May 22, 2025 • 48 mins
Tariffs are inflicting economic damage that will force more companies to default on their debt, according to Polus Capital Management. “We do have a more substantial book of single name, high-yield credit shorts,” Robert Dafforn, the firm’s chief investment officer for opportunistic credit, tells Bloomberg News’ James Crombie and Bloomberg Intelligence’s Tim Riminton in the latest episode of the Credit Edge podcast. “We think about it as the foothills before the mountain as you go on the slow ascent, and then it kind of picks up more broadly after that,” says Dafforn, referring to an increase in delinquency amid high interest rates and slowing growth. The CIO of Polus also discusses trouble brewing in the chemicals, building materials, packaging and consumer sectors, as well as “equity-like returns” for distressed-debt investors.
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Episode Transcript
Available transcripts are automatically generated. Complete accuracy is not guaranteed.
Speaker 1 (00:17):
Hello, and welcome to the Credit Edge Weekly Markets podcast.
My name is James Crombie. I'm a senior editor at
Bloomberg and.
Speaker 2 (00:23):
I'm Tim Rimington, a senior analyst covering basic materials at
Bloomberg Intelligence. This week, we're very pleased to welcome Rob Deforne,
chief investment officer at Polus Capital Management, which invests in
special situations leveraged and structured credit.
Speaker 3 (00:37):
How are you, Rob, Oh, very well, thank you, Thanks
for having me today.
Speaker 2 (00:40):
Great to have you here. So Rob, you founded baby
Brook Capital back in twenty fourteen, which, after a merger
with Karen Capital, went on to become Polus and now
manages more than twelve billion in aum. Before that, you
were a partner at Eton Park and previously at Millennium.
So I have to say, as a highield analyst, I'm
very excited to be here asking you the questions. It's
(01:03):
normally the other way around, so I'm very excited to
hear what you have to say and heading over to James.
Speaker 1 (01:11):
Yeah, So before we get to the questions, I just
want to set the scene a bit. Markets are on
edge after the US lost its triple A credit rating,
Moody's was only really following the lead of the other
rating agencies, so the cut should not have been a surprise,
but it does come as another reminder of the fragile
state of US government finances, calling into question the concept
of risk free rate while also reigniting the Cell America trade.
(01:32):
Despite this, credit markets are projecting an air of calm
and optimism about the economy. All the losses from the
so called Liberation Day have been erased. Bond spreads are
back to where they were before the US announced tariffs
that were effectively embargoes, but the tide didn't lift all boats.
Spreads on the lowest quality corporate debt remain wide to
long term averages, indicating some concern about whether the weak,
(01:54):
highly indebted companies can survive as earnings decline and stagflation
risks rise. So what do you make of it? Credit
spreads would suggest that we're all in the clear now,
everything's going to be okay. What's your take?
Speaker 3 (02:05):
Well, yes, I think the there's obviously been an amount
of technical strength and credit hasn't there as they have
been in most risk markets over the last few weeks.
But you know, I don't think we necessarily see the
fundamental picture having been the sounding of an all clear.
You know, for us, I think as you as you
(02:26):
alluded to, we were actually at pretty much embargo conditions
and we've now gone to you know, from embargo and
potential kind of meaningful shock, meaningful non linear moment for
the economy, and we've pivoted that to know, a rewiring
of trade, and from that kind of more acute kind
(02:48):
of you know, let's call it real shock, we're moving
into a more sustainable, but longer duration potentially rewiring of trade,
which will just be you know, very very costly for
the global economy and certainly for the US manufacturing goods, importers,
et cetera. So you know, we definitely see the likelihood
(03:09):
of a fundamental impact to be setting in and setting
in for the medium term. So you know, it's with that,
I think obviously the markets have there are those technical
forces and kind of you know, people were underweight and
they sold a lot of risk and they had cash
(03:29):
balances coming into this, but they've really bought into the
idea that an all clear has been sounded. From a
pricing perspective, I think that does provide a medium term
opportunity to take to take the other side.
Speaker 2 (03:42):
Of it, and I think just following on from that
on the on the macro side. You know, one of
the things that I've seen in my coverage and Basic
Materials is essentially we've been in an industrial recession for
the past three years already, from around twenty twenty two,
and you know, we've heard again and again about this recovery,
(04:03):
you know, this H two recovery that never really materializes.
You know, do you think this shock that you know
might be materializing now is going to be the sort
of catalyst to sort of trigger another leg down.
Speaker 3 (04:18):
I think it is more likely than not. Would definitely
be how we're thinking about it. So you know what
you mentioned there about the sort of we have been
in relatively tough conditions for the last three years, so
we would absolutely agree with what we see. You know
right now is obviously your market very very focused on
(04:40):
sort of the next piece of information, the next piece
of news, whether it's tariffs, whether it's you know, US
rateing downgrades. But what it all really is is the
end of a fifteen year cycle, and this is a
late cycle. This is a late cycle time at the
end of you know, ultimately a pretty long period in
the most drawn out cycles that's been unsustainably and in
(05:04):
many ways artificially sustained for a few extra years. And
you know, is with that we do see as you say,
kind of that industrial recession. Yeah, you know, they have
been there have been various sub sectors that have been
struggling for the last few years, which is what you
(05:25):
get at the tail end of the cycle. You know,
we've been told about the restocking that was coming in
chemicals right for quite a while. There's obviously the early
losers at the tail end of a cycle, which you know,
if you're looking at basic materials, building products, and that
exposure to the housing market which has been lackluster, you
(05:49):
know since twenty twenty two, and the rise in interest
rates globally. So there have been a number of sectors
which have been stuttering. And you know what is actually
the most interesting, to be honest, is over that three years,
how you know we have avoided major issues already, right,
(06:09):
I mean I think that this, you know, our characterization
of the market, well the economy in a late cycle
period really does suggest that, you know, we are to
some extent on borrow time and you're really looking for
kind of what is the catalyst that tips it over
the edge in the end. And I think those kind
(06:31):
of very heavy goods associated sectors that you mentioned, which
are have interest rate sensitive end consumer demand are clearly
the ones which have been the weaker since twenty two
because those are the places where you know, end demand
was more constrained by the traditional interst rate function and
(06:53):
how it impacts consumer spending. I think kind of so
for us, you know, we really do feel that for
whatever shot comes down the pipe, we do think most
likely tariffs, but you know, it could equally be sovereign funding,
et cetera. There are several there are several things that
are kind of available at the end of this economic
(07:14):
cycle to be the ultimate one that breaks this breaks
the camera's back, as it were. But you know, they
all sit within a context of, you know, credit wasn't
that credit worthy over the last couple of years. You know,
we are looking at very very high debt to cash
flow statistics. We're looking at extremely high amounts adjustments of
(07:38):
adjustments to earnings, and none of these things can really
pay your debt, you know. So that's why the market
is somewhat more fragile in the credit sector is somewhat
more fragile in the lower rated spectrum to these forces.
Speaker 1 (07:55):
I feel like we've been talking about this scenario for
years though, in terms of, you know, the end of
the cycle and a big distressed cycle coming, and there's
all this money been raised for that strategy, and yeah,
it just never happens, you know, certainly on mass. I
mean there's there's specific situations. You see, there's companies that
you kind of see dropping into trouble and you know
that they're going to get into worse trouble. But you
know the size of that that opportunity just seems so
(08:17):
small relative to the whole market. So so why should
we worry? Now, what's the tipping point that we're really
focused on. What are the signs that you're seeing to
show that's coming.
Speaker 3 (08:25):
Yeah, Look, it's the process, right, The creation of of
of excess misallocated credit is very much a process, and
it takes place over a sustained period of time, and
that you know, that was really the build up of
debt through that low interest rate period that we've had
(08:46):
since the GFC. So you know, the statistics really are
that we have seen that incredible pick up in just
the amount of the volume of sub investment. Great credit.
You know, we're not worried about credit in general. Investment
grade balance sheets are very strong, and you know, there
was a corporate windfall from effectively the pandemic and the
(09:07):
pandemic in era stimulus. So investment grade companies are about
as about as good as they have been. Yeah, they've
they've maybe overspent a little bit on buybacks, right, you know,
ultimately and kind of left a bit of leverage on
balance sheets. There are, of course a few exceptions which
are a little bit weak, but you know, by and
(09:28):
large igs okay. But high yield went from being that
niche asset class to you know, very much mainstream post
to GFC maybe five hundred billion dollars of loan and
high year bonds outstanding, which is now five trillion dollars. Right,
ten x the number of names, you've ten x the amount.
