It has been a wild time for markets. In 2020, stock markets around the world endured their steepest crash in history due to an unthinkable global pandemic, only to rebound in the steepest recovery ever recorded largely due to unthinkable amounts of monetary and fiscal stimulus. In the middle of March 2020, at the height of the risk-off environment, nearly every asset class became dysfunctional and unhinged from past performance behaviour. For example, between March 9 and 26, the yield on the 10-year Government of Canada bond nearly doubled from 0.54% to 1.04%, the FTSE Canada Universe Bond Index¹ fell 6.5%, leveraged loan spreads exploded +1,000 basis points, and gold, the quintessential safe-haven asset, suffered a decline of 12.5%. Investors suffered whiplash – credit spreads tightened back in just three months, after central banks pledged to effectively backstop anything and everything credit-related, from sovereign Treasuries (in order to lower overall market interest rates), investment-grade corporates, mortgage-backed securities and, in the case of the U.S. Federal Reserve (the “Fed”), even high yield bonds. As credit analysts at KKR recently pointed out to investors, on March 23, over 80% of the U.S. credit market yielded greater than 7%, and by the end of the second quarter, only 27% of the market yielded greater than 7%. The broad rally in risk markets went into overdrive in the fourth quarter, fueled by optimism around COVID-19 vaccine developments. At the end of 2020, only 16% of the U.S. credit market yielded greater than 7%. In an incredible reversal of fortunes, most asset classes finished in the green in 2020. The S&P 500 was up 16.23%, the S&P/TSX up 5.6%, U.S. high yield up 6.17%, U.S. leveraged loans up 3.12%, and the FTSE Canada Universe Bond Index up a robust 8.7%, three times its annualized return over the past ten years.

Technology was the sector most responsible for leading equity and credit markets out of the red in 2020. Technology companies were largely unaffected by the pandemic and instead enjoyed a strong tailwind from the acceleration of existing trends calling for digital transformation in online communication platforms, cloud services and e-commerce. This digital paradigm, however, does not mean technology companies have unlimited value. Many tech stocks that listed publicly through high-priced SPACs² doubled or tripled their price in a day, with many investors seemingly oblivious of the fact that the underlying companies were often not profitable or even operational. Reminiscent of the late 1990s, public market company enterprise values are an eye-watering 8 turns higher than comparable private company enterprise multiples (as a multiple of EBITDA).³ The rally in tech stocks today looks grossly overextended and is being primed again by retail investors; however, this time, retail investors have stimulus checks and zero commission trading accounts and can own fractional shares in companies through online brokerages, no longer making stock price a barrier.

Goldman Sachs research found that in 2020, U.S. stocks favored by retail investors (like Tesla) outperformed those favoured by institutional investors and did dramatically better than the overall market by nearly 5 times. Segments of the equity markets have turned into online casinos. The volume of out-of-the-money single stock call options with less than two weeks to expiration have exploded. Institutional investors rarely buy such options, which are not much different than bets on a roulette wheel. Margin debt – the amount of money that investors have borrowed in order to buy stocks – is now at the highest level ever, in both absolute terms and relative to U.S. GDP.⁴ Historically, peaks in the ratio of margin debt to GDP have been harbingers of market crashes (like 1987, 2000, 2007, and today).

2020 was unquestionably a dramatic year filled with fear and uncertainty. In uncertain environments, people always feel more secure in herds. During the pandemic, for example, investors have preferred herding rather than being wrong about a decision on their own. Human minds are lazy and prefer decisions that require the least cognitive effort. According to Daniel Kahneman, acclaimed psychology professor and author of the best-selling book “Thinking Fast and Slow”, laziness is built deep into the nature of people: “If there are several ways of achieving the same goal, people will eventually gravitate to the least demanding course of action. In the economy of action, effort is a cost, and the acquisition of skill is driven by the balance of benefits and costs.” When in fear, people tend to expend even less effort (a “paralysis” sets ins), which partially explains why human beings tend to copy others and be conformists rather than innovate and separate from the pack. So, when millions of small retail investors start posting their intentions to buy a particular stock on online forums, more investors became inclined to the proposition even if it was irrational for fundamental reasons. The crowd gets larger as the stock moves higher and farther divorced from reality. For investors, nothing eases worries more than easy money. As John Maynard Keynes posited in 1935, contagious “animal spirits” move markets. Investors will need to break from the herd if they are going to avoid being prey when markets eventually crash.

