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LCD Q&A: Bain special situations head Robinson sees stress in system

September 24, 2019

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Bain Capital Credit’s global head of distressed and special situations, Jeff Robinson,
sees opportunity in the growth of leveraged lending that has coincided with this
historic bull-market run. Though not a systemic issue in his view, the greater number
of companies with highly levered balance sheets in this $2.5 trillion market for
leveraged loans and high-yield bonds—double that of the last default peak—will be to
the benefit of distressed managers once the cycle turns. Robinson, who leads a global
platform with a 69-person team, spoke all things distressed debt investing with LCD’s
Rachelle Kakouris.

LCD: Much has been made of the massive growth in the leveraged credit markets.
Is this something people should be concerned about? Do you agree with some of the
warning bells that have been sounded by politicians and regulators?

JR: I’m a little less concerned about it than maybe the headlines would suggest.
While the leveraged credit markets have certainly grown, they’ve grown at a lower
rate since the financial crisis than investment grade has, and they’ve grown at a lower
rate than U.S. Treasuries have.

When you consider the U.S. credit markets more broadly, then yes it has grown, but
sub-investment grade hasn’t grown disproportionately. I think it’s become more of a
mature asset class. I don’t think we as a firm are concerned; we wouldn’t characterize
it as explosive credit growth relative to other areas of credit.

Does it, though, bring an opportunity set?

From an opportunity perspective, there are more companies in our markets now, both
in the leveraged loan and high-yield market. There are more companies in the middle
market and direct lending world also that we think have borrowed too much money. I
think that will create an opportunity—the more companies out there that have levered
balance sheets, the more that should be to our benefit once the cycle hits. But I don’t
think it is necessarily a systemic risk.

If liquidity and access to funding is what ultimately matters in keeping a company
afloat, what is your view on the market reaction in late 2018 and summer 2019?

As a distressed investor trying to find value, it was encouraging to see the market no
longer moving one directionally upwards. Some of the bigger names traded off more
because that was where the sellers could find liquidity and so by definition, it wasn’t
the riskier companies that took the hit, it was more orderly than that. As a sell-off,
these were not huge value drivers.

Where we find good value is when there are irrational selloffs, as we saw when a
number of investors fled from the energy sector. There were companies that had
difficulty accessing capital, either in a restructuring or outside of a restructuring, and
that’s where we can step in and charge a premium for the risk. We are currently
seeing this potential opportunity arise again in many of the energy-related sectors.

Are you playing across the capital structure? Talk us through your strategy.

We participate in everything from pure distress for control, where we look to convert
a company from debt to equity through a form of restructuring. The second part of
that is we’ll trade in and out of stressed and distressed companies’ securities even if
they don’t go through a restructuring. We also provide capital to companies—whether
it’s convertible preferred securities, junior capital, or equity investments. It’s a wide
remit as we seek to match return expectations with the risk profile we’re looking to
achieve.

What are your expectations for when the market will see a significant uptick in
distressed investment opportunities and restructuring activity (be that a meaningful
increase in stressed situations or actual distress and defaults)?

While the U.S. economy is in a relatively stable place, we are seeing signs that
companies, more than consumers, are getting more cautious with discretionary
spending on additional capital outlays. Once we start seeing some of that slowdown
and pulling back, that will start triggering some caution from the market.

From the leveraged credit market’s perspective, I think we are starting to see signs of
stress in the system. There are a lot of companies that have been borrowing—as they
should when rates are relatively low to extend runways—but they also require some
sort of growth story, or consistent growth story to grow into that capital structure. To
the extent that growth doesn’t materialize, I think there will be a pretty good
opportunity to find value.

So regardless of when the cycle turns, the reason we have built our platform the way
we have is so we don’t have to sit around and think about this question. We can focus
on the industries and the companies that we like and source opportunities on a global
basis where there are always some countries or sectors where capital is seizing up.
Our current fund, as an example, is only 20% in North America, so for a U.S.
manager to have that little exposure shows the flexibility of our platform.

Even if a recession hits next year, LCD’s data suggests issuers are operating with
decent headroom in terms of interest coverage and could have a decent runway
before succumbing to a default, especially companies with looser covenants. What’s
your view?

From a creditor’s perspective, lenders are buying contracts that are significantly worse
than they were before the financial crisis and the last default wave, so we have to
acknowledge that the ability to catch a company with a covenant breach is not as
strong as it used to be. Not only is there a lot of buffer in the market right now, but
there are a lot of ways in which the equity of a company can prolong the runway, such
as, for example, through the use of debt baskets allowing more flexibility for a
borrower to raise debt, and also the ability of companies to “pro forma” their way into
better results to avoid covenants.

What we ultimately expect to see is a little bit more duration until the cycle impacts
the companies, a little bit more lag until defaults, and more true payment defaults
when those companies actually get into liquidity issues and can’t refinance their
current capital structure. Of course, that is dependent on the steepness of the
slowdown, and the unique situation of a company in terms of what its liquidity and
working capital cycle looks like.

Shouldn’t this keep the tourists out of the distressed market? How will this impact
recoveries?

It should. If you look at covenant-lite, senior secured bonds in the capital structure,
they are basically term loans without covenants, and those recoveries tend to be 10
points lower than term loans historically. So, we have a good sense of what the
expected recoveries should be, broadly speaking. I think tourists would stay away
because it’s too complex, and there’s too much risk. As a value investor, the fear is
they’ll come in and buy too soon and not actually let the securities get to the
appropriate price where we would participate.