But in that period of time, actually a lot of
(09:49):
the sort of number of eyeballs looking at things has
been outsourced to passive you know, passive purchasing. So the
the kind of that has a lot the kind of
a man of scrutiny on a lot of the single
names to be reduced. So we definitely have kind of
through that process. You know. My point here is really
that we have been building up this misallocation as a
(10:12):
process and then kind of you know, credit always gets
to the same tipping point at the end of a cycle,
which is what is the point where you sort of
compare your growth rate the G, with your financing costs,
your interest rate the R, and what matters to servicing
credit is you kind of need a bigger G and
(10:32):
a smaller R. And obviously, through the period of low
interest rates the reason why credit was misallocated. Then you
can see that from kind of how much credit grew
relative to GDP, right, you know, so much more credit
growth than there than there was GDP growth. And you
get to the end of that process where you didn't
(10:53):
need much G. Right, you didn't need to be producing
much G you know, pre pandemic because because the R
was so low. Come out of kind of the pandemic era,
you know, twenty twenty two onwards, and we've seen kind
of the R, the financing costs, the risk free rate
for the economy pick up, but we haven't really seen
(11:13):
a ton of real growth. And then the thing that
kind of obviously everyone who was said, have said, well, look,
the moment where your our versus G mixed, your ORE
rises quickly and your G is constrained because you know,
the economy is ultimately interest rates sensitive, was when we
went into the hiking cycle of twenty two, And I
(11:33):
think it's pretty fair to say that would be attributed
to be a pretty good, you know, kind of starting
bell for the the the unraveling of what at the
time was a sort of twelve or thirteen year period
of pick up in debt. The reason why it didn't
is not, in my view, because the economy is no
(11:55):
longer interst rate sensitive or as interest rates sensitive as
it was, is actually that it was a very unusual
period where that monitor tightening came with an enormous fiscal loosening,
so the monasary tightening didn't bite as much as it
otherwise would have done, not only the fiscal loosening that
we saw twenty two to twenty three, twenty four, but
(12:16):
also kind of the legacy unspent fiscal funds from twenty
to twenty one. So really it has to be thought
of as a stock flow impact, which is ordinarily you know,
twenty two's interest rate cycle and the aftermath of it
would have created those higher interest rates, higher financing costs,
which would have you know, really started the pinch on
(12:39):
corporate credit balance sheets. But the economy was just awash
with fiscal money and then got more physical money, and
that did kind of that unsustainable element did did draw
out this tail end of the cycle. But you know,
the forces of physics and the forces of finance, you know,
they don't change, right, This is just a stock flower,
(13:00):
and we went into the usual kind of bad flow
piece of lower growth and higher financing costs, but with
a much larger stock, much larger buffer for the economy
to take it. But you know, we call this time
under tension, right, which is also the corporate don't. They
don't roll over at the first moment of a higher
(13:22):
interest rate. You kind of have to leave in place
that period of higher interest rates and lower growth for
a longer period. Is the time under tension, not just
the existence attention. And that time is a little bit
drawn more drawn out this time because of because of
the support that offset the monetary tightening that we had.
(13:43):
But it is real, right, and you do see kind
of it's more of a niche practice, but obviously you've
been a massive pickup in liability management distressed exchanges, and
we've had a pretty meaningful sort of default rate across
leverage loans and high yield right you know, for a
robust part of the cycle, it's been non zero, which
(14:06):
is which is unusual and is now being followed up.
What's super interesting right now when you think about that
kind of the impact that interest rates have. You know,
we're now starting to see that pickup in delinquencies, you know,
certainly in the US across credit card, auto loan, obviously
the end of student loan for bearns, the impact that
(14:29):
that has an f A h A mortgages. So I
think a large part of kind of that delayed reaction
coming through from from interest rate hikes is starting to
be seen in the data in the in the US consumer.
We're going to have it in Europe as well, with
a kind of moderate upwards drifting NPL. So you know,
(14:50):
think about it. We think about it as kind of
you know, the foothills before the mountain, as you can
kind of go on the slower sent and then and
then it kind of picks up more broadly after that.
So you don't always need a shock. I think like
the financial markets love to look for that one shock,
and it could actually just be a set of things
(15:12):
building in the background. If you allow me to the
labor my R versus G thing for a little bit longer,
I would say that, Well, the reason why tariffs are
a really interesting one is because they in it as
a supply shop for the US and a demand shock
for everyone that exports to the US, so simultaneous supply
(15:36):
demand shop. We don't see many simultaneous supply demand shocks,
So that's you know, highly likely to be a lower G,
and for every unit of lower G, you're going to
have a slightly stickier R. As we know sort of
central banks should be it should be slightly harder for
(15:57):
them to react to slow down in growth because this
is something that raises prices, even if it's only on
a one time basis. I dispute that, but you know,
because it's a supply shot. But you know, the you know,
you will make the G versus our mechanic harder. So
(16:17):
the interesting thing about about tariffs is you stop. You know,
My view would be we are starting with a difficult
starting point for the end of a cycle. Big pickup
in debt it has been sort of artificially extended by that,
by that fiscal policy, which is effectively allowed kind of
(16:37):
three years of additional poor management for those corporates to
stick into place, and then you're hitting it with you know,
what should be a credit negative shock at the end.
So it's very difficult time to be a kind of
highly levered corporate because obviously it is a companies do
have the ability to react to some of these things.
(16:59):
But if you've got a lot of debt than your
ability aware with all an effect of deep degrees of
freedom to act are meaningfully lower. And so I think
kind of, you know, leverage is really the enemy for
a corporate at this time.
Speaker 2 (17:14):
And in terms of your strategy, you know, how are
you how are you positioned to take advantage of that view?
You know, you mentioned perhaps US markets might see more
opportunities there. You know, I think that's interesting, you know,
covering chemicals, the US has actually been until recently one
of the stronger markets and Europe's been the weak one.
But perhaps with the tariff shock that's now going to reverse.
Speaker 3 (17:37):
Yeah, yeah, I mean, how we're positioning for it is
we do have a more substantial book of single name
high your credit shorts. So we have increased the let's
call it the percentage exposure of the fund as well
as the number of names that we're exposed to, because
(17:59):
you know, as I mentioned, if you came into if
you came into this year, you know, we were certainly thinking, well,
there is that general misallocation in credit, right, and there's
obviously kind of those misallocations could be poor quality yearnings,
weaker businesses from a cyclical or secular basis, then you
(18:20):
impose on it. Additionally the tariff issue. You understand, there's
kind of our number of different sectors at play. Challenges
for consumer discretionary businesses as there's just less real link
and that impacts lots of different service and goods businesses.
As I mentioned earlier, the housing cycles being struggling, so
there's a lot of different sectors that are actually impacted here.
(18:44):
So really what we're we've been looking for is week
company with high leverage. We obviously like subordination as well
in shorts, because if someone sits ahead of you in
the queue in one of your restructurings, then the recovery
(19:04):
is clearly likely to be lower. Right, Because we're obviously
selecting for high loss given default, looking for those low recoveries.
We're selecting for a high probability of default. The company
has leverage. We business cyclically challenged because of the because
of the particular dynamics in the end markets that might
be unfolding. So you know, basically expanding by number the
(19:28):
set of situations that we have, but also increasing the
number of them that we have Paris would draw in
a larger larger set of names, clearly, But as I
mentioned earlier, you know, we are talking to several thousand
names in the high yield market. So if you were
to say we focus on the bottom ten or twenty
(19:50):
percent of names by quality, that's still one thousand names
that we could be looking at and pouring over to find,
let's say the weakest one hundred and fifty or two
hundre hundred. So it's really mean about kind of screening
and looking for more weaker situations, trying to understand what
would a cyclical slow down globally mean for that business,
(20:13):
what would the tariff cost mean for that business. I mean,
we've seen kind of a lack generally of commentary from
companies and therefore you know they have not been educating
analysts on the exact costs right of tariffs to them.
Obviously a lot of them will hide behind well, I'd
(20:33):
buy my things from a US based distributor, right, You're like, yes,
in the US based distributor probably purchased it from somewhere
else that wasn't in the US. Right, So you know,
the clarity of the information there isn't super clean. But
ultimately an enormous amount of intermediate products do you come
into the US from other countries, So there's a lot
(20:55):
of analytical work to do there. We would spread our
bets these days in terms of kind of the number
of situations we would look at quite simply because the
nature of restructurings has changed, Right. You know, we see
a lot of distress exchanges in lmes, and what those
(21:17):
really are is sort of, you know, in the nicest
possible way, is you know, avoiding a default that should
have happened now and almost always pushing into the future. Right.
You know, the majority of these companies do not make it.
You're buying time, but ultimately buying that time doesn't actually
(21:38):
generate success for the equity owner of the business. And
it's because of that kind of appetite to pursue those transactions.
You're seeing a lot of you know, the definition of
zombie has widened, right from something that's sort of looked
like it might not have been able to pay the
interest and principle on its debt to literally one where
(22:00):
the creditor said, you don't have to pay me anymore.
Let's just pretend that you know, we're still with you know,
this is still a performing credit. So it's because of
that kind of dynamic in the market that we like
to kind of shield ourselves maybe from what we see
as as those sort of not full restructurings.
Speaker 2 (22:18):
Yeah, I'd actually like to push a bit further on
the on the ownership and kicking the can down the
road theme. But before we do that, I think it
would be quite interesting to hear a little bit more
about the mechanics of how you shot these names. Are
you looking to do it physically synthetically? Can you talk about,
you know, how you manage some of the risks, you know,
(22:40):
they're quite expensive short sometimes, you know, the liquidity can
be an issue. You know, perhaps even any examples you're
able to share.