Good Yield Hunting

Ultra-low rates are increasing the challenge for fixed-income investors to find income without taking on uncomfortable levels of risk. While total U.S. institutional leveraged loan issuance in 2020 was $287.8 Billion, down 7% from 2019, the share of highly-leveraged loans issued by borrowers (rated B-/B3) was at its highest rate ever, at 36% of volume and up 9% in issuance compared to 2019. By Q4-2020, the risk premium on highly-leveraged loans (senior debt to EBITDA >5x) over less leveraged loans (senior debt to EBITDA <3.5x) was just 74 bps but enough to dominate issuance and investor appetite. With Treasury yields in the U.S. and Canada still near record lows, and historic policy changes by central banks to keep rates low even if short term inflation or GDP spikes, credit will be generally impeded of its ability to generate much incremental return. As we have repeatedly recommended, relying on passive top-level exposures to credit in the current environment will lead to losses. Investors need to understand credit fundamentals on an issuer-by-issuer basis and preferably outside traded markets where sourcing and selection are more inefficient and therefore fertile for higher returns.

Government stimulus extended the credit cycle and delayed the distressed wave but it has not eliminated the cracks surfacing among highly-leveraged issuers and those operating in industries that will struggle to adjust their business models to fit a new post-pandemic world. In the U.S., the Fed’s decision to buy high-yield bonds as part of its good intentions to keep capital markets functioning has had the perverse effect of benefiting larger issuers and creating a false bifurcation between perceived high-quality credit and storied names. Take for instance, issuers in the leisure industry which constitute the most troubled loans in the S&P/LSTA Leveraged Loan Index. These loans returned -2.63% in 2020; yet high-yield loans in the same industry were +0.78%. Large leisure companies, notably cruise lines such as Norwegian, Viking, and Carnival, which were previously solvent entities hit hard by the pandemic, were able to make multiple trips to the high-yield markets to extend maturities, borrow at attractive rates, and bolster liquidity. Smaller leisure companies, which rely on bank loans, have not been able to take advantage of the same opportunity. The dispersion in traded credit markets caused by the Fed’s selective moral hazard provides an advantage to credit investors willing to put in the hard work to hunt for attractive yields.

Oiled Up

Oil market fundamentals today may be the most constructive in over a decade. Global oil markets are driven primarily by either demand (e.g., emerging market growth, COVID-19 destruction) or supply (e.g., U.S. shale growth, OPEC policy, Saudi-Russia price war), but rarely by the simultaneous occurrence of both.

In the U.S., the New Year began with oil demand of 19.7 million barrels per day (mbpd), which is within 1.2% of its level in January 2020 and within the range of demand for the past five years. More recent data published by the U.S. Energy Information Administration (EIA), prior to the polar vortex that ravaged Texas, shows U.S. oil demand rose even further to 20.7 mbpd representing growth of +5.4% year-over-year. Oil demand also appears to have recovered globally; for instance, China’s oil imports rose 18% month-over-month in January 2021 and India’s oil demand neared its pre-pandemic levels. In fact, EIA estimates that global oil demand rebounded to 96.7 mbpd in February 2021 to within 1.0% of its February 2020 level of 97.7 mbpd. Global oil demand has continued to exceed supply since the third quarter of 2020. EIA currently projects that global oil demand could grow by 8.9 mbpd over the next couple years (5.4 mbpd in 2021 and 3.5 mbpd in 2022). If these projections are accurate, it would represent the largest two-year global oil demand increase on record since 1950.