Does that feed into the point that if the right holders aren’t in the debt, or a
company isn’t forced to the bargaining table, when the time comes to actively have
these discussions it will be in a worse state? Is that something you would agree
with?

I would. We are typically buying companies in crisis. Sometimes you have a healthy
company with a slightly over levered balance sheet that has to restructure. But more
often than not, these companies are having issues, and in the world we are talking
about right now, it takes payment defaults and running out of liquidity to bring them
to the table. Reverberations up and down the value chain, whether that’s with
suppliers or customers, need to be well understood. When we enter in to buy a
company that is in a period of crisis, we really need to be thoughtful about how that
will play out and what operational turnaround capabilities we can bring to bear to
stabilize and grow the company.

Talk about customer concentration risk. Is this inherent in the market or more
idiosyncratic?

There are always companies with customer concentration risk, particularly with lower
middle market companies where their position in the value chain is different. With
businesses of that size you may have to accept that concentration risk. Certainly, that
goes into our underwriting and pricing of that risk, the probability of a contract loss,
rather than the impact, often being the more challenging scenario to analyze.

What in your view will trigger a credit downturn? What are the warning signs you
look for?

At the company level, we look at whether there is a lot of cost pressure in the system.
If you take the three core components of a company there’s cost of goods, cost of
labor, and cost of capital. Over the last couple of years, those costs have risen. If you
look at the various macro statistics, obviously capital is going to stabilize with the Fed
not expected to raise rates and previously lowering rates, but we’ve seen cost increase
and yet margins have remained good from a macro perspective. That means either
companies are improving productivity, which they are, but not at the same rate they
have been, or they are passing on those price increases to customers to protect
margins, which of course is self-inflationary.

And so, when we look at signs of late cycle behavior, there is a lot of cost pressure
that’s pulling through to protect margins. In the event of a slowdown, any little
deferral gives us an indication it will unwind.

I think what we saw in December last year and late August, more on the technical
side, people are a little nervous so we saw some flight from the market,
and that abated very quickly, the December selloff by the Fed saying they weren’t
going to raise rates. But if we have any more technical concerns, I think we will see
quite a bit of resetting and repricing in the market. As we know, the Fed does not have
a large basis from which to cut rates and it is debatable how effective rate cuts will be
after such a long period of low rates.

Does that mean we will go into a huge default wave? Probably not. But I always say
to our team, our cost of capital is 20% plus, and with the way the credit markets are
right now, there are not a lot of situations where our cost of capital is relevant. So,
from our vantage point, we need the market to reprice or the distribution of spreads or
yields to widen out so that we have more opportunity to find good value.

Where are you looking in terms of sector specifics?

We are focusing our efforts on cyclical industries that ultimately sell into
discretionary industries. The automotive sector is one example where purchases are
largely discretionary, where we start seeing the deferral of purchases and people hold
onto cars a little bit longer. I think the auto companies are going to be fine from a debt
perspective. They’re fairly well levered but if you work back up the supply chain to
steel producers and some of the chemicals that go into those discretionary purchases,
there are some companies that are thinly margined and highly levered that have been
adding capacity, so I think there will be some sectors like that which we think will
provide good opportunities to find companies that have a purpose, that have factories
and plants but have been caught up in the cycle at the wrong time and didn’t take
advantage of the good times to delever.

Retail is a sector that of course is seeing a lot of stress and distress. We don’t do a lot
in this space as we think it’s difficult to underwrite the collateral value in the strength
of the brands, so while there might be stress, we have a higher threshold before that
becomes a high conviction sector for us.

In terms of benchmarking your portfolio, how do you measure your performance?

In general, we are seeking equity returns with largely credit instruments. We have
conversations with a variety of investors that have different benchmarks or ways that
they place our fund strategies into their portfolio because we are not a pure private
equity or fixed-income allocator.

Our return profile and the complexity of what we do sit somewhere in the middle. We
are focused on absolute return of delivering good value across the various market
cycles rather than looking at specific benchmarks. The indices will move up and
down, but we should be able to find good value that delivers attractive returns to our
investors through any market cycle.

Are you involved in the outer rims of distressed such as bankruptcy trade claims?

We are, but I would say our core focus is more on the true, corporate side of the
equation, meaning actually trying to understand, and ultimately influence, if not
outright own the company.

Bain Capital Credit has been very involved in India as a geographical region. Are
you still seeing opportunities there?

As a distressed investor, India is probably the most fascinating market globally right
now. We have a significant presence in India and a joint venture with Piramal Group,
a Mumbai-based conglomerate, where we invest capital in the form of debt and
equity, in distress to control situations in the Indian market. One of the main drivers
for opportunities is India’s recently adopted bankruptcy code, which is far more
creditor friendly than previously. We’ve made a number of investments and continue
to see a healthy pipeline of either buying assets out of the new bankruptcy auction
process or working with companies who are under the threat of bankruptcy to
effectively do prepackaged restructurings.

We also have a large platform in Asia, and we’re incredibly bullish on the opportunity
set there given the immaturity and inefficiencies of the credit and capital markets and
the lack of competition. Our presence in the region and activity across China,
Southeast Asia, India, and Australia is a unique differentiator for our global platform.