Speaker 3 (22:48):
Well, to be honest with you, I think the biggest
the biggest way of managing your risk there is is
to leave as few footprints as you can. Right. So
one of the reasons why we have you know, a
lot of shorts, so you know, hundreds, is so that
we're not exposed to any single name and the instability
(23:09):
of repo or the ability to borrow bonds in any
one of those names. We don't tend to use a
lot of synthetic, so we don't tend to use a
lot of CDs. I think both sides of the Atlantic
have obviously seen lots of high profile examples over the
years of CDs not really being a particularly efficient tool
(23:29):
for taking a view on on credit. You know, plenty
of high profile examples where company went bust but CDs
was uphaned or you know, engineered default or what have you. So, yeah,
we stick to the physical market, but leave no footprints. Really,
So if we if we have you know, if we
(23:51):
spend the effort analytical time, research, you know, research time,
research expense on finding as men of the weak names
as possible, we can have a smaller position in each one.
Therefore there isn't going to be crowded repo in them,
and and and as a result, you know, the cost
(24:15):
tends to be lower, the availabilities higher, the liquidity risk
is lower, so we kind of manage around that, to
be honest with you, just but what it requires is
to have looked at a lot of names, because if
you're going to assured one hundred and fifty names, you
have to have looked at one thousand, and you have
to have looked at them properly, you know, I would
say that kind of in this very very low volatility
(24:39):
period that we've been in for a while, excluding April
and May twenty five, the availability of repo for high
year bond has been very very high because it was
a good source of financing revenue for low fee, low
fee funds, and you know, there wasn't really a market
(25:02):
or appetite for shortening any of the debt, so you know,
it was just ultimately for the end owner of the bond,
quite good way of generating extra income. So the availability
and depth of the repay market is higher than it
ever has been. I think what we would expect as
times get slightly tougher for these credits, we'll see more,
(25:24):
we'll see more kind of you know, instability in that market,
and we'll probably see more regulator reinforcement action as a result, right,
you know, because sort of the easy way to generate
a bid for a weak position is to try and
engineer a repost squeeze by the end owner, and you know,
(25:44):
obviously you're not allowed to do that, so you know,
it is something that the regulator knows to look out
for at the end of a cycle. So a lot
of the times the instability and the risk you're managing
around is really around somebody doing something they're not supposed to.
So fortunately we have regulators for that.
Speaker 2 (26:03):
So would you see opportunities in some of these more
creative lem examples we've seen over recent years. I mean,
Federick Gourney had a toggle pick that came out last year.
There's been a number of other picks or partial picks
from you know, highly levered European names over the last
year or so. You know, is that the sort of
(26:25):
thing that interests you as well?
Speaker 3 (26:27):
In a word, no, the look, you can make money
on them here all there. But I think as a strategy,
I buy credit and the goal with credit is I
you know, when you're buying it, you want to make
a yield, right, and the yield requires that I get
paid a coupon, and I also get my money back
(26:50):
at the end, and that, unfortunately, is one of the
reasons why I don't think lms in distressed exchanges, et
cetera work particularly well, which is, if I'm picking and
rolling out maturities, then I'm not getting paid either the
principle or interest, and therefore I'm kind of left wondering
(27:12):
how if I have to be the end owner of
that credit, right, if I cannot find a way to
recycle that risk, I'm left wondering how I'm going to
make a profit, because the reality is I'm probably taking
a corporate that has been struggling recently. I'm leaving the
(27:33):
current management team in to continue running it in an
otherwise difficult It's obviously a difficult cyclical or secular environment
with the same amount of debt and presumably relatively constrained
cash flow. Because if they can't pay me as a creditor,
presumably they're they're under investing in R and D, CAPEX,
(27:56):
they might actually be underpaying staff, you know, all of
those things. That doesn't strike me as kind of a
situation where I would be saying, Okay, well, I'm going
to get my money back as the person who ends
up holding these because this company's going to recover because
it just doesn't have Like you just statistically, if you're
short on cash, you can't pay your debt. You haven't
(28:17):
got less debt and your cash flow constrained, and you
left the same management team in and you had a
bad starting point. I don't see how I underwrite the recovery.
So you know, ultimately, when we're looking at these situations,
we want to be the top of the stack. We
want asset based situations. I want them to be free
(28:38):
cash flow positive before debt service, so that I know
that the thing I'm buying actually has some cash flow
coming into that box. And and and you know a
lot of these lems the issue is they are burning cash, right,
you know that it's not they're not generating cash, and
therefore they're very, very difficult to do from a stress
(28:58):
and distress perspective.
Speaker 2 (29:00):
Yeah, so I think I'll sort of pivot onto the
private equity side of it now. Then, you know, you
mentioned you're seeing a lot of kicking the can down
the road, you know, with these lemis. I totally agree
private equity firms huge driver of issuance in the sector,
but the exit market seems largely closed. You know, I'm thinking,
(29:22):
especially in the industrial sector, multiples that come down earnings
are you know, troughing. You know, so we've heard talk
in the past of sort of there being dry powder
and you know, they can sort of continue propping up
these these companies. I think, you know, anecdotally, we might
have seen a bit less of that dry powder being
deployed and a bit more of these more creative financing
(29:43):
opportunities or solutions rather. You know, how do you view
the ownership structure of the you know, the positions you're
taking on the on the short and the alongside. Is
there sort of specific you research you do into pe
funds that you know may have been fully deployed and
you know are limited on the on the drive powder.
Speaker 3 (30:06):
Yes, so you're definitely looking for that as one of
your pieces of due diligence. Is the likelihood of a
company to be supported by by the owner. It's worth
remembering there's an awful lot of debt is on non
sponsor businesses as well, especially in the US market. But
(30:26):
it is true that kind of there is a lot
of sponsor There are a lot of sponsor businesses. You know,
it's not a surprise to anybody that exits have been lower,
right in terms of frequency. There's obviously, you know, lots
of high profile news out there about the discomfort that
private equity investors have about the lack of return capital,
(30:51):
and it looks like it should continue, right, you know, ultimately,
which is it is hard to see what really brings
about a wave of exits, right. You know, so private
equity activity is easier to envisage in a decent economy
with low rates right and low finante costs. So you know,
(31:15):
we don't have the low enough rates and we don't
have a decent enough or stable enough economy right now,
so it is difficult to imagine being able to monetize
at the multiples that the would effectively get private equity
out at their now. So you know, obviously, with that,
(31:38):
the idea of dry powder is key. Now, there's two
types of dry powder, right. The dry powder in the
private equity firms is also dry powder in private credit.
So you have to take both of those things into
account as a potential source of capital into your lungs
(31:59):
and shorts. And you know, candidly, if you're long, you're saying,
I wonder how I can get some of that dry
powder into this business. And that absolutely happens. Not every
company that enters stress or distress is insolvent. Some of
them are just over levered. So effectively, we would push
(32:23):
the equity owner of the business, you know, or sometimes
of a sponsor, you know, if you want to keep
this asset, support it with some equity, and that goes
to pay me down and de levers me. And I
feel like I'm in a better place, and I will,
you know, make some compromises to you, maybe on kind
of the duration of I'll leave the capital with you, you know,
(32:44):
in return for that. So we really would ask that
if we were a long something that the private equity
company does step in with cash. What has been interesting
has been that in a lot of l and ees
that the owners of the debt have not pushed for that.
They've basically given the private equity firms a free option
(33:04):
on holding the business and running it into the future.
And you know, which is odd in situations where it's
not working right now, right there is stress and distress
because you know, maybe it's the governance of the business,
maybe it's the capital structure, maybe it's the business itself,
but it's not working. You do need to change something,
(33:27):
and you know, that does strike me as odd that
that hasn't happened. It's worth noting that the kind of
private credit dry powder. You know, sometimes they could come
in as a refinancier if they're very friendly. You know,
you've bought something as a stress debt, but they're very
friendly with a private equity sponsor and they come in
and do some refinancing, sometimes as a second lean, and
(33:50):
we might have been a first lean, so they've kind
of taken the role of putting that extra cash into
Deleverers as the first lean. But in general, you know,
I would say that your goal has to be well,
there is dry powder out there, so if you long something,
you should be finding a way to get that capital
(34:11):
into the business. And when we're short something, it is
you know, just ultimately it is a risk that that
that capital comes in, but it frequently hasn't, right, And
the reason why it hasn't is because the capital from
your investors is absolutely precious, right, you know, it is
it is you know, and it has to be used
(34:33):
for you know, it has to be used for the
right purpose. Your fiduci you duty to be a good
custodian of that capital. And if and if the business
isn't working and you're not achieving any deleveraging, then you know,
really you're not doing the right thing for your investors.
And if that is what ends up happening as a
(34:54):
private equity firm, just dropping some money into a into
a failing business that you kind of knew you were
going to burn, then it starts to taint your reputation
for future future capital raising, and that that is effectively sacrificing.
You know, that's the one thing that you would never
want to do. So I see why they've been cautious,
(35:15):
which is why would they put the capital into some
of these situations. Like you know, if you imagine a
business has you know, two billion dollars of debt and
it's got a sustainable debt capacity of one billion dollars,
which is probably about the right maths for a lot
of these credits. Well, you know, what can you put
in there to achieve a one billion dollar debt right off?
(35:37):
And it might be you know, no one's willing to
take that. They'll only do that if you hand the
business over. You can't really put in fifty million of
new equity and hope that people are going to ride
a billion off. So the kind of maths hasn't really
been working. And then kind of saying, well, we've got
a pretty high nave on this asset. You know, how
(36:00):
do we sell this twelve times leathered business at sixteen times?
You know that's difficult as well. We need to deliver
it at six to six before we could, and you know,
the math doesn't really work. So they're keeping the dry
powder safe.