Bolstering the demand side is higher vaccine distribution and massive fiscal stimulus, much of it in infrastructure spending planned under the Biden administration in the U.S. According to the Washington Post’s vaccine tracker,⁵ approximately 50 million people (or ~15% of the population) in the U.S. have received at least one dose of a vaccine. An average of approximately 1.65 million does per day are being administered currently with expectations that virus mitigation measures such as lockdowns and mobility restrictions will become mostly unnecessary by the summer. Global lockdown measures caused unprecedented declines in transportation, which accounts for ~56% of global oil demand according to the International Energy Agency (IEA), an autonomous inter-governmental organisation within the OECD. Global aviation activity fell more than 60% by the end of Q1-2020 and almost came to a halt in some countries. Road transport dropped between 50% and 75% in the U.S. as lockdowns spread. Vaccine distribution will help release high pent-up demand for travel (including from planes, trains, and automobiles). Indications from U.S. airlines such as Delta Airlines advising of increased summer travel bookings and the U.S. Transportation Security Administration hiring more than 6,000 security officer positions by June 2021, show travel is set to rebound.

The fiscal stimulus package and infrastructure plan of the Biden administration is expected to cause oil consumption to rise, at least in the near term. The new President’s first day energy-related executive orders were largely inconsequential to oil producers. The subsequent order halting all new permitting and leasing on Federal acreage, among other measures, was widely anticipated and, because it does not limit activity on existing leases, will have minimal impact on oil and gas production in the near term. If leases on Federal land are not subsequently renewed over the next 2-3 years, U.S. oil production could be reduced by 300,000 bpd according to S&P Global. Energy consulting firm, Rystad Energy, believes that any “green” focus of the Biden infrastructure bill will be mostly additive to oil demand in the U.S. due to increased construction activity, creating upside in 2021 of approximately 60,000 bpd, before rising in 2022 to 330,000 bpd. Depending on the scope and success of the various renewable projects planned by the government, particularly around solar, the risks to conventional energy are mostly limited to medium-term oil demand.

A steepening backwardation in global oil benchmarks is indicative of a market that expects a significant tightening and potential shortage of available barrels as global inventories are depleted to below-normal levels in the near term. OPEC 2.0⁶ has communicated plans to normalize inventories but any increase in output is likely to be modest, at least until the demand recovery becomes durable. The supply response outside OPEC 2.0 may be more muted given limited access to capital, resource exhaustion, and the altered priorities of major producers. Annual conventional oil production is approximately 25 billion barrels per year, but recent discoveries have been averaging close to 5 billion barrels per year, creating a situation where most of the production decline offsets from existing wells will have to come from enhancing oil recovery from already producing fields. Drilling productivity in the major shale basins in the U.S. and in Canada’s WCSB have been rapidly declining since 2019 and total production has plateaued globally. New discoveries are also lagging – in the last one hundred years there has not been a single year when new conventional oil discoveries surpassed production. The annual new discovery to production ratio deficit, combined with lower field productivity, means that total global conventional production is moving from a long plateau to a steady and permanent decline trend in the next few years.

Despite recent higher spot oil prices, capital spending guidance from the largest oil producers continues to be pushed lower. Part of this may be due to the brief Saudi-Russia oil price war from March 2020 still remaining fresh in mind, but enormous investor and societal pressures to transition away from oil are influencing where energy companies invest. Companies with significant energy exposure have been penalized and encouraged to divest those assets because of a vision of a decarbonized world. It is peak gloom for energy producers. A year ago, we acknowledged in our Q4-2019 Investor Report that the energy transition was “a powerful downward force on oil and gas investments” that would likely “take decades” to play out. We also proclaimed that energy investments looked “remarkably inexpensive”. We are extremely well positioned today to benefit from higher prices and believe that the forces of supply and demand are now working in tandem to spark a new supercycle for the global oil market.

