Man: Welcome to the Center for Investment Excellence, a production of JPMorgan Asset Management. The Center for Investment Excellence is an audio podcast that provides educational insights across asset classes and investment themes.

Heather Arison: Welcome, everyone. I hope you all had a very happy Memorial Day weekend. And thank you for taking the time to join us today. My name is Heather Arison. I’m a Client Advisor in our North America Institutional Business here at JPMorgan Asset Management.

I’m pleased to introduce my colleague joining us today, Leander Christofides.  Leander is Co-CIO of JPMorgan Global Special Situations Team, which focuses on distressed and event-driven credit.

Over the next 45 to 60 minutes, we’ll have a discussion on the distressed credit space and how it’s been impacted by the COVID-19 crisis. So, Leander, I’ll start with some questions I prepared for you. So, we’ll begin if you’re ready.

Leander Christofides: Yes. Thank you, very good to be here.

Heather Arison: Great. Leander, you’ve been a longtime investor in social situation and credit opportunities. And as they begin, could you give us a quick overview of your background and from your lens, how you define private and opportunistic credit?

Leander Christofides: Yes. Thank you, Heather. So, as Heather said, I’m the Co-CIO of the Global Special Situations Team. As the team name suggests we’re global.  I’m based with half of our team in London and the other half of our team are based in New York with my fellow Co-CIO, Brad DeLong.

 We’ve been the same team for over 17 years now.  And what we focus on is detailed analysis on single name, corporate credit risk. And we focus on two defined sub-strategies. The first sub-strategy is distress.  Probably, the easiest to understand and is typically focused on nonperforming assets, where a company goes through a process, either a debt for equity swap on one side, all the way through to liquidations on the other side. And often requiring new money along that journey.

These processes are typically very intensive from a legal perspective. And typically, the average dollar price in our historical distress track record is about 50 cents on the dollar. And these are typically longer dated transactions and average about four years' average life. And therefore, capital appreciation from income drives a lot of the returns and the distress sub-strategy.

The second sub-strategy is what we call an event-driven and stress. And these are companies which are typically under some stress, typically through short-term underperformance. They need perhaps a minor restructuring and sometimes also need new money as well.

And these transactions typically have a slightly higher dollar price. Historically, for us, this sub-strategy has an average entry price about 75 to 80 cents on the dollar. And it’s typically shorter dated. They average about two to three years.  And as a result, income and capital appreciation and perhaps, more evenly weighted in terms of the return profile.

Perhaps, the difference between the two also is that because they’re shorter dated. The event-driven and stressed transactions, you get to often recycle that capital, so you end up with a similar money multiple as a distress. But you get a second bite of the cherry as well.

Now, some of these transactions, we originate and structure ourselves and we’re often the sole participants in them and we call those bespoke transactions and some of the transactions we source from the market.

As a result, we have a lot of flexibility in this strategy, and that we target both private debt markets as well as tradable debt and we use a relatively wide variety of instruments as well to express our view and that ranges predominantly around senior debt, but also junior debt, reorganized equity and plains to name but a few of the instruments.

However, when you think about both of these sub-strategies, for us, they’re the same transaction, whether we make the transaction ourselves or as market-driven, distressed vendor.

And we look, in essence for the same three factors. Firstly, we look for a value cushion in that we typically like to enter assets for the 30% to 40% discount on average to the intrinsic value that we see in the asset. Secondly, we look for a capitalist. Often that capitalist in an event is often independent of capital markets and releases that value cushion.

And then currently we generally don’t like to take big industry bets. So historically, for example, we found it very challenging to - for example, say, oil and gas or retail shipping, for example, assets. Not because we have (Barclays), we have in fact, industry agnostic. It’s just to fit those three criteria very challenging in some of those sectors.

Heather Arison: Certainly Leander, the COVID-19 crisis has given rise to some interesting opportunities in your space. And we’ll discuss that here in a bit. But perhaps, first, it makes sense to talk about what was going on in credit pre-COVID-19. So, to set the stage, what was the trends in the credit markets at the beginning of 2020?

Leander Christofides: Yes. So, if we set the scene for pre-COVID, we - local have very high debt levels. To give you some numbers from the global financial crisis, today, corporate credit markets have grown from 6 trillion to over 11 trillion in size, with basically double the amount in outstanding corporate debt since the global financial crisis. And we saw what happened in the global financial crisis with that 6 trillion.

But the second factor as well was, we also had record high leverage. And the record high leverage really manifests itself in two ways. Firstly, overtly, and you can see that, for example, that the majority of investment grade debt was centered around BBBs, all the way through to the leveraged land where we saw LBOs have gotten up to an average of 11.5 times multiples on the enterprise value.

And I think if you compare that to 2007, which is the previous peak, you had only reach 9.7 times. But also, we had so much excess capital in the market that there were other covert actions happening around leverage. And that primarily manifested itself in EBITDA adjustments.

This is where a company, for example, say, it had 30 million of EBITDA. And then what they did was they hoped that in the future, revenues would go up and that they could cut costs as well in the future. And they perform at all of those future revenue expectations and cost cuts expectations into today’s EBITDA and call that adjusted EBITDA. And so with all that 30 of EBITDA was only now turned into 50.

And by 2019, we’ve seen that on average transactions had always 2.5 times of adjustments with EBITDA. So, where it looked like it was a six times levered. It was really 8.5 times levered, if you stripped out the adjustments.

 And so, it was interesting because at the end of last week, even the Fed suggested that we have not seen leverage levels this high since 1987. So put it into prospective so extremely high leverage.

And away from that, I think some of the other points that you’re all familiar with around cut-lines. But generally, we saw, for example, Moody’s came to score structural protection with the lowest on record. And it wasn’t just cut-light and there’s also the ability for assets to be leaked out.

You know, current view story out, last week was around the sponsors Elliot on Travelport, where negotiations, now the strength assets with their lenders. And they were able to pull out a billion dollars-worth of IP out of the assets, which definitely creates a new dynamic into the discussions with lender.

So that definitely gives you a feel for the quantum of debt and the leverage that was built up in the system pre-COVID.

Heather Arison: Absolutely.  And following the COVID outbreak, can you talk a little bit about how these trends have played out and how the market have changed?

Leander Christofides: Confidence has created a very constructive opportunity to staff to deploy capital as a special situations and distress funds. In April, we did see a record number of defaults in a single month at 19 defaults. I think the previous monthly record for monthly defaults for 17 defaults set in April 2009.

And currently, defaults are running at just under about 5% so far. And the majority of the defaults that we’re seeing are related to energy, retail and leisure.  However, future defaults are expected to be very high, in fact, higher than the global financial crisis.

We think about it in cumulative three-year defaults. And the cumulative three-year default rates, we expect to hit somewhere between 18% and 20%, this cycle. And if you compare that to the global financial crisis that peaked at about 15%.

So we are only at the very beginning of that distress cycle, despite the moving markets, we have significant amounts of defaults to come. If you want to put some numbers around that, if we - first of all, take the leverage loan and high yield bond markets are added up across the US and Europe, they are up to just under $3 trillion in size.

In addition, there’s approximately, a trillion in direct lending. And so, if you apply that 20%, three accumulative default rate, we’re looking at about somewhere between 600 to 800 billion of defaults before you factor in fallen angels.

Now, we talked about timing, but I think it’s worth also just finishing up this question with a view on that. Historically, defaults like what happens with markets. In the global financial crisis, default actually peaked in Q1 2010 or 12 months from the start of the crisis.

So, we expect that defaults are really going to raise their head in end of Q3, beginning of Q4 and really hit that peak sometime in the early to mid-part of next year.  And there’s a practical reason for that.

I think most advisors that you speak to will tell you to actually default the practicality of having, you know, forward business plan that's credible, you need to have your supply chains reopen and so on and so forth. So, a lot of faults that are coming are not coming quite yet, just because of that is practical nature but will nonetheless come.

Heather Arison: So, looking forward, what is the opportunities that you see today, as well as going forward, and how have you been allocating capital?

Leander Christofides: So, the way we think about the world is downgrades, defaults and requirements for new money. Now, clearly governments around the world have created new money programs that have been truly immense, so much. So I think you’ve seen a lot of whining for some of the most prominent investors in our space, such as Jim Simons or Howard Marks, especially around some of the actions the Fed has conducted around highly levered high-yield companies.

And we’ve definitely seen a strong snapback in markets over the last six to eight weeks, which has taken many by surprise. But actually, if we look at what’s happened, there’s been this significant bifurcation of the market. If you think about companies today, if a company has no new money requirements, it doesn’t look like it has a restructuring need, is that be attractive? Very quickly, a lot of real money influx. But the moment the company looks like it needs restructuring or new money, it has significantly lies the rally.

So much so that when you look at the price action and some of those assets, tradable assets, for example. They are, you know, at the lows of setting new lows today.  So, the market is very situational. And a lot of the hot money is chasing this safe with their own assets. At the moment there has any care you’re relying on dedicated locked up company with specialization, which is harder to come by.

The other thing to think about is not just defaults, which make a lot of those noise in the market. It’s actually downgrades that also matter as well. And specifically, the reason why downgrades are so important is because they’re tied structurally with the biggest holders of leverage risk in the market, and that’s CLOs.

Those EBITDA adjustments that I talked about earlier, there’s no such thing in EBITDA adjustments in the bond market because they use gap accounting. But in a loan agreement, you can define EBITDA in (one).

And so, a lot of the most aggressive lending happened in both CLOs and in the private debt markets.  But specifically with CLOs and secondly with private debt lenders, when you have these CCC buckets being breached, in this case, the CLOs is an important percentage of the portfolios that are CCC or below. The magic number to look out for is 7.5%.

And today, we’re already now at 11%.  And this means that CLOs passed their sub-fees and we expect the CCC overload buckets in CLOs to actually climb up to about 33% of their portfolios.

So most importantly, what it does is it restricts CLOs from being able to provide new money to some of the companies that have difficulty. And therefore, what happens now is that the problem companies (unintelligible) become more problematic than they perhaps should you’ll need to have other capital come in to provide that new money capital. So, it creates a little bit of a vicious circle, some of the weakest companies. And that’s one of the biggest reasons for your team's negative price action on these weaker-performing companies.

In addition, I think a lot of the financial press have been talking about, you know, a lot of companies being saved. We’ve had some very high profile defaults and downgrades occurred.

For example, we thought two weeks ago, Virgin Australia, we thought, you know, airlines are getting bailed out. And Virgin Australia has very strong shareholders, especially with Temasek in Singapore and Etihad in the Middle East. But they were not supportive with new money in file.

We saw Swissport in Europe, not getting a bailout from the Swiss government because they didn’t want to look like they were bailing out for political reasons with US subsidiaries. So, we can see that, you know, we often see a lot of support, they’ve been plenty of high profile as well as smaller companies often as part of those processes.

So, what have we been doing?  Well, this should give you a good sign. Most distressed funds, who bought a significant amount of assets in March have sold almost everything that they bought in March by today, when we sit in May. And that should definitely give an indication of the future market expectations of, you know, the stress can be achieved around the credit rally that we’ve seen so far.

From our perspective, we really focused on four categories. First of all, assets that have quantifiable products that we can value, and then take a significant discount that I talked about perhaps earlier in the call today. Secondly, would be in focusing on counter cyclical assets. And thirdly, assets, where we can get paid the premium for our re-structuring in jurisdictional expertise.

And then, lastly, we skewed ourselves towards Europe, parts of the US currently, just because of the way the government support is structured. So, we’ll talk about that later in a little bit more detail.

Heather Arison: Great. Thanks Leander and it sounds like you and the team certainly have a robust opportunity set in front of you and with the team currently managing a drawdown style closed end fund. Can you touch a little bit more on how today’s environment is impacting your allocation decisions going forward?

Leander Christofides: So, in terms of allocation right now, we have looked at both private as well as public markets currently. But we are now looking, example, on our analysis on private markets. And private markets typically have grown by over two and a half times where they were the global financial crisis to about a trillion dollars in size.

And we actually anticipate that 75% of private debt portfolios, companies are going to need, you know, new money or some form of restructuring. And many of the private debt deals that exist in the market have not just high leverage, but they have what was called Unitron structures.

So, if you think about historically, the capital structure companies have senior debt, junior debt and then the equity. But then, most of the new transactions have occurred, especially in the private debt markets. And just one tranche. So, when the company underperformed there wasn’t this value cushion below them.

So, as a result, the recoveries were supposed to be less and the losses are higher and the likelihood of default also high.  We’ve actually spent a lot of time on the private debt side looking at a lot of the BBCs, the UK Trust. And what’s really interesting about these structures is that when you do the analysis, the expected recovery on a lot of these smaller businesses is expected to be about 50 to 55 cents on the dollar.

And the problem that you have as a manager such as yourself is that there are so many small line items attached to the time and effort and opportunity costs to do the work on those individual situations to make the return on capital work means that the deal interest, likely comes in at around 25 to 30 cents on the dollar.

Now, what I would say to you is that there are big differences between direct lenders and private credit that have been afforded to large companies versus direct lending portfolios, which was associated as sort of small to medium sized companies.

So, the structures is going to be the numbers that I’m talking about today are associated with some of the smaller end of the market. But I think nonetheless, a very important statistic, given the low recovery that we expect to see on a lot of these private debt markets.

Heather Arison: You mentioned that you are focused on more opportunities in Europe. Can you tell us a bit more about this and why your focus has been in this geographic area?

Leander Christofides: Yes, so in Europe versus the US, if you look at some of the government programs that have been created, Europe has been much more effective in getting capital to companies due to their banking relationships as well as the Social Security Systems that exist.

For example, we think the US is actually dollar for dollar more support out as a percentage of GDPs in Europe. But the difference is that in Europe, most of its capital is being used to support company’s ability to maintain employments.

For example, unemployment grew by 11.2% in the US in April. If you compare that to, for example, in Germany, unemployment only grew by less than 1% and that’s pretty much because of these programs.

In the US, most of the capital is being used to support unemployed individuals so much so that in some cases the income support received for people being higher than what they received in employment.

So, I think if we look now, in terms of our portfolio companies or the companies that we recently added in our portfolio post-COVID over one of the companies we’ve invested have applied for and received commitments from government sponsored, more interest, unsecured loans in Europe. Definitely not the case in the US entities that we’ve invested in or looking at currently these days.

So, you can see that there’s a very big difference between Europe and the US from that perspective.

Heather Arison: And Leander what would be a turning point for you for opportunities into the US to become more attractive?

Leander Christofides: So, from our perspective, the majority of our pipeline of opportunities are US-based.  And the reason for that is because in the US, because you have less support for the companies, those companies are more likely to default.

And therefore, from, you know, the seat that we sit in in terms of targeting distress and stressful situations, the pipeline of defaults are weighted much more to the US.

So, in addition to that, the US therefore is going to go through this process of cleansing its balance sheet. So that they default, they shed that. And what emerges are stronger companies that can grow faster.

And just generally, you should be more bullish around the US economy versus Europe in the long run, because you don’t have a structure Zombie Companies that are over levered that are just being put on life support as it were by their governments.  But they are actively able to increase productivity and growing it.

So therefore, the long-term future and pipeline for us is so much more skewed towards the US. So, I think the flexibility to flex across Europe waiting today than the US waiting tomorrow, I think reflects the opportunities as we go through the cycles.

Heather Arison: Are there other credit-related asset classes that are a concern to you?

Leander Christofides: Well, a natural derivative of single main corporate risk centers around CLOs and we talked about the CCC buckets in the last provision of providing new money, the CLOs themselves and the companies. But if we actually look at the CLO tranches themselves, they are going to become a significant focus as defaults increase, downgrades increase.

And they are, as I said earlier, also the center of ownership for a lot of the problem credits. If you think about the mathematics around (CLO) tranches, Moody’s predicts that the recoveries are similar in this cycle, maybe around the low 40s in terms of cents on the dollar recovery.

And then compare that to the last cycle narrowed to very high 60s, low 70s. If you then think about, as I talked about earlier, cumulative default rates of about 20% or more especially because it’d probably be higher than that fashion CLOs.  It means that the expected losses are going to be nearer to about somewhere between 10% and 15%.

And that means that not just the equity tranche, but also the BB tranche and maybe in some cases, encroaching right into the BBB tranche at CLOs as well, when they themselves become distressed assets. And so, they will be very interesting target investments over the course of the next two, three years as well.

Heather Arison: And Leander, when you are looking at the opportunity set that you invest when, their case of deals have you passed on recently?

Leander Christofides: A lot of the transactions that came out earlier on post-COVID as I said have been related to retail energy.  And whilst we are industry agnostic, the investment process that we talked about earlier without having a bad impression on the capitalists. But most importantly, not taking a big industry that method is very challenging for us to operate on this but we realize over 200 credits.

And you know, within the retail space, a lot of the bit interest that we’ve been able to get comfortable would be around about 10 to 15 cents on the dollar, which, you know, in many cases, they are still trading at 20 to 30 cents on the dollar, which is still too high for us in that context. So, that’s challenging.

However, the last, we have been able to deploy a significant amount of capital over the last console expect. As I said, a significant amount of opportunity, really hitting Q3, Q4. And when we think about deployments, where perhaps they were planning on deploying capital over a three-year period. COVID has accelerated that deployment and then made it more rapid and it’s also weighted towards more distressed assets rather than the event-driven stress strategy.

I’ve mentioned earlier, the stress assets are longer dated, and there’s probably time for investors to invest in, you know, somewhere around four years. With likely means that even though we turned down a significant amounts of assets, we’ll probably likely have to come back to market in the talk from to raise additional capitals, given the size of the pipeline that we are seeing today.

Heather Arison: Great. Thanks, Leander. So, we talked a lot about the opportunity set across the stress and event-driven credit today. And, what is your perspective on dry powder in the market?

Leander Christofides: So, identify, first of all, talk about the numbers. We think about, we talked about three trillion of leverage risk. We talked about a trillion private credit. We talked about some of the fallen angels will come to the market and stuff fairly also that 20% cumulative default rate leading to about a trillion of defaults.

If you factor that into how much capital we think is actually raised and dedicated towards special system distress, we think that is roughly three to four times the amount of capital that is actually available. And otherwise, there will actually be a supply and demand issue in the market (Unintelligible) capital allocated to the space versus the weight of opportunity that exists are coming 34 to 36 months.

 And in addition to that, we would add that a significant portion of that opportunity set is European based. And also having individual European restructuring capability and jurisdictional capability going to make a significant difference between institutions that they can operate successfully across the opportunity set as well.

Heather Arison: Well, thanks Leander. And with that, we will wrap up our call today.  And we want to thank you all for joining us and we appreciate your continued partnership. And hope you found today’s call impactful.

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