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9Questions is our Q&A series featuring key decision-makers in leveraged finance — get in touch if you know who we should be talking to!

Chaney Sheffield is an investment partner at Canyon Partners and a co-portfolio manager for Canyon’s Distressed Opportunity Fund IV. He also oversees the investment team focusing on packaging, leisure, lodging and gaming sectors. Sheffield was previously at Morgan Stanley, first as an investment banker and then as an investor in distressed and special situation securities.

He spoke to 9fin about distressed debt opportunities, evolving language in credit documents, in addition to consolidation in the casino space.

1) You joined Canyon Partners in 2008, right around the time of the Great Financial Crisis. What lessons can today’s levfin community learn from that credit cycle?

I joined Canyon the day IndyMac Bank was closed by regulators. I remember being welcomed with the phrase, “Here is your desk, now fasten your seatbelt.” The next year certainly proved to be quite the roller coaster.

One of the biggest lessons learned from that crisis was it takes time for markets to grapple with regime changes. With unprecedented monetary policy intervention, investors needed to be told: “don’t fight the Fed.” Of course, the market learned this lesson well, and that resulted in over a decade of a “buy the dip” mentality.

The leveraged finance market exploded over this time frame. Capital structures, real estate projects, and Federal deficits were all constructed with a “lower for longer” mentality. As we sit here today, we are potentially trudging through a reversal. “Higher for longer” is getting more acceptance but similarly, it will likely be a prolonged process, and the leveraged finance markets will have their work cut out for them dealing with capital structures built under a different regime.

2) Defaults and distress have been ramping up over the last few months — what is Canyon doing to prepare for this?

Ensuring a deep understanding of what is in all loan documents is key to succeeding in a market in transition, so we are doing what we always do: digging into our credits, scouring the indentures and credit agreements, and developing scenarios to identify opportunities to invest with solid downside protection and attractive returns for our investors.

We are re-underwriting names we passed over the last few years, preparing for a potentially prolonged distressed cycle as the financial system adjusts to higher rates. Today, our analysts have “shopping lists” for our traders. These are credits we like fundamentally, and we stand ready to pick up loans and bonds should selling pressures result in offers that hit our price targets.

3) Last October, Canyon said that hung bank bridge loans are a great buy for distressed debt investors given the discounts on some of these deals — has Canyon’s view changed since then?

Not really. We are always excited to look at situations where selling pressures can result in discounts to what we believe is the fundamental value of the credit. These are case-specific situations, but distressed investors generally want to step into situations that reflect broader market stress, rather than an idiosyncratic credit problem.

4) Given the history of distress in the gaming sector, how are casinos positioned financially as we head into a possible recession — and is there potential for any M&A in the sector?

Interestingly, despite being forced to completely shut down operations during covid and incur a substantial amount of extra debt to survive, casinos are generally much less levered today than entering 2020. The entire industry was able to rethink their business models, and emerged from the shutdowns with a much leaner cost structure, both on number of employees as well as the amount of promotions given away to customers.

Additionally, as the economy reopened, almost all gaming, lodging and leisure sectors experienced, and continue to experience, incredibly strong demand. While initially explained by “pent up demand”, the strength of the recovery has generally been stronger than anyone expected. The mega trend of consumer spending favoring experiences over goods seems to have accelerated after consumers were forced to stay home. Additionally, gaming and lodging spend continues to be supported by the return of business travel, and most recently China’s reopening.

Regarding M&A, consolidation has been a consistent theme for decades, facilitated by the rise of gaming REITs like VICI Properties and GLPI, and we believe the advent of online sports betting and online casinos will continue to drive M&A discussions. Casinos are in an arms race to provide an omni-channel (brick and mortar as well as online) offering to their customers, as they try to drive customer loyalty, and scale is a key part of that strategy.

5) In the leisure and lodging sector, some brands are confident that high earning customers can help them weather inflationary pressures and a potential downturn. Do you still see this as a viable strategy?

