small business loans are really performing right now. That picture is still foggy and it’s not clear what will happen when these measures are withdrawn.
That means you have to dig very deeply into the data. You need access to, for example, data on millions of consumers and tens of thousands of small businesses so you can start looking for patterns. There are many sectors and areas of the economy that don’t have that fog around them, but you can only identify them if you have the right information and can perceive actual performance. I don’t think many players have this.
How do you create certainty in what is a very uncertain market?
JH: If you look at the market today, there are lots of areas that look as they did in previous cycles. Successful investing requires strong pattern recognition, and for that you need to have lived through prior downturns. You also need diversification to be able to compare and contrast those patterns. That’s how you move forward with certainty in uncertain times.
No one really knows how long the pandemic will last, and it’s difficult to know how much of a bridge economies and portfolios will need. But if you have large pools of asset portfolios with diverse underlying positions, you can analyse and structure in ways you otherwise cannot if you are making single name risk investments. You can ask, for example, can I be draconian in my underwriting scenarios and still protect capital? If the answer is yes, I believe you can move forward.
KA: If you have strong relationships with your counterparties, you can also bring certainty of execution to your partners. In our firm, our direct lending franchise has forged longstanding, robust relationships with sponsors. That means we have been able to do large proprietary transactions with sponsors as a preferred counterparty. In a bull market environment, everyone seems to have access to opportunities. When times become stressful, reputation and relationships count for so much more than the last few basis points of yield. One’s reputation as a counterparty shows up in access to transactions at a time of stress. I believe there’s a level of comfort with Ares as a preferred counterparty that may not exist with some other firms.
How do you see the market evolving over the coming period?
KA: The last default cycle had a significant impact on the flow of capital to alternative credit. It resulted in a hyper-fragmentation of capital as it was directed away from securitisations and banks and to small, niche shops. There is an acute lack of institutionalisation in this market. Over the coming period – and it may take some time – we expect to see growing institutionalisation in alternative credit as a select few platforms gain further scale.
JH: Reconsolidation will occur and you will naturally see fewer players in the market because of the resources needed to be successful. In the current market, you have hundreds of small funds usually only looking at a single sector, or you have tourists such as hedge funds that may allocate just 20 percent of what they do to alternative credit. Yet, we find that smaller players have tended to promise meaningfully higher returns to attract capital, pushing them into riskier strategies. Larger firms with larger teams can offer more competitive capital without necessarily taking additional risk. The barriers to entry are very high but so is the potential for attractive risk adjusted returns.
How might we see the landscape of players shift?
JH: Our market has changed dramatically over the past five years and I believe there are few that can tap these opportunities. While there has been a trend of increasing institutionalisation in corporate direct lending as banks have departed the market, the opposite has happened in alternative credit. Over the past three to five years, we’ve seen the exit of major players such as GE Capital and CIT and a shrinking of the prop desks at the banks. This has created a large set of opportunities for those with scaled platforms and large sourcing networks supported by sizeable teams. Those investing across all asset sectors, like Ares, further benefit from seeing and analysing the entire universe of opportunities, and across liquid and illiquid markets.