[1] The FTSE Canada Universe Bond Index measures the performance of the Canadian Dollar denominated investment-grade fixed income market, covering Canadian government, quasi-government, and corporate bonds. The index is designed to track the performance of marketable government and corporate bonds outstanding in the Canadian market.
[2] SPACs are special purpose acquisition companies formed for the sole purpose of raising investment capital through an initial public offering “(IPO”), which is then used to acquire one or more unspecified businesses to be identified after the IPO.
[3] Partners Group, Switzerland, June 2020
[4] From research compiled by Hussman Strategic Advisors
[5] https://www.washingtonpost.com/graphics/2020/health/covid-vaccine-states-distribution-doses/?itid=sn_coronavirus_3/
[6] OPEC 2.0 is a group of 24 oil producing countries that controls about 60% of the current world supply. OPEC currently includes 14 countries: Algeria, Angola, Ecuador, Equatorial Guinea, Gabon, Iran, Iraq, Kuwait, Libya, Nigeria, Congo, Saudi Arabia, UAE, and Venezuela. The non-OPEC signatory countries are: Azerbaijan, Bahrain, Brunei, Kazakhstan, Malaysia, Mexico, Oman, Russian Federation, Sudan, and South Sudan.

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When a borrower faces financial distress it will first resort to negotiating with its creditors through an informal restructuring. If affected parties engage in good faith negotiations with genuine intentions to achieve an amicable resolution, then the savings in time and expense versus a formal restructuring are enormous. It also avoids the likely loss of confidence from stakeholders in the borrower’s value chain (especially suppliers and customers) and the attendant interruption in operations. The stigma of a formal restructuring, conducted through a statutory insolvency regime,² may unfairly create the perception of greater risk of failure of the borrower, and result in vendors and customers avoiding credit extensions, preferring upfront cash payments or delivery before payment, respectively. The signal of formal restructuring may also negatively impact the borrower’s brand perception. Where possible, an informal restructuring should be pursued to save resources and preserve value in the distressed business.

Informal restructuring best functions where the creditors are either few in number or share a common goal of seeing the restructuring through. Coordinating the response of lenders to ensure they can reach a consensus towards supporting a borrower out of crisis is difficult. Not all lenders are willing to exercise restraints in the face of default and there is little incentive to share in the benefits and burdens of a business rescue if not all lenders are going to provide additional financing or be willing to cooperate with the borrower to achieve a workout plan.

There was a time when self-enforcing market norms encouraged lenders to cooperate. A lender that was a part of a syndicate, for instance, who was overly-absorbed with maximizing its own utility even at the expense of the other lenders or the successful restructuring of the distressed business would have put itself in a position to be censured by the other lenders through the imposition of informal sanctions. The deviant lender would not be “invited” into future syndications and would be left out of the opportunity to partake in profitable loans. Such moral suasion works when there are only a handful of lenders in a given market (like Canada’s bank oligopoly). However, as the number of non-bank lenders has increased in Canada, self-interest and zero-sum outcomes have become more prevalent. Any informal restructuring depends on the willingness of lenders to alter their pre-distress rights, a condition that introduces game-theoretic arguments for settlement, which are more difficult to resolve if any of the lenders are indifferent to future relations. There is no way to bind a dissenting creditor in an informal restructuring, who can hijack the rehabilitation of a distressed borrower. An informal restructuring saves distressed firm transaction costs and averts interference with operations of a business but does not guarantee coordination and consensus among creditors. The whim of a single creditor can usurp negotiations. Given the rise of non-bank lenders in Canada, in particular credit-focused hedge funds and distressed/special situation private debt funds, which TEC estimates have doubled in the past decade, the willingness of creditors to settle on a restructuring plan without court involvement has become impractical.

Formal restructuring has the advantage of binding all relevant stakeholders, including creditors, to a court-approved restructuring plan. It offers the distressed business the opportunity to not only restructure its debts but emerge and continue to operate as a going concern. At the heart of a formal restructuring is the maximization of value for the creditors of the business and the rehabilitation of the distressed business. In many cases, the expectation that the business can be restored to financial health, continue to provide jobs, and remain a going concern motivates a restructuring over a liquidation. A hastened liquidation of the business may best serve the interests of senior creditors protected by security over the assets of the borrower, especially where asset values are depleting, but courts will scrutinize the consequences of allowing a sale based on its utilitarianism. In TEC’s experience, liquidations are most practical when the business has no prospects of being a going concern and management has conceded to such view (often implicitly by way of abandonment).