Speaker 1 (36:14):
I me, but some of the distressed investors out there,
I mean, there's so much cash that they've raised over
the years for not a lot of opportunity in relative terms,
there seem to be under pressure to deploy, and in
some cases they're lending new money to these stressed companies
that seems to be more, you know, more of a
popular strategy. How do you see that? I, well, we don't.
Speaker 3 (36:36):
Do that because I'm old fashionate enough James to think
that a company that's struggling with too much debt might
not need more of it. So look the way that
I think the way the industry is it has proceeded
to say, in the absence of interesting secondary distress purchases
(36:57):
right of buying somebody else's mistake. They pushed towards kind
of primary stress and to stress. So lend money into
a struggling situation. And I suppose the capital solutions industry
has evolved from doing into doing that in an effectively
subordinated format. Now I can't imagine taking a stressed company
(37:19):
and wanting to put subordinated capital into that, right, but
I know it happens. I think that you know that
the turnaround that would be required in that situation in
terms of the operation of the business, the quality the
business would just be enormous that you would have to
underwrite two to feel that you were definitely going to
(37:39):
get that money back. You know, we would obviously do
senior rescue financy, but that's not really what's been happening
out there, right, You know, a lot of it is
really sort of stressed subordinated. So you know, rule number
one never subordinate yourself and the other is never pick yourself.
So if it breaks the the cardinal rules, then I
(38:01):
wouldn't do it. So, yeah, we're not really into that.
I think kind of more broadly, for your investors, you
also have to think about, well, what am I really doing? Right?
The reason why we stick to only secondary purchases the
average purchase price on our distress debt. So we've done
our one hundred and thirty five transactions in nearly twelve years,
(38:22):
the average purchase price has been fifty five cents on
the dollar. So the thing about entering the debt via
the secondary at a discount, they have to be able
to find it right, and that's a whole new thing.
You know, we have managed to sustain a franchise for
purchasing that secondary distress debt. But if you buy the
right stuff, you have gone into a situation where you
(38:47):
kind of feel like the worst thing has already happened, right,
You've gone bankrupt. And therefore, kind of if you think
about the conditional probabilities of this, what's the probability wants
a really terrible thing has happened, then another really terrible
thing happens afterwards, and also it is clearly much lower. Right,
the bad thing has already happened. So, you know, we
(39:09):
got in there at fifty five cents on the dollar
feeling like, well, if we can get the assets or
cash flows, maybe get forty five or fifty back but
if we get it right, there's a potential equity like
return available here. The problem with giving the company fresh
new capital on a primary basis is you basically given
them one hundred. You said, well, keep paying me my
(39:29):
twelve of coupon that you're going to afford. But if
I get it wrong, I get zero. Right, So you know,
if you think about the skew on ours, we've paid
fifty five to try and get somewhere between fifty and
one hundred, and you know if you but if you've
done the primary example that new money capital solutions is money,
you've given them one hundred. Your best case, you get
one hundred. In your worst case you get zero. But
(39:51):
you subordinated yourself, so the probability of the zero is
much higher. So you have to charge a pretty substantial coupon.
But then theblem is that the company's probably struggling. If
it's struggling with debt, then it's going to be picking
your coupon presumably, So it kind of falls a little
bit down on the common sense thing, which is, you know,
if you were talking to your grandma about that, what
(40:13):
would she say, you know, when you'd sort of you
know her neighbor wasn't paying their mortgage, so you said, well,
i'll give you, you know, I'll give you another twenty
five percent of your house value. You don't have to
pay me a coupon, and I'll sit behind the bank.
You know. She would say, well that now, I'm not
sure that makes a ton of common sense. And I
(40:35):
think you know, that's why we would describe maybe that
primary Cap solutions as an innovation as we call it
in finance, which isn't a real innovation. It might just
be a fad.
Speaker 1 (40:47):
So when you're pitching this rob to you investors out there,
you know, in terms of a strategy, what's the upsite
right now? What's kind of questions they asking you? In
you know the context? Also, you know they can get
five and a half percent on an investment grade by
with zero likelihood of default, So why should they stick
their necks out and really you know, jump into distress
right now?
Speaker 3 (41:06):
Well you can definitely make more than that on good distress,
you know, so it really forms part of a you know,
balanced portfolio, right you know. And and what I think
you're really saying to investors is, look, that becomes a
time each cycle, right, we have these micro distress cycles
(41:29):
and we have a macro distress cycle. You know, ultimately
also insues and what they provide you is the opportunity
to create assets at the meaningful discount to their intrinsic
value via the debt. And so you can actually make
equity like returns from you know, being senior in a
capital structure, right, so you can actually be in the
(41:49):
in the lower risk part of it, and you can
make equity live returns from that top of the cap
stack position in really really great assets, right. You know,
it could have been done in realists day, or aviation
or hotels or yeah, some operating businesses, infrastructure, you name it.
So you can get these brilliant businesses and you can
actually take the kind of thin slices at the top
(42:11):
and generate equity like returns from that. But you only
get that every so often, and it's in these periods
where you've kind of kind of the misallocation has has
built up over the years, and you get to a
position where when we get the market clear and you
you absolutely get kind of a brilliant opportunity for that.
I think investors have been really receptive over over the
(42:35):
over the last couple of years. I think they they
have have a couple of perceptions. One of one of
them is we also we have kind of a real
business for doing this, right. It's not just waiting for
the things to kind of turn up and jump jump
out at you off the screen. We have had to
kind of find a way to keep sourcing the really
(42:57):
interesting risk that fits that top of the capital strut
a big discount against asset based situations, right, and having
built that infrastructure has been really key for investors to
understand that, well, we can find things when there isn't
a big macro cycle, then when it turns up, hopefully
will be a safe custodium for their capital when when
(43:19):
one does turn up. I think the other thing that
one centers from investors is they're absolutely not kind of
entirely comfortable with the current setup of of of market
prices and fundamentals because you know, I think it's one thing,
(43:39):
you know, investors don't have an other people's money mindset, right,
It is absolutely their money that they manage and that
you know, they have been entrusted with, certainly our end investors,
and therefore they're trying to come up with what the
right thing to do is and it's quite hard to
find kind of that fundamental justification, you know, is a
(44:00):
high and fundamentals a week for just sort of you know,
you know, just plow on and keep the faith and
sort of diamond hand at whatever. So you know, I
think what what you send is that trepidation that they
have and sort of meet more and more people with
with grady degrees of anxiety, you know, on behalf of
(44:21):
you know, if it's a pension fund, you know, the
trustees of that pension fund, or it's an endowment, it's
the maybe some of the important programs that they're doing
with the funds that are available. The sovereigns kind of
you know, the longer dated you know, a wealth of
their countries, so they don't necessarily really want to just
(44:42):
be yoloing it. So you know, it's with that that
they kind of you know, maybe also what can appeal
is these more balanced portfolios where you're not just running lot.
Speaker 1 (44:54):
I've got to answer that because you mentioned it. If
you don't equity like returns, you know, in the US
for some people that only remember last year, that's you know,
in excess of twenty percent, So what does it mean to.
Speaker 3 (45:02):
You, well, yeah, and then in twenty twenty two, I
guess it was down about that much. So you know, yes,
I think I think you have to think about it
through the cycle. But I mean, equity like returns is
you know, maybe a bit of a glib phrase, James,
but you know, credit like returns is four to ten
and equity like returns is kind of you know whatever,
(45:24):
twelve to twenty and and you know that that is
that is just kind of broad bucketing as much as anything.
Speaker 1 (45:34):
So what's the edge then, where's the best relative value
right now?
Speaker 3 (45:38):
On the long side? Is really mining for you know,
what we're looking for is European bank owned risk that
tends to have been more conservatively underwritten in the initial
you know, in the initial underwrite and actually has the
(45:58):
hard asset backing. But what I would say is more broadly,
you know, it's a time for caution. There's a lot
it's difficult to underwrite longs because you don't necessarily know
what's going to happen next. But I think that sort
of where we're finding the best value is is in
things that were more conservatively underwritten initially on the long side,
(46:19):
which therefore pushes us to buy in bank non performing loans.
But you know, I think the you know, I think
the I think the bigger miss pricing lies still in
the lower rated parts of credit and utilizing those as
are short because they do imply a pretty low probability
(46:40):
of default and loss given default, which in these kind
of unusual circumstances may well not transpire.
Speaker 1 (46:47):
One more question from me, Rob, Bloomberg News has reported
that your firm is up for sale. What can you
tell us about that.
Speaker 3 (46:54):
I'm afraid that's something I can't comment on, but thank
you for asking.
Speaker 1 (46:58):
I'm sure you'll tell us first when it happens. Great stuff,
Rob Daforon, Chief investment Officer at Polist Capital Management. It's
been a pleasure having you on the credit edge.
Speaker 3 (47:05):
Many thanks, Thank you much appreciate it.
Speaker 1 (47:07):
And Tim Riminton with Bloomberg Intelligence, thank you very much
for joining us today.
Speaker 2 (47:11):
Thanks, it's been a pleasure.
