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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!

David Allen has in excess of 30 years of financial services and investment experience, with a focus on the High Yield and Leveraged Finance Markets. Prior to founding AlbaCore Capital Group, he managed Canada Pension Plan Investment Board’s European Principal Credit Fund and was a member of the Investment Committee.

David was also a Partner, Investment Committee member and Senior Portfolio Manager at GoldenTree Asset Management, where he established and ran the firm’s European presence. He spent a decade with Morgan Stanley in New York and Hong Kong, working across M&A and investment banking before specialising as a High Yield media analyst.

Are firms like AlbaCore (that can also take private credit), given uncertainty in the market and the number of underwritten hung deals, well positioned to take advantage of this situation? Do the current circumstances allow private markets to eat into public markets?

Not all private credit is created equal. One of the primary features of AlbaCore’s strategy since our founding, and indeed during our time together at CPPIB from 2010 to 2016, is our flexible approach between private capital solutions and being opportunistic in public markets, depending on where the best relative value lies. In March 2020, we saw better value in trading senior bonds and loans at dollar prices of 75-85 cents on the dollar. Whilst private lending saw some spread widening in that time frame, it did not offer the kind of convexity that we saw in public markets. Similarly, in late 2021, with high yield markets yielding close to 4%, there were very limited opportunities in public markets, but we were seeing private capital deal flow which could still generate mid-teen types of returns.

What is AlbaCore’s strategy in the current market? Is it better to be defensive given uncertainty or to be actively adding through positions because the market has traded down?

The current market is somewhere in between the bookends we highlighted in the previous question. High yield markets are down 5-6% on the year, but loans are flat. The fixed income and equity markets have taken a beating this year as well, and the macro environment certainly feels more likely to drop 5% than recover to par in the next few months. Dislocation in public markets creates opportunities for our strategy, whether it is banks selling previously underwritten deals at a discount, issuers looking for a more turn-key solution versus trying to syndicate debt, or PE activity requiring financing. The breadth of opportunities is very solid right now, allowing us to be very selective in the next deal to add to our funds. We have been selectively adding in public markets where we see a near-term catalyst like short maturities trading 5-10 points below par.  In these situations, even if markets trade down more broadly, we are looking at companies that will be able to refinance, albeit at higher rates, in order to refinance their capital structures.

Given the market selloff, what’s the likely impact on new LBO flow for the rest of the year? What type of deals do you expect to characterise the near-term pipeline?

Traditional LBO activity generally takes a pause on the front end of market volatility, but eventually it finds a clearing price or a need to deploy capital after a few quarters. If traditional LBO activity remains muted, sponsors will usually find other accretive M&A or growth opportunities for their portfolio companies. Or alternatively, market prices will reach a clearing level where LBO activity picks up again. The buying side of LBOs is easier in choppy markets than selling companies, and that is where we are seeing some pockets of creativity from sponsors. For businesses that intended to IPO in 2022, those exits will have to wait, but that does not preclude sponsors from doing things like convertible preferred stock or pre-IPO convertibles in order to either partially monetize existing investments, or bolt on smaller, value accretive businesses to enhance value further when IPO markets normalise.

How will sponsors be able to navigate market volatility? Is it just about paying more?

To a degree “paying more” will be a combination of higher ongoing interest costs, and perhaps a normalisation of valuation multiples resulting from central bank activity, and the market’s response. It is possible that multiple expansion continues or holds at current levels. It really depends on the sector. We have been more cautious on tech/software valuations in recent quarters. We don’t have a lot of exposure, but we have noted a trend where it’s not just the valuation multiple that is sky high, the starting leverage levels in those sectors leave very limited protection if multiples compress and growth projections don’t deliver. Look no further than the tough time experienced by Netflix on the back of a modest reversal of growth sending the stock down 40% in a day. Netflix is an established company with substantial revenues and earnings, so if the market is going to penalise a lack of growth this severely it will be challenging for other sectors where companies don’t meet earnings or growth projections.