The CCAA framework in Canada allows distressed companies to liberate from legacy costs, remove burdensome contracts, and eschew obsolete business models. It gives a debtor “breathing room” through an interim “stay” (or moratorium) on enforcement of actions or claims against its assets, which can be co-opted as a tool to ensure that the debtor is to maintain liquidity necessary for running the distressed business pending negotiation of a restructuring plan. Faced with financial distress, a company should be able to continue in the use of its assets or as much of its assets as is necessary to facilitate the restructuring. It means pre-distress secured lenders may not remove assets that are necessary for the continued operation of the business, until management comes up with a proposal or plan for the restructuring and implements same. The proposal or plan of restructuring lies at the heart of a formal restructuring, even against the objection of some creditors, to the extent that such creditors are not treated unfairly.

A successful formal restructuring requires participation from a broad set of actors including management, directors, creditors, shareholders, investors, regulators, administrators (including monitors, receivers, and trustees), and courts. However, the determination of who manages the distressed business has implications on outcomes. The most common option is to have current management remain in place to run the day-to-day affairs of the business and lead development of an exit plan. At the other extreme is replacing existing management with a new team, which signals to observing constituencies a lack of confidence with previous operators. An in-between option is appointing an external person, such as a “Chief Restructuring Officer” to supervise the management of the distressed business as the restructuring is negotiated, and a restructuring plan is put in place.

One of the strongest arguments in support of retaining the distressed management as the business commences restructuring, is the experience and knowledge which the management of the debtor provide. This experience and knowledge may be lost with the immediate replacement of the management of the debtor upon the commencement of formal restructuring. The formal restructuring regimes in Canada and the U.S. support a debtor-in-possession (“DIP”) concept, which keeps existing management in place and the debtor in control of its property and estate as the process of restructuring is underway. In addition to the knowledge and experience which is brought to bear, retaining the management of the distressed business may be a critical step to ensuring that the restructuring of the distressed business starts as early as the signs of distress become evident. This is because retaining at the early stage of its distress, the debtor presumably still has valuable operations and setting restructuring in motion can yield better chances of ensuring that the distressed debtor emerges successfully.

Existing management’s retention of control of a distressed business is not an absolute privilege. A management team that has defrauded, or has been dishonest in its dealings, will not be afforded the room to continue in its fraud, at the expense of the creditors of the business. A DIP must act as a fiduciary and is duty bound to protect the interests of creditors too. That is why the CCAA provides for a mechanism for an independent insolvency professional to monitor the distressed company’s ongoing operations and assist with reporting to the court and stakeholders on viability of the business and progress on the restructuring plan. A monitor’s mandate includes the power to take financing initiatives, such as borrowing money and granting super-priority security to lenders during the period of restructuring (commonly referred to as DIP financing).

Even in light of this, TEC notes that the bar to displace management is very high. Merely evidencing incompetency, mismanagement or imprudent decision making on the part of management is not enough. Fraud and gross negligence have to be proven to compel a restructuring court to oust existing management, although TEC has been successful in motivating untrustworthy management teams to resign by increasing their potential exposure to certain liabilities. The monitor has the power to challenge transactions undertaken by the management of the now distressed business which it considers to be disadvantageous to creditors, and request a court order for them to be clawed back into the estate of the debtor. Such fraudulent conveyance cases tend to be highly contested and are typically not pursued unless the underlying amounts are significant.

The successful restructuring of a distressed business depends vitally on a stay of creditor action and enforcement, a plan and means of enforcing that plan (even against the volition of dissenting creditors), and a management structure to implement the restructuring. Informal restructuring has advantages but its reliance upon cooperation among the parties (primarily the creditors) limits achievement of the foregoing vital components necessary for success. A formal restructuring is the only sure way to ensure legal certainty of a plan and secured lenders must “dress” appropriately before entering such a process.

Virtuous Distress

One of the underlying themes of every restructuring is the existence of defaulted debt. Disagreements between investors, creditors, distressed debtors and other stakeholders largely revolve around what to do about the debt: the desire for immediate repayment, the need to make compromises to facilitate the survival of the business, the desire to be divested from the business, among other considerations. During the period when the company considers commencing a restructuring, some creditors for varying reasons may be unwilling to either remain invested in the distressed business or provide further capital. These pre-distress creditors may seek to sell their debt to a distressed debt investor that expects to reap a profit either by reselling the debt, by liquidating the claim in the process of restructuring, or by taking an equity position in the debtor as it exits restructuring. Banks have a heightened incentive to dispose of their distressed debts.

