A Focus on Specialty Finance for COVID Recovery

The COVID-19 pandemic has created difficult liquidity challenges for many companies due to a fundamental collapse of earnings and business models. Within the past year, corporate bankruptcies have dramatically increased and business earnings have fallen dramatically. The most concerning aspect is that there is no clear indication or projection for recovery.

Businesses with the vision to adapt to an evolving market will survive, but those that have been supported only by the low cost of capital are susceptible to fail regardless of their price of debt and how it is restructured. Lowering of interest rates and providing liquidity likely will not rescue these companies again. Some companies may get a lifeline from credit managers that have significant undeployed capital or raised large sums of money for distressed investment opportunities presented by the pandemic, but the fundamental question still remains: can earnings and business models recover and how long will it take?

As investors weigh their optimal exposure to private credit strategies, they should consider that distressed investing is often a risky bet dependent upon when and how a market recovers. Financing the recovery and its related economic development initiatives presents a more stable and more impactful opportunity. Since the outbreak of the pandemic, the Federal Reserve and U.S. Treasury have injected several trillions of dollars into the economy. Financing the recovery means focusing on targeted opportunities that work alongside the government’s initiatives and have government payments or guarantees, reducing or, even eliminating, the uncertainty of predicting which companies can and will adapt and survive and which will not.

The Role of Private Credit in the Recovery

Private credit funds are expected to play a significant role in the market recovery, with many managers seeking to invest in distressed assets with hopes they will recover. However, it is important to remember that growth of this asset class in recent years has been accompanied by signs of increased risk-taking.

As managers seek to shore up their existing portfolios, many are attempting to mitigate performance declines by raising new distressed funds to take advantage of market dislocation opportunities and help restructure balance sheets. Such funds may be providing liquidity to companies that are restructuring their overleveraged balance sheets but may still have business models that may or may not survive the current crisis given the uncertainty around how long the recovery will take.

Focus on Specialty Finance

Companies with traditional business models face difficult third and fourth quarters as the reopening of the economy is expected to be slow and fraught with many interrelated complications and increased costs. Therefore, it is important for investors to focus on specialty finance–specifically, alternative credit strategies that are substantially less uncorrelated to the broader economy, have strong capital protections and collateral and offer compelling risk adjusted returns in today’s market.

In Conclusion

Private credit mangers who maintained their discipline and had the foresight to avoid borrower-friendly private equity sponsor deals and correlated exposures, and alternative credit managers that see the value of partnering with governments to effectively re-animate the economy will ultimately be rewarded.