Are inflation concerns fully priced into leveraged credit? How about in private markets?

Inflation numbers continue to print at decade high levels. This ought to moderate as comparables begin to lap last year’s meaningful uptick in the spring/summer. The war in Ukraine and ongoing, sizeable Covid lockdowns in China continue to add pressure to supply chains in spite of an easing of energy prices in recent weeks. Most of this is reflected in dispersion across sectors. Manufacturers, energy intensive businesses, or companies reliant on smooth functioning just-in-time supply chains are certainly trading at steeper discounts to companies which are less impacted. To be clear, inflation touches nearly all companies in some respects through the use of labour, energy, or debt financing. We take a bit more comfort here as AlbaCore’s focus has always been on larger companies. In an inflationary environment, it’s more likely the companies we invest in can pass through costs more quickly, or be more confident in their standing as a key customer for their suppliers, making them less likely to suffer shortages than smaller companies.

What’s the opportunity set like in stressed situations right now?

We are definitely seeing an uptick in stressed situations, some of which are tangentially related to eastern Europe, and others which are simply fundamental credit issues which have struggled to improve short-term liquidity, or have seen operations struggling through and post-Covid. It’s not a deluge of situations, but we are also expecting defaults to pick up. This is not a terribly controversial position, given rising rates will act as an ebbing tide revealing weaker businesses as historically cheap financing starts to get more expensive. In most of these situations we are keeping track of what’s going on in the companies and underlying markets. There is always an exchange of value when a holder base significantly shifts hands. There will definitely be more to do in stressed situations over the next year versus 2021, and we’ll be looking more for good businesses with challenging balance sheets than distressed takeover opportunities.

How has liquidity held up during the crisis period?

Liquidity in 2022 has been relatively orderly. Unlike in 2020, there are fewer forced sellers moving large blocks of risk in size and pushing the market down. In late February and early March we were still able to add risk in names we liked at prices in the low 90’s where clear catalysts were present. We saw the opportunity as more of a “mini-dislocation,” primarily in high yield bonds, given how well the loan market has held up. The primary market has been pretty stagnant for almost two months, which will eventually force companies in need of refinancing to come back to markets, even if they would rather not pay higher rates. This limited primary activity has also caused a slight disruption in primary issuance of CLOs, which has offered some attractive spread levels on Single-B through Single-A risk tranches compared to the past few years in the market.

Where do you see value in the current sell-off in secondary bonds and loan markets?

We’ve been focused on senior secured risk in names we already know, with shorter term maturities (<2.5 years). It’s possible to find some convexity, even if the market goes wider from here. Loans have held in well, so value is limited, but with high yield down 5%-6% YTD, you would expect loans to also be impacted if markets head more into risk-off territory. We haven’t seen disorderly selling, though a sustained period of equity underperformance will potentially lead to a rebalancing of portfolios, and either a shift from equity to credit, or a broader risk-off market. We generally hold a bit of dry powder in our accounts to best react to these scenarios.

Private markets and ESG – What are your expectations when it comes to ESG and private markets moving forwards?

More focus on ESG is the way the market is moving. We are seeing this especially in Europe, which is leading these efforts by a wide margin relative to the US where we still see some very binary approaches to ESG. We are probably entering a phase in the ESG market where the proliferation of ESG-related products will lead to a more refined approach from investors trying to discern the strategy differences of funds, claiming to achieve various level of compliance with regulation such as the EU’s Sustainable Finance Disclosure Regulation (SFDR) and Taxonomy Regulation. We have always had an ESG focus, but have been conservative in how aggressively we characterise that against market conventions and definitions to ensure we do not fall into greenwashing territory. As the parameters of the regulation (i.e. SFDR product level requirements) become more clear, we think that will help investors distinguish amongst products but will also ensure managers are not using such regulation merely as an ESG labelling tool.

9Questions — David Allen, Chief Investment Officer & Managing Partner, AlbaCore Capital Group

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