When a debtor’s financial prospects deteriorate, with the possibility of default, regulators require the lender banks to make provisions (or reserves) for the likelihood of default. Such provisioning by a bank means that it has more capital tied up in respect of a debt, the repayment of which is uncertain. While the imposed regulatory adjustments may better facilitate prudence, for bankers, these adjustments do not make economic sense for bank profitability. In such situations, it makes even less economic sense for banks to provide additional financing to distressed debtors. Distressed debt investors like TEC are active buyers of distressed debts from banks and other traditional lenders.

Banks are inclined to sell their distressed debts at a discount because, compared to the risk of a fire-sale following insolvency or bankruptcy enforcement, they are better off with a predictable loss arising from the trade. Banks also prefer cash to a possible debt for equity exchange which the debtor might propose as part of its restructuring plan. Banks rarely possess the expertise to profit from distress. TEC does not have the regulatory pressure faced by banks and is willing to partake in the process of corporate restructuring, in which it has extensive experience. This benefits the restructuring process but also the economy as a whole: TEC serves as a source of liquidity for the bank and the borrower. Banks can channel that liquidity towards healthier undertakings, thereby improving economic activities.

Investing in distressed businesses is complicated and time consuming. It also requires investors to have proven expertise in operational turnaround, which can only be developed through years of transactional experience. It should not be surprising that the asset-based lending (ABL) industry is associated with providing financing to distressed businesses. Its historical origins in Canada are associated with cash-strapped businesses that view the ABL industry as lenders of last resort. The goal of the borrowers was to obtain interim financing to enable the business to keep its head above water, until when they can obtain credit facilities from banks or other traditional lenders. Although the ABL industry may not be regarded as exclusively providing financing for distressed businesses, it still plays a strong role in the financing of distressed businesses seeking new financing to support their restructuring. ABL providers like TEC focus on the value creation and enhancement of distressed businesses so that profits can be maximized for TEC investors, which incidentally also results in benefits for the distressed debtor and its other stakeholders.

TEC takes direct steps to see to the success of the businesses in which it is invested. This in effect means that TEC is bound to seek the highest possible returns on the investments made in distressed situations. TEC believes the control of a firm in distress should be in the hands of creditors whose interests align with the interest of the firm as a whole. The process of financial restructuring often goes hand in hand with organizational restructuring. Reorganizing a financially distressed debtor encourages the distressed debtor to look more closely at its assets, and to determine the most appropriate combination of assets that will allow the business to operate efficiently going forward. With this restructuring, the distressed debtor is able to make operational changes where needed. For instance, it can do away with non-core assets with negative synergies and focus financial and managerial resources on its core business. The participation of distressed debt investors can drive the process of restructuring as investors come with characteristic qualities that can translate to value for the distressed debtor. TEC will typically require control so that it can drive the process and add value.

Distressed debt investors have been shown to not only cooperate with other stakeholders, but also generally support the restructuring of the debtor.³ But, to be clear, their motives are not altruistic – they are self-interested, profit maximizing market participants. However, involvement by investors like TEC do have salutary impacts on other stakeholders of distressed businesses. TEC never sets out with a “loan to own” strategy but realizes that, at the extreme, it must be prepared to own and operate a distressed business until it can be turned around and sold. TEC can use its secured debt position in the capital structure of a debtor to influence business strategy and effect the change in management of distressed companies, usually by the threat or actual invocation of enforcement rights. When TEC provides new money to a distressed business, it has, through the loan covenants, immense latitude to monitor the progress of the business, and exert pressure on the management to make certain decisions that may drive value. TEC can also orchestrate a change in management especially where the company failure is attributable to poor leadership or the lack of entrepreneurial creativity on the part of the extant management team. Through our activism we are able to unlock value which had been previously unharnessed or ignored by the distressed business.

