The unprecedented lockdown measures put in place around the world a year ago led to immediate and significant changes for organisations as well as individuals. While the adjustment has been profoundly challenging for many businesses, these events are often catalysts.
Many businesses have now adapted, tailoring their offering to opportunities that have been created by the pandemic. Others have benefited from operating in areas where demand for their product or service has increased, with logistics, technology, healthcare and housing being some examples here.
As the world’s focus shifts from the response to the pandemic to longer-term recovery, it is important for investors not to forget about the fundamentals, which for many businesses means the strength of their balance sheet and access to liquidity. Both are key indicators in determining the ability of organisations to traverse challenging economic conditions.
Despite the backdrop, corporate insolvencies in England and Wales in the second and third quarters of 2020 were actually at historically low levels, which was probably due in part to the level of support provided by temporary government and central-bank schemes.
Some argue the pandemic has exacerbated an apparent disconnect between the real economy and the financial markets. In February of this year, the FTSE 250 index approached its previous all-time high watermark recorded in late 2019, despite a GDP release showing that the UK economy shrank by 10% in 2020.
In a world of uncertainty, one factor seems increasingly certain – that current supportive measures are unsustainable as governments want to rebalance public finances. This is likely to involve the tapering of support schemes, which could increase default rates, particularly in those sectors more affected by the longer-term changes precipitated by the pandemic.
Debts, public and private
The private debt market for corporate issuers was not immune to the pandemic; volumes were impacted and pricing, following trends set in the public bond markets, was volatile. Nevertheless, this market remained a crucial funding source, and the current climate similarly represents both a challenge and an opportunity for institutional investors and borrowers alike.
The key factors include:
• The tapering of government support schemes, combined with the longer-term trend of bank retrenchment and more disciplined lending.
• The universe of opportunities in private corporate credit varying significantly, across both issuer characteristics (e.g. sector, size, location, etc.) and types of debt facility (e.g. USPPs, Euro PPs, and senior loan facilities). This provides a greater depth and variety of investment opportunities, and promotes diversified portfolio construction.
• The predominantly unrated nature of issuers means that diligence in private corporate credit is typically deeper. This allows for greater differentiation between opportunities, and an ability to better understand which borrowers are more likely to be resilient through the cycle (e.g. understanding how longer-term structural changes are likely to impact certain borrowers). This is crucial given investors’ predominant “buy and hold” strategies.
• Environmental, social and governance (ESG) considerations are increasingly important to investors. Borrowers that place ESG factors at the heart of their strategy are, in our view, more likely to be resilient over the longer term. The flexibility the private debt market affords allows ESG criteria to be placed front and centre of the investment process, and is increasingly becoming explicit in deal structures (such as by directly linking ESG performance to pricing and/or available capital).
• Focus on structural protections – in times of uncertainty, the value of capital-structure seniority and covenant protection increases.
Private credit investments have increased in recent years and, while the pandemic has presented clear challenges and created some uncertainty, we believe corporate private debt markets will continue to provide opportunities that offer attractive risk-adjusted returns to investors and support businesses.
Understanding how the pandemic has and could impact specific issuers and sectors going forward, taking into account factors such as those highlighted above, will in our view be key to determining investment outcomes.