Speaker 1 (47:13):
For even more analysis, read all of Tim Riminton's great
work on the Bloomberg terminal. Bloomberg Intelligence is part of
our research department, with five hundred analysts and strategists working
across all markets. Coverage includes over two thousand equities and
credits and outlooks on more than ninety industries and one
hundred market induses, currencies, and commodities. Please do subscribe to
(47:34):
The Credit Edge wherever you get your podcasts. We're on Apple, Spotify,
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at b pod Go. Give us a review, tell your friends,
or email me directly at Jcrombie eight at Bloomberg dot net.
I'm James Crombie. It's been a pleasure having you join
us again next week on the Credit Edge.
Hello, and welcome to the Credit Edge Weekly Markets podcast.
My name is James Crombie. I'm a senior editor at
Bloomberg and.
Speaker 2 (00:23):
I'm Tim Rimington, a senior analyst covering basic materials at
Bloomberg Intelligence. This week, we're very pleased to welcome Rob Deforne,
chief investment officer at Polus Capital Management, which invests in
special situations leveraged and structured credit.
Speaker 3 (00:37):
How are you, Rob, Oh, very well, thank you, Thanks
for having me today.
Speaker 2 (00:40):
Great to have you here. So Rob, you founded baby
Brook Capital back in twenty fourteen, which, after a merger
with Karen Capital, went on to become Polus and now
manages more than twelve billion in aum. Before that, you
were a partner at Eton Park and previously at Millennium.
So I have to say, as a highield analyst, I'm
very excited to be here asking you the questions. It's
(01:03):
normally the other way around, so I'm very excited to
hear what you have to say and heading over to James.
Speaker 1 (01:11):
Yeah, So before we get to the questions, I just
want to set the scene a bit. Markets are on
edge after the US lost its triple A credit rating,
Moody's was only really following the lead of the other
rating agencies, so the cut should not have been a surprise,
but it does come as another reminder of the fragile
state of US government finances, calling into question the concept
of risk free rate while also reigniting the Cell America trade.
(01:32):
Despite this, credit markets are projecting an air of calm
and optimism about the economy. All the losses from the
so called Liberation Day have been erased. Bond spreads are
back to where they were before the US announced tariffs
that were effectively embargoes, but the tide didn't lift all boats.
Spreads on the lowest quality corporate debt remain wide to
long term averages, indicating some concern about whether the weak,
(01:54):
highly indebted companies can survive as earnings decline and stagflation
risks rise. So what do you make of it? Credit
spreads would suggest that we're all in the clear now,
everything's going to be okay. What's your take?
Speaker 3 (02:05):
Well, yes, I think the there's obviously been an amount
of technical strength and credit hasn't there as they have
been in most risk markets over the last few weeks.
But you know, I don't think we necessarily see the
fundamental picture having been the sounding of an all clear.
You know, for us, I think as you as you
(02:26):
alluded to, we were actually at pretty much embargo conditions
and we've now gone to you know, from embargo and
potential kind of meaningful shock, meaningful non linear moment for
the economy, and we've pivoted that to know, a rewiring
of trade, and from that kind of more acute kind
(02:48):
of you know, let's call it real shock, we're moving
into a more sustainable, but longer duration potentially rewiring of trade,
which will just be you know, very very costly for
the global economy and certainly for the US manufacturing goods, importers,
et cetera. So you know, we definitely see the likelihood
(03:09):
of a fundamental impact to be setting in and setting
in for the medium term. So you know, it's with that,
I think obviously the markets have there are those technical
forces and kind of you know, people were underweight and
they sold a lot of risk and they had cash
(03:29):
balances coming into this, but they've really bought into the
idea that an all clear has been sounded. From a
pricing perspective, I think that does provide a medium term
opportunity to take to take the other side.
Speaker 2 (03:42):
Of it, and I think just following on from that
on the on the macro side. You know, one of
the things that I've seen in my coverage and Basic
Materials is essentially we've been in an industrial recession for
the past three years already, from around twenty twenty two,
and you know, we've heard again and again about this recovery,
(04:03):
you know, this H two recovery that never really materializes.
You know, do you think this shock that you know
might be materializing now is going to be the sort
of catalyst to sort of trigger another leg down.
Speaker 3 (04:18):
I think it is more likely than not. Would definitely
be how we're thinking about it. So you know what
you mentioned there about the sort of we have been
in relatively tough conditions for the last three years, so
we would absolutely agree with what we see. You know
right now is obviously your market very very focused on
(04:40):
sort of the next piece of information, the next piece
of news, whether it's tariffs, whether it's you know, US
rateing downgrades. But what it all really is is the
end of a fifteen year cycle, and this is a
late cycle. This is a late cycle time at the
end of you know, ultimately a pretty long period in
the most drawn out cycles that's been unsustainably and in
(05:04):
many ways artificially sustained for a few extra years. And
you know, is with that we do see as you say,
kind of that industrial recession. Yeah, you know, they have
been there have been various sub sectors that have been
struggling for the last few years, which is what you
(05:25):
get at the tail end of the cycle. You know,
we've been told about the restocking that was coming in
chemicals right for quite a while. There's obviously the early
losers at the tail end of a cycle, which you know,
if you're looking at basic materials, building products, and that
exposure to the housing market which has been lackluster, you
(05:49):
know since twenty twenty two, and the rise in interest
rates globally. So there have been a number of sectors
which have been stuttering. And you know what is actually
the most interesting, to be honest, is over that three years,
how you know we have avoided major issues already, right,
(06:09):
I mean I think that this, you know, our characterization
of the market, well the economy in a late cycle
period really does suggest that, you know, we are to
some extent on borrow time and you're really looking for
kind of what is the catalyst that tips it over
the edge in the end. And I think those kind
(06:31):
of very heavy goods associated sectors that you mentioned, which
are have interest rate sensitive end consumer demand are clearly
the ones which have been the weaker since twenty two
because those are the places where you know, end demand
was more constrained by the traditional interst rate function and
(06:53):
how it impacts consumer spending. I think kind of so
for us, you know, we really do feel that for
whatever shot comes down the pipe, we do think most
likely tariffs, but you know, it could equally be sovereign funding,
et cetera. There are several there are several things that
are kind of available at the end of this economic
(07:14):
cycle to be the ultimate one that breaks this breaks
the camera's back, as it were. But you know, they
all sit within a context of, you know, credit wasn't
that credit worthy over the last couple of years. You know,
we are looking at very very high debt to cash
flow statistics. We're looking at extremely high amounts adjustments of
(07:38):
adjustments to earnings, and none of these things can really
pay your debt, you know. So that's why the market
is somewhat more fragile in the credit sector is somewhat
more fragile in the lower rated spectrum to these forces.
Speaker 1 (07:55):
I feel like we've been talking about this scenario for
years though, in terms of, you know, the end of
the cycle and a big distressed cycle coming, and there's
all this money been raised for that strategy, and yeah,
it just never happens, you know, certainly on mass. I
mean there's there's specific situations. You see, there's companies that
you kind of see dropping into trouble and you know
that they're going to get into worse trouble. But you
know the size of that that opportunity just seems so
(08:17):
small relative to the whole market. So so why should
we worry? Now, what's the tipping point that we're really
focused on. What are the signs that you're seeing to
show that's coming.
Speaker 3 (08:25):
Yeah, Look, it's the process, right, The creation of of
of excess misallocated credit is very much a process, and
it takes place over a sustained period of time, and
that you know, that was really the build up of
debt through that low interest rate period that we've had
(08:46):
since the GFC. So you know, the statistics really are
that we have seen that incredible pick up in just
the amount of the volume of sub investment. Great credit.
You know, we're not worried about credit in general. Investment
grade balance sheets are very strong, and you know, there
was a corporate windfall from effectively the pandemic and the
(09:07):
pandemic in era stimulus. So investment grade companies are about
as about as good as they have been. Yeah, they've
they've maybe overspent a little bit on buybacks, right, you know,
ultimately and kind of left a bit of leverage on
balance sheets. There are, of course a few exceptions which
are a little bit weak, but you know, by and
(09:28):
large igs okay. But high yield went from being that
niche asset class to you know, very much mainstream post
to GFC maybe five hundred billion dollars of loan and
high year bonds outstanding, which is now five trillion dollars. Right,
ten x the number of names, you've ten x the amount.
But in that period of time, actually a lot of
(09:49):
the sort of number of eyeballs looking at things has
been outsourced to passive you know, passive purchasing. So the
the kind of that has a lot the kind of
a man of scrutiny on a lot of the single
names to be reduced. So we definitely have kind of
through that process. You know. My point here is really
that we have been building up this misallocation as a
(10:12):
process and then kind of you know, credit always gets
to the same tipping point at the end of a cycle,
which is what is the point where you sort of
compare your growth rate the G, with your financing costs,
your interest rate the R, and what matters to servicing
credit is you kind of need a bigger G and
(10:32):
a smaller R. And obviously, through the period of low
interest rates the reason why credit was misallocated. Then you
can see that from kind of how much credit grew
relative to GDP, right, you know, so much more credit
growth than there than there was GDP growth. And you
get to the end of that process where you didn't
(10:53):
need much G. Right, you didn't need to be producing
much G you know, pre pandemic because because the R
was so low. Come out of kind of the pandemic era,
you know, twenty twenty two onwards, and we've seen kind
of the R, the financing costs, the risk free rate
for the economy pick up, but we haven't really seen
(11:13):
a ton of real growth. And then the thing that
kind of obviously everyone who was said, have said, well, look,
the moment where your our versus G mixed, your ORE
rises quickly and your G is constrained because you know,
the economy is ultimately interest rates sensitive, was when we
went into the hiking cycle of twenty two, And I
(11:33):
think it's pretty fair to say that would be attributed
to be a pretty good, you know, kind of starting
bell for the the the unraveling of what at the
time was a sort of twelve or thirteen year period
of pick up in debt. The reason why it didn't
is not, in my view, because the economy is no
(11:55):
longer interst rate sensitive or as interest rates sensitive as
it was, is actually that it was a very unusual
period where that monitor tightening came with an enormous fiscal loosening,
so the monasary tightening didn't bite as much as it
otherwise would have done, not only the fiscal loosening that
we saw twenty two to twenty three, twenty four, but
(12:16):
also kind of the legacy unspent fiscal funds from twenty
to twenty one. So really it has to be thought
of as a stock flow impact, which is ordinarily you know,
twenty two's interest rate cycle and the aftermath of it
would have created those higher interest rates, higher financing costs,
which would have you know, really started the pinch on
(12:39):
corporate credit balance sheets. But the economy was just awash
with fiscal money and then got more physical money, and
that did kind of that unsustainable element did did draw
out this tail end of the cycle. But you know,
the forces of physics and the forces of finance, you know,
they don't change, right, This is just a stock flower,
(13:00):
and we went into the usual kind of bad flow
piece of lower growth and higher financing costs, but with
a much larger stock, much larger buffer for the economy
to take it. But you know, we call this time
under tension, right, which is also the corporate don't. They
don't roll over at the first moment of a higher
(13:22):
interest rate. You kind of have to leave in place
that period of higher interest rates and lower growth for
a longer period. Is the time under tension, not just
the existence attention. And that time is a little bit
drawn more drawn out this time because of because of
the support that offset the monetary tightening that we had.
(13:43):
But it is real, right, and you do see kind
of it's more of a niche practice, but obviously you've
been a massive pickup in liability management distressed exchanges, and
we've had a pretty meaningful sort of default rate across
leverage loans and high yield right you know, for a
robust part of the cycle, it's been non zero, which
(14:06):
is which is unusual and is now being followed up.
What's super interesting right now when you think about that
kind of the impact that interest rates have. You know,
we're now starting to see that pickup in delinquencies, you know,
certainly in the US across credit card, auto loan, obviously
the end of student loan for bearns, the impact that
(14:29):
that has an f A h A mortgages. So I
think a large part of kind of that delayed reaction
coming through from from interest rate hikes is starting to
be seen in the data in the in the US consumer.
We're going to have it in Europe as well, with
a kind of moderate upwards drifting NPL. So you know,
(14:50):
think about it. We think about it as kind of
you know, the foothills before the mountain, as you can
kind of go on the slower sent and then and
then it kind of picks up more broadly after that.
So you don't always need a shock. I think like
the financial markets love to look for that one shock,
and it could actually just be a set of things
(15:12):
building in the background. If you allow me to the
labor my R versus G thing for a little bit longer,
I would say that, Well, the reason why tariffs are
a really interesting one is because they in it as
a supply shop for the US and a demand shock
for everyone that exports to the US, so simultaneous supply
(15:36):
demand shop. We don't see many simultaneous supply demand shocks,
So that's you know, highly likely to be a lower G,
and for every unit of lower G, you're going to
have a slightly stickier R. As we know sort of
central banks should be it should be slightly harder for
(15:57):
them to react to slow down in growth because this
is something that raises prices, even if it's only on
a one time basis. I dispute that, but you know,
because it's a supply shot. But you know, the you know,
you will make the G versus our mechanic harder. So
(16:17):
the interesting thing about about tariffs is you stop. You know,
My view would be we are starting with a difficult
starting point for the end of a cycle. Big pickup
in debt it has been sort of artificially extended by that,
by that fiscal policy, which is effectively allowed kind of
(16:37):
three years of additional poor management for those corporates to
stick into place, and then you're hitting it with you know,
what should be a credit negative shock at the end.
So it's very difficult time to be a kind of
highly levered corporate because obviously it is a companies do
have the ability to react to some of these things.
(16:59):
But if you've got a lot of debt than your
ability aware with all an effect of deep degrees of
freedom to act are meaningfully lower. And so I think
kind of, you know, leverage is really the enemy for
a corporate at this time.
Speaker 2 (17:14):
And in terms of your strategy, you know, how are
you how are you positioned to take advantage of that view?
You know, you mentioned perhaps US markets might see more
opportunities there. You know, I think that's interesting, you know,
covering chemicals, the US has actually been until recently one
of the stronger markets and Europe's been the weak one.
But perhaps with the tariff shock that's now going to reverse.
Speaker 3 (17:37):
Yeah, yeah, I mean, how we're positioning for it is
we do have a more substantial book of single name
high your credit shorts. So we have increased the let's
call it the percentage exposure of the fund as well
as the number of names that we're exposed to, because
(17:59):
you know, as I mentioned, if you came into if
you came into this year, you know, we were certainly thinking, well,
there is that general misallocation in credit, right, and there's
obviously kind of those misallocations could be poor quality yearnings,
weaker businesses from a cyclical or secular basis, then you
(18:20):
impose on it. Additionally the tariff issue. You understand, there's
kind of our number of different sectors at play. Challenges
for consumer discretionary businesses as there's just less real link
and that impacts lots of different service and goods businesses.
As I mentioned earlier, the housing cycles being struggling, so
there's a lot of different sectors that are actually impacted here.
(18:44):
So really what we're we've been looking for is week
company with high leverage. We obviously like subordination as well
in shorts, because if someone sits ahead of you in
the queue in one of your restructurings, then the recovery
(19:04):
is clearly likely to be lower. Right, Because we're obviously
selecting for high loss given default, looking for those low recoveries.
We're selecting for a high probability of default. The company
has leverage. We business cyclically challenged because of the because
of the particular dynamics in the end markets that might
be unfolding. So you know, basically expanding by number the
(19:28):
set of situations that we have, but also increasing the
number of them that we have Paris would draw in
a larger larger set of names, clearly, But as I
mentioned earlier, you know, we are talking to several thousand
names in the high yield market. So if you were
to say we focus on the bottom ten or twenty
(19:50):
percent of names by quality, that's still one thousand names
that we could be looking at and pouring over to find,
let's say the weakest one hundred and fifty or two
hundre hundred. So it's really mean about kind of screening
and looking for more weaker situations, trying to understand what
would a cyclical slow down globally mean for that business,
(20:13):
what would the tariff cost mean for that business. I mean,
we've seen kind of a lack generally of commentary from
companies and therefore you know they have not been educating
analysts on the exact costs right of tariffs to them.
Obviously a lot of them will hide behind well, I'd
(20:33):
buy my things from a US based distributor, right, You're like, yes,
in the US based distributor probably purchased it from somewhere
else that wasn't in the US. Right, So you know,
the clarity of the information there isn't super clean. But
ultimately an enormous amount of intermediate products do you come
into the US from other countries, So there's a lot
(20:55):
of analytical work to do there. We would spread our
bets these days in terms of kind of the number
of situations we would look at quite simply because the
nature of restructurings has changed, Right. You know, we see
a lot of distress exchanges in lmes, and what those
(21:17):
really are is sort of, you know, in the nicest
possible way, is you know, avoiding a default that should
have happened now and almost always pushing into the future. Right.
You know, the majority of these companies do not make it.
You're buying time, but ultimately buying that time doesn't actually
(21:38):
generate success for the equity owner of the business. And
it's because of that kind of appetite to pursue those transactions.
You're seeing a lot of you know, the definition of
zombie has widened, right from something that's sort of looked
like it might not have been able to pay the
interest and principle on its debt to literally one where
(22:00):
the creditor said, you don't have to pay me anymore.
Let's just pretend that you know, we're still with you know,
this is still a performing credit. So it's because of
that kind of dynamic in the market that we like
to kind of shield ourselves maybe from what we see
as as those sort of not full restructurings.
Speaker 2 (22:18):
Yeah, I'd actually like to push a bit further on
the on the ownership and kicking the can down the
road theme. But before we do that, I think it
would be quite interesting to hear a little bit more
about the mechanics of how you shot these names. Are
you looking to do it physically synthetically? Can you talk about,
you know, how you manage some of the risks, you know,
(22:40):
they're quite expensive short sometimes, you know, the liquidity can
be an issue. You know, perhaps even any examples you're
able to share.
Speaker 3 (22:48):
Well, to be honest with you, I think the biggest
the biggest way of managing your risk there is is
to leave as few footprints as you can. Right. So
one of the reasons why we have you know, a
lot of shorts, so you know, hundreds, is so that
we're not exposed to any single name and the instability
(23:09):
of repo or the ability to borrow bonds in any
one of those names. We don't tend to use a
lot of synthetic, so we don't tend to use a
lot of CDs. I think both sides of the Atlantic
have obviously seen lots of high profile examples over the
years of CDs not really being a particularly efficient tool
(23:29):
for taking a view on on credit. You know, plenty
of high profile examples where company went bust but CDs
was uphaned or you know, engineered default or what have you. So, yeah,
we stick to the physical market, but leave no footprints. Really,
So if we if we have you know, if we
(23:51):
spend the effort analytical time, research, you know, research time,
research expense on finding as men of the weak names
as possible, we can have a smaller position in each one.
Therefore there isn't going to be crowded repo in them,
and and and as a result, you know, the cost
(24:15):
tends to be lower, the availabilities higher, the liquidity risk
is lower, so we kind of manage around that, to
be honest with you, just but what it requires is
to have looked at a lot of names, because if
you're going to assured one hundred and fifty names, you
have to have looked at one thousand, and you have
to have looked at them properly, you know, I would
say that kind of in this very very low volatility
(24:39):
period that we've been in for a while, excluding April
and May twenty five, the availability of repo for high
year bond has been very very high because it was
a good source of financing revenue for low fee, low
fee funds, and you know, there wasn't really a market
(25:02):
or appetite for shortening any of the debt, so you know,
it was just ultimately for the end owner of the bond,
quite good way of generating extra income. So the availability
and depth of the repay market is higher than it
ever has been. I think what we would expect as
times get slightly tougher for these credits, we'll see more,
(25:24):
we'll see more kind of you know, instability in that market,
and we'll probably see more regulator reinforcement action as a result, right,
you know, because sort of the easy way to generate
a bid for a weak position is to try and
engineer a repost squeeze by the end owner, and you know,
(25:44):
obviously you're not allowed to do that, so you know,
it is something that the regulator knows to look out
for at the end of a cycle. So a lot
of the times the instability and the risk you're managing
around is really around somebody doing something they're not supposed to.
So fortunately we have regulators for that.
Speaker 2 (26:03):
So would you see opportunities in some of these more
creative lem examples we've seen over recent years. I mean,
Federick Gourney had a toggle pick that came out last year.
There's been a number of other picks or partial picks
from you know, highly levered European names over the last
year or so. You know, is that the sort of
(26:25):
thing that interests you as well?
Speaker 3 (26:27):
In a word, no, the look, you can make money
on them here all there. But I think as a strategy,
I buy credit and the goal with credit is I
you know, when you're buying it, you want to make
a yield, right, and the yield requires that I get
paid a coupon, and I also get my money back
(26:50):
at the end, and that, unfortunately, is one of the
reasons why I don't think lms in distressed exchanges, et
cetera work particularly well, which is, if I'm picking and
rolling out maturities, then I'm not getting paid either the
principle or interest, and therefore I'm kind of left wondering
(27:12):
how if I have to be the end owner of
that credit, right, if I cannot find a way to
recycle that risk, I'm left wondering how I'm going to
make a profit, because the reality is I'm probably taking
a corporate that has been struggling recently. I'm leaving the
(27:33):
current management team in to continue running it in an
otherwise difficult It's obviously a difficult cyclical or secular environment
with the same amount of debt and presumably relatively constrained
cash flow. Because if they can't pay me as a creditor,
presumably they're they're under investing in R and D, CAPEX,
(27:56):
they might actually be underpaying staff, you know, all of
those things. That doesn't strike me as kind of a
situation where I would be saying, Okay, well, I'm going
to get my money back as the person who ends
up holding these because this company's going to recover because
it just doesn't have Like you just statistically, if you're
short on cash, you can't pay your debt. You haven't
(28:17):
got less debt and your cash flow constrained, and you
left the same management team in and you had a
bad starting point. I don't see how I underwrite the recovery.
So you know, ultimately, when we're looking at these situations,
we want to be the top of the stack. We
want asset based situations. I want them to be free
(28:38):
cash flow positive before debt service, so that I know
that the thing I'm buying actually has some cash flow
coming into that box. And and and you know a
lot of these lems the issue is they are burning cash, right,
you know that it's not they're not generating cash, and
therefore they're very, very difficult to do from a stress
(28:58):
and distress perspective.
Speaker 2 (29:00):
Yeah, so I think I'll sort of pivot onto the
private equity side of it now. Then, you know, you
mentioned you're seeing a lot of kicking the can down
the road, you know, with these lemis. I totally agree
private equity firms huge driver of issuance in the sector,
but the exit market seems largely closed. You know, I'm thinking,
(29:22):
especially in the industrial sector, multiples that come down earnings
are you know, troughing. You know, so we've heard talk
in the past of sort of there being dry powder
and you know, they can sort of continue propping up
these these companies. I think, you know, anecdotally, we might
have seen a bit less of that dry powder being
deployed and a bit more of these more creative financing
(29:43):
opportunities or solutions rather. You know, how do you view
the ownership structure of the you know, the positions you're
taking on the on the short and the alongside. Is
there sort of specific you research you do into pe
funds that you know may have been fully deployed and
you know are limited on the on the drive powder.
Speaker 3 (30:06):
Yes, so you're definitely looking for that as one of
your pieces of due diligence. Is the likelihood of a
company to be supported by by the owner. It's worth
remembering there's an awful lot of debt is on non
sponsor businesses as well, especially in the US market. But
(30:26):
it is true that kind of there is a lot
of sponsor There are a lot of sponsor businesses. You know,
it's not a surprise to anybody that exits have been lower,
right in terms of frequency. There's obviously, you know, lots
of high profile news out there about the discomfort that
private equity investors have about the lack of return capital,
(30:51):
and it looks like it should continue, right, you know, ultimately,
which is it is hard to see what really brings
about a wave of exits, right. You know, so private
equity activity is easier to envisage in a decent economy
with low rates right and low finante costs. So you know,
(31:15):
we don't have the low enough rates and we don't
have a decent enough or stable enough economy right now,
so it is difficult to imagine being able to monetize
at the multiples that the would effectively get private equity
out at their now. So you know, obviously, with that,
(31:38):
the idea of dry powder is key. Now, there's two
types of dry powder, right. The dry powder in the
private equity firms is also dry powder in private credit.
So you have to take both of those things into
account as a potential source of capital into your lungs
(31:59):
and shorts. And you know, candidly, if you're long, you're saying,
I wonder how I can get some of that dry
powder into this business. And that absolutely happens. Not every
company that enters stress or distress is insolvent. Some of
them are just over levered. So effectively, we would push
(32:23):
the equity owner of the business, you know, or sometimes
of a sponsor, you know, if you want to keep
this asset, support it with some equity, and that goes
to pay me down and de levers me. And I
feel like I'm in a better place, and I will,
you know, make some compromises to you, maybe on kind
of the duration of I'll leave the capital with you, you know,
(32:44):
in return for that. So we really would ask that
if we were a long something that the private equity
company does step in with cash. What has been interesting
has been that in a lot of l and ees
that the owners of the debt have not pushed for that.
They've basically given the private equity firms a free option
(33:04):
on holding the business and running it into the future.
And you know, which is odd in situations where it's
not working right now, right there is stress and distress
because you know, maybe it's the governance of the business,
maybe it's the capital structure, maybe it's the business itself,
but it's not working. You do need to change something,
(33:27):
and you know, that does strike me as odd that
that hasn't happened. It's worth noting that the kind of
private credit dry powder. You know, sometimes they could come
in as a refinancier if they're very friendly. You know,
you've bought something as a stress debt, but they're very
friendly with a private equity sponsor and they come in
and do some refinancing, sometimes as a second lean, and
(33:50):
we might have been a first lean, so they've kind
of taken the role of putting that extra cash into
Deleverers as the first lean. But in general, you know,
I would say that your goal has to be well,
there is dry powder out there, so if you long something,
you should be finding a way to get that capital
(34:11):
into the business. And when we're short something, it is
you know, just ultimately it is a risk that that
that capital comes in, but it frequently hasn't, right, And
the reason why it hasn't is because the capital from
your investors is absolutely precious, right, you know, it is
it is you know, and it has to be used
(34:33):
for you know, it has to be used for the
right purpose. Your fiduci you duty to be a good
custodian of that capital. And if and if the business
isn't working and you're not achieving any deleveraging, then you know,
really you're not doing the right thing for your investors.
And if that is what ends up happening as a
(34:54):
private equity firm, just dropping some money into a into
a failing business that you kind of knew you were
going to burn, then it starts to taint your reputation
for future future capital raising, and that that is effectively sacrificing.
You know, that's the one thing that you would never
want to do. So I see why they've been cautious,
(35:15):
which is why would they put the capital into some
of these situations. Like you know, if you imagine a
business has you know, two billion dollars of debt and
it's got a sustainable debt capacity of one billion dollars,
which is probably about the right maths for a lot
of these credits. Well, you know, what can you put
in there to achieve a one billion dollar debt right off?
(35:37):
And it might be you know, no one's willing to
take that. They'll only do that if you hand the
business over. You can't really put in fifty million of
new equity and hope that people are going to ride
a billion off. So the kind of maths hasn't really
been working. And then kind of saying, well, we've got
a pretty high nave on this asset. You know, how
(36:00):
do we sell this twelve times leathered business at sixteen times?
You know that's difficult as well. We need to deliver
it at six to six before we could, and you know,
the math doesn't really work. So they're keeping the dry
powder safe.
Speaker 1 (36:14):
I me, but some of the distressed investors out there,
I mean, there's so much cash that they've raised over
the years for not a lot of opportunity in relative terms,
there seem to be under pressure to deploy, and in
some cases they're lending new money to these stressed companies
that seems to be more, you know, more of a
popular strategy. How do you see that? I, well, we don't.
