European special situations outlook

Eric Larsson and Laurence Raven, Portfolio Managers and Co-Heads of Special Situations, offer their answers and thoughts on the European special situations market.

Introduction

From the global financial crisis (GFC) until 2022, a decade-plus of extraordinarily dovish monetary policy and ultra-low interest rates fueled an explosion of leveraged finance, with the European sub-investment grade market quadrupling in size to US$1.2 trillion.¹

In 2022, central banks slammed the policy brakes to cool off scorching inflation, raising interest rates at an unprecedented pace. As economic growth slowed and borrowing costs surged, banks pulled back, either unable or unwilling to lend, and the new financing market essentially shut down. In Europe, high-yield and leveraged-loan issuance fell 78% and 56% year-over-year, respectively.² Valuations came under pressure and financial performance began declining, dramatically in some sectors. Credit spreads widened, and default rates, a lagging indicator of economic activity, started to rise. In July, Fitch Ratings forecast that European default rates will rise significantly in 2023 and 2024, with a massive maturity wall of nearly €300 billion looming in 2024–2026.³ With leverage levels at their highest point since the GFC, refinancing will be more challenging for many and likely impossible for some.

As a result, the opportunity for European Special Situations investors to take advantage of temporary dislocations in the market, provide liquidity and work with companies to recapitalize their balance sheets, is the most fertile it has been since the global financial crisis.

Special situations investments could capture better risk-adjusted return than other asset classes, achieving equity-like return through investing in senior secured debt:

• Low LTVs (typically 40-50%) of consideration paid by equity owner
• Strong downside protection through asset security
• High current yield with upside convexity

In this paper, we focus on the European special situations credit:

• Setting the opportunity foundation.
• Digging deeper into the industries and geographies.
• Competition for assets and white lists.
• The Alcentra difference to sourcing opportunities.
• Looking ahead on interest rates.

We believe the confluence of these factors will result in a massive and disparate set of opportunities for savvy, well-positioned investors to combine strong running yields with the potential for equity-like returns over times, all with a risk/reward balance that’s arguably better than it has been for a very long time.