Yes. I think exposure to a higher earning customer will help them weather inflationary pressures, but the answer gets more complicated if we shift to recessionary environments and depends on the business and the depth of the recession. Luxury hotels, Las Vegas Strip casinos, or high-end restaurants that are exposed to significant amounts of corporate travel can see large swings in revenues if corporations tighten their travel and entertainment budgets.

Conversely, the ski industry will likely demonstrate more stability as their higher-end customers tend to ski in the winter regardless of the environment. On the lower end of the spectrum, regional gaming companies, or regional theme parks tend to be more stable, as some customers choose to stay closer to home than head to a destination resort.

6) How are packaging companies coping with supply chain disruptions and rising input costs? What other headwinds are these companies focusing on?

So far, packaging companies have coped fairly well. Significant price increases have generally gone through faster than expected. This makes sense because of the pervasiveness of inflation this time around.

In past periods of margin squeeze, packagers faced input cost increases while the broader inflation environment remained tame, setting up very difficult conversations with their customers pushing back on increases. With broad based inflation and well documented supply shortages, packagers’ pricing power clearly improved.

More recently, supply chain pressures have eased, reducing the cost on packagers. While this is clearly a relief, demand and labor are the headwinds companies are focused on today. In the fourth quarter, managements saw demand really drop off, which they have positioned to investors as (hopefully) a one-time inventory de-stocking from their customers.

Dealing with slow supply chains, customers over-ordered to ensure supply. Once supply chains improved, they found themselves with too much inventory. Lower demand will clearly impact pricing power going forward, but thankfully improving supply chains have eased cost pressures at the same time.

The most persistent problem facing packagers, and much of the broader economy, is labor. It is still very difficult to staff plants, despite significant wage increases, and turnover remains high. Managements are clearly focused on improving their operations and investing to modernize and potentially consolidate facilities.

7) More issuers have been choosing private credit over the broadly syndicated market — how will this impact restructuring negotiations in the future?

All else equal, the rise of private credit will elongate a credit cycle, delay restructurings, and potentially result in fewer defaults in a mild or temporary economic downturn. As a lender, when investments are held in vehicles that don’t mark to market, there is a strong incentive to reach a deal quickly, provide some relief to the company, and hope that the company’s cash flows rebound.

This is all about constructive and collaborative work to help companies avoid costly and distracting restructurings. In mild, or brief downturns, temporary relief is often all that is required to maintain a credit’s health and after all, the goal of the private fund is to earn a solid return and get repaid.

If we experience a prolonged or severe economic downturn, it is likely we will see a significant number of these private credits default. These capital structures are heavily exposed to floating rates, and it may simply be the case that they are no longer sustainable. You might even see private creditors seek liquidity by attempting to sell their exposure, rather than workout the deal internally.

8) Are there any specific provisions in credit documents that have/are becoming contentious recently?

“Sacred rights” covenants are a hot topic, wherein a majority group of lenders attempt to disadvantage the 49% minority. Most often, this is attempted by amending pro-rata provisions and releasing substantially all of the collateral backing the debt. As a result of a series of transactions, the 51% majority moves to a new loan that is effectively senior to the 49% minority left behind in the original, now substantially weakened debt documents.

While there has been a recent increase in these creditor-on-creditor aggressions, we suspect lenders will take actions to protect themselves by signing cooperation agreements, and revising documents, where possible, to strengthen the language protecting these sacred rights (like increasing the voting threshold to 67% from 51%).

9) We had to throw at least one East Coast versus West Coast question in here: Which do you prefer and why — Shake Shack or In-N-Out Burger?

I spent 10 years on the East Coast, and I will admit I do enjoy Shake Shack. They do a great job. But, I was born and raised in Southern California. At Shake Shack I go with the Chicken Shack 90% of the time because no burger can compete against a Double-Double with grilled onions. Too many happy childhood memories hitting up In-N-Out with Dad after a little league game to change loyalty.

9Questions — Chaney Sheffield, Canyon Partners

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