Speaker 3 (36:36):
Do that because I'm old fashionate enough James to think
that a company that's struggling with too much debt might
not need more of it. So look the way that
I think the way the industry is it has proceeded
to say, in the absence of interesting secondary distress purchases
(36:57):
right of buying somebody else's mistake. They pushed towards kind
of primary stress and to stress. So lend money into
a struggling situation. And I suppose the capital solutions industry
has evolved from doing into doing that in an effectively
subordinated format. Now I can't imagine taking a stressed company
(37:19):
and wanting to put subordinated capital into that, right, but
I know it happens. I think that you know that
the turnaround that would be required in that situation in
terms of the operation of the business, the quality the
business would just be enormous that you would have to
underwrite two to feel that you were definitely going to
(37:39):
get that money back. You know, we would obviously do
senior rescue financy, but that's not really what's been happening
out there, right, You know, a lot of it is
really sort of stressed subordinated. So you know, rule number
one never subordinate yourself and the other is never pick yourself.
So if it breaks the the cardinal rules, then I
(38:01):
wouldn't do it. So, yeah, we're not really into that.
I think kind of more broadly, for your investors, you
also have to think about, well, what am I really doing? Right?
The reason why we stick to only secondary purchases the
average purchase price on our distress debt. So we've done
our one hundred and thirty five transactions in nearly twelve years,
(38:22):
the average purchase price has been fifty five cents on
the dollar. So the thing about entering the debt via
the secondary at a discount, they have to be able
to find it right, and that's a whole new thing.
You know, we have managed to sustain a franchise for
purchasing that secondary distress debt. But if you buy the
right stuff, you have gone into a situation where you
(38:47):
kind of feel like the worst thing has already happened, right,
You've gone bankrupt. And therefore, kind of if you think
about the conditional probabilities of this, what's the probability wants
a really terrible thing has happened, then another really terrible
thing happens afterwards, and also it is clearly much lower. Right,
the bad thing has already happened. So, you know, we
(39:09):
got in there at fifty five cents on the dollar
feeling like, well, if we can get the assets or
cash flows, maybe get forty five or fifty back but
if we get it right, there's a potential equity like
return available here. The problem with giving the company fresh
new capital on a primary basis is you basically given
them one hundred. You said, well, keep paying me my
(39:29):
twelve of coupon that you're going to afford. But if
I get it wrong, I get zero. Right, So you know,
if you think about the skew on ours, we've paid
fifty five to try and get somewhere between fifty and
one hundred, and you know if you but if you've
done the primary example that new money capital solutions is money,
you've given them one hundred. Your best case, you get
one hundred. In your worst case you get zero. But
(39:51):
you subordinated yourself, so the probability of the zero is
much higher. So you have to charge a pretty substantial coupon.
But then theblem is that the company's probably struggling. If
it's struggling with debt, then it's going to be picking
your coupon presumably, So it kind of falls a little
bit down on the common sense thing, which is, you know,
if you were talking to your grandma about that, what
(40:13):
would she say, you know, when you'd sort of you
know her neighbor wasn't paying their mortgage, so you said, well,
i'll give you, you know, I'll give you another twenty
five percent of your house value. You don't have to
pay me a coupon, and I'll sit behind the bank.
You know. She would say, well that now, I'm not
sure that makes a ton of common sense. And I
(40:35):
think you know, that's why we would describe maybe that
primary Cap solutions as an innovation as we call it
in finance, which isn't a real innovation. It might just
be a fad.
Speaker 1 (40:47):
So when you're pitching this rob to you investors out there,
you know, in terms of a strategy, what's the upsite
right now? What's kind of questions they asking you? In
you know the context? Also, you know they can get
five and a half percent on an investment grade by
with zero likelihood of default, So why should they stick
their necks out and really you know, jump into distress
right now?
Speaker 3 (41:06):
Well you can definitely make more than that on good distress,
you know, so it really forms part of a you know,
balanced portfolio, right you know. And and what I think
you're really saying to investors is, look, that becomes a
time each cycle, right, we have these micro distress cycles
(41:29):
and we have a macro distress cycle. You know, ultimately
also insues and what they provide you is the opportunity
to create assets at the meaningful discount to their intrinsic
value via the debt. And so you can actually make
equity like returns from you know, being senior in a
capital structure, right, so you can actually be in the
(41:49):
in the lower risk part of it, and you can
make equity live returns from that top of the cap
stack position in really really great assets, right. You know,
it could have been done in realists day, or aviation
or hotels or yeah, some operating businesses, infrastructure, you name it.
So you can get these brilliant businesses and you can
actually take the kind of thin slices at the top
(42:11):
and generate equity like returns from that. But you only
get that every so often, and it's in these periods
where you've kind of kind of the misallocation has has
built up over the years, and you get to a
position where when we get the market clear and you
you absolutely get kind of a brilliant opportunity for that.
I think investors have been really receptive over over the
(42:35):
over the last couple of years. I think they they
have have a couple of perceptions. One of one of
them is we also we have kind of a real
business for doing this, right. It's not just waiting for
the things to kind of turn up and jump jump
out at you off the screen. We have had to
kind of find a way to keep sourcing the really
(42:57):
interesting risk that fits that top of the capital strut
a big discount against asset based situations, right, and having
built that infrastructure has been really key for investors to
understand that, well, we can find things when there isn't
a big macro cycle, then when it turns up, hopefully
will be a safe custodium for their capital when when
(43:19):
one does turn up. I think the other thing that
one centers from investors is they're absolutely not kind of
entirely comfortable with the current setup of of of market
prices and fundamentals because you know, I think it's one thing,
(43:39):
you know, investors don't have an other people's money mindset, right,
It is absolutely their money that they manage and that
you know, they have been entrusted with, certainly our end investors,
and therefore they're trying to come up with what the
right thing to do is and it's quite hard to
find kind of that fundamental justification, you know, is a
(44:00):
high and fundamentals a week for just sort of you know,
you know, just plow on and keep the faith and
sort of diamond hand at whatever. So you know, I
think what what you send is that trepidation that they
have and sort of meet more and more people with
with grady degrees of anxiety, you know, on behalf of
(44:21):
you know, if it's a pension fund, you know, the
trustees of that pension fund, or it's an endowment, it's
the maybe some of the important programs that they're doing
with the funds that are available. The sovereigns kind of
you know, the longer dated you know, a wealth of
their countries, so they don't necessarily really want to just
(44:42):
be yoloing it. So you know, it's with that that
they kind of you know, maybe also what can appeal
is these more balanced portfolios where you're not just running lot.
Speaker 1 (44:54):
I've got to answer that because you mentioned it. If
you don't equity like returns, you know, in the US
for some people that only remember last year, that's you know,
in excess of twenty percent, So what does it mean to.
Speaker 3 (45:02):
You, well, yeah, and then in twenty twenty two, I
guess it was down about that much. So you know, yes,
I think I think you have to think about it
through the cycle. But I mean, equity like returns is
you know, maybe a bit of a glib phrase, James,
but you know, credit like returns is four to ten
and equity like returns is kind of you know whatever,
(45:24):
twelve to twenty and and you know that that is
that is just kind of broad bucketing as much as anything.
Speaker 1 (45:34):
So what's the edge then, where's the best relative value
right now?
Speaker 3 (45:38):
On the long side? Is really mining for you know,
what we're looking for is European bank owned risk that
tends to have been more conservatively underwritten in the initial
you know, in the initial underwrite and actually has the
(45:58):
hard asset backing. But what I would say is more broadly,
you know, it's a time for caution. There's a lot
it's difficult to underwrite longs because you don't necessarily know
what's going to happen next. But I think that sort
of where we're finding the best value is is in
things that were more conservatively underwritten initially on the long side,
(46:19):
which therefore pushes us to buy in bank non performing loans.
But you know, I think the you know, I think
the I think the bigger miss pricing lies still in
the lower rated parts of credit and utilizing those as
are short because they do imply a pretty low probability
(46:40):
of default and loss given default, which in these kind
of unusual circumstances may well not transpire.
Speaker 1 (46:47):
One more question from me, Rob, Bloomberg News has reported
that your firm is up for sale. What can you
tell us about that.
Speaker 3 (46:54):
I'm afraid that's something I can't comment on, but thank
you for asking.
Speaker 1 (46:58):
I'm sure you'll tell us first when it happens. Great stuff,
Rob Daforon, Chief investment Officer at Polist Capital Management. It's
been a pleasure having you on the credit edge.
Speaker 3 (47:05):
Many thanks, Thank you much appreciate it.
Speaker 1 (47:07):
And Tim Riminton with Bloomberg Intelligence, thank you very much
for joining us today.
Speaker 2 (47:11):
Thanks, it's been a pleasure.
Speaker 1 (47:13):
For even more analysis, read all of Tim Riminton's great
work on the Bloomberg terminal. Bloomberg Intelligence is part of
our research department, with five hundred analysts and strategists working
across all markets. Coverage includes over two thousand equities and
credits and outlooks on more than ninety industries and one
hundred market induses, currencies, and commodities. Please do subscribe to
(47:34):
The Credit Edge wherever you get your podcasts. We're on Apple, Spotify,
and all other good podcast providers, including the Bloomberg Terminal
at b pod Go. Give us a review, tell your friends,
or email me directly at Jcrombie eight at Bloomberg dot net.
I'm James Crombie. It's been a pleasure having you join
us again next week on the Credit Edge.
Host
James Crombie
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