Distressed debt investors typically possess and exploit the necessary know-how about their target companies, which is important for engaging with the debtor and other stakeholders in order to unlock the underlying value of the distressed business. In the context of restructuring, value can be created through the effective recapitalization of the assets of the debtor, a process that does require new money, whether as debt or equity. The new money, in the form of DIP financing, may be particularly needed to help the company remain open and to continue to carry on its business. It is important to clarify that any rescue efforts must depend on the possibility that the distressed firm is viable but only financially distressed. Making this determination is not always an easy call but TEC, as a sophisticated and experienced distressed debt investor, is better placed to determine which firms are and worthy of a rescue endeavor. Distressed debt investors not only provide financing to the distressed business, but also provide the intelligence to guide the restructuring in a way that increases returns to the investor and other stakeholders of the company. Distressed debt investors play a critical role in ensuring managerial accountability and efficiency in the conduct of a distressed business.

Given the interests of the distressed debt investor in the business, there is an increased likelihood that the intervention of such investors can prevent a liquidation of the business. For some lenders, absent any legal basis for constraining their desire to quickly liquidate the borrower, that option is the first recourse, taking advantage of the financial pressures of the debtors, to extract value for themselves. This was the case in one contentious formal restructuring in which TEC was involved whereby another secured lender vehemently opposed a restructuring plan, instead preferring a speedier liquidation of the indebtedness to them. TEC’s involvement and its larger debt position, as well as its reorganization strategy, was critical in driving a restructuring-focused negotiation. With the cooperation of several other stakeholders, TEC was able to drive the negotiations in the direction of a successful restructuring of the business, providing initial new financing, and preserving thousands of jobs and taxes for the local government.

The reputation of distressed debt investors as “vultures” has been coloured by the emotions of losing management teams and sensationalized by the media. In the current crisis environment, distressed debt investors are increasingly present at the negotiating table in formal restructurings. Empirical evidence shows that participation of such investors in a formal restructuring help distressed companies successfully emerge as going concerns.⁴ In that respect, firms like TEC are the “phoenix” for the reorganization process contributing, among other things, substantial resources in the form of capital, business and financial acumen, and expertise.

[2] In Canada, the two primary pieces of bankruptcy legislation are the Bankruptcy and Insolvency Act (the “BIA”) and the Companies’ Creditors Arrangement Act (the “CCAA”). The BIA is the principal federal legislation in Canada applicable to insolvencies. It governs both voluntary and involuntary bankruptcy liquidations as well as debtor reorganizations. The CCAA is specialized companion legis- lation designed to assist larger corporations to reorganize their affairs and is similar to Chapter 11 of the United States Bankruptcy Code. The CCAA provides a restructuring corporation with greater flexibility and greater creativity in conducting its reorganization.
[3] Fuller M (2006). The distressed debt market – a major force that’s here to stay. Recovery, 15. The paper suggests that contrary to acting in a self-serving manner, distressed debt investors in the UK have worked with other lenders to drive the value proposition of the group.
[4] Wei Jiang et al., Hedge Funds and Chapter 11, 67 J. FIN. 513, 513 (2012)

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Consumers will save more, in our opinion, and firms will invest less. Lost jobs, many of them potentially permanent (in parts of the real estate and travel industries, for example), will increase slack in the labour market and exert downward pressure on wages. We believe the pre-pandemic status quo around certain issues, like teleworking, office space, supply chains, inventory management, online shopping, education, healthcare, and public policy, will be shaken.

The economic outlook is highly uncertain and the number of dead branches on the decision tree for investors is growing. Worries of an economic reopening curtailed by a second wave of COVID-19 infections, and a China-U.S. cold war, will keep volatility high. Risk assets are priced for steady economic progress and reopenings so any disturbance to these expectations could lead to lower valuations. Many investors, policymakers and medical experts believe that a second and more dangerous wave of infections will occur in the fall or winter months (when other coronaviruses tend to spread more readily) after the economy reopens and people become less vigilant about social distancing. A study of the Spanish Flu showed that second peaks frequently followed the sequential start, stop, and restart of nonpharmaceutical interventions.[2] The second influenza wave in 1918 caused much greater mortality world-wide than the wave that preceded it. The independent scientific committee advising the U.K. government, for example, warned in March 2020 that countries with heavy suppression would experience a second peak once such measures were relaxed[3]. There are contrasting views and different political motivations and no one really knows the ultimate truth because COVID-19 is a novel virus. However, at least for now, governments are inclined to reopen sooner than desired by medical experts because the cost of lockdown is too expensive for the economy relative to the risk.

Policymakers will continue their aggressive fiscal and monetary support. With real interest rates unable to decline in any meaningful manner to stimulate private consumption and investment, the onus falls on fiscal policy to fill the hole in demand. Canadian federal aid in response to the pandemic has already been enormous totalling about $330 Billion, or 14% of GDP, most of it to keep workers employed or supplemented in case of layoff.  As the recovery in the labor market slows, households will need further income support. Otherwise, personal spending will collapse and have a ripple effect throughout the economy. The Bank of Canada’s key role will be to ensure that Canada’s large fiscal deficits are funded smoothly and cheaply. The federal government is projecting a record deficit of $343.2 Billion for the current fiscal year ending in March 2021; nearly ten times what the government had predicted in December 2019. Tiff Macklem, the new Governor of the Bank of Canada, has reiterated his predecessor’s commitment to continue large-scale asset purchases until the economic recovery is advanced. The central bank’s balance sheet has more than tripled in size since the onset of the pandemic, reaching approximately 22% of 2019 GDP. The new mantra from the Fed and Bank of Canada may have to change from “lower for longer” to “lower forever”. For investors, the thirst for yield remains unquenchable.

[1] To achieve herd immunity, many people would necessarily die and the pressure on the health care system could be overwhelming. See our commentary in the Q1-2020 Investor Report.
[2] See our commentary in the Q1-2020 Investor Report for a discussion of the Spanish Flu study.
[3] https://www.gov.uk/government/collections/sage-meetings-march-2020

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We want to share with you how we are managing the impact of COVID-19 on our investments and the threats and opportunities we believe lie ahead. We have always built our portfolios to withstand recessionary conditions and weather through volatile storms without suffering catastrophic loss. We strive to build the ark before the flood. We never anticipated the possibility of a runaway global pandemic but, by staying steadfast to our disciplined investment process, we never had to. Being at the top of the capital stack of good businesses with valuable assets, means management, shareholders, and other creditors all have to suffer loss before we ever do.

Across the world, we are witnessing the destabilization of good businesses that, due to no fault of their own, are suddenly seeing demand and revenues plunge, obligations soar, and cash run out. They are being forced to layoff workers, curtail new projects, and lose market share. Some companies are facing existential threats and may fail. These new realities have quickly sent shockwaves through the leveraged loan markets, caused banks to reduce and refuse exposures, and erased the calendar for new bond issuances. The leveraged loan index is down more than 14% so far this month; spreads in the U.S. high yield market have blown out to 1000 bps above Treasuries. These are extraordinary times for us in terms of both risk and opportunity.

On risk, defaults will rise in our portfolio. The outbreak has cut demand for companies operating in nearly every industry, not the least of which is energy, which is also suffering from an irrational surge in supply. We have significant loans to companies operating in the upstream and midstream sectors of the energy industry. Fortunately, our borrowers here are hedged for commodity prices below the cash cost of production or are otherwise considered critical suppliers to their customers and will be less affected than their peers. For all our loans, including those in the energy industry, we believe we have sufficient quality collateral to avoid any permanent impairments of capital. We expect to increase credit loss provisions due to IFRS 9-related scenario adjustments and take reserves on our private equity holdings, both of which we anticipate being temporary and hope to reverse when COVID-19 is contained.

It has never been more critical to be proactive in crisis management. Our continuous tracking of transactions within borrowers’ bank accounts and our rights to take those over give us powerful forward visibility. Moreover, our turnaround management and distressed investing skills, combined with a cycle-tested track record of successfully managing through complex workouts, has given us unique perspectives on how to properly triage troubled businesses. We have been actively engaging in risk mapping exercises with all our portfolio companies. We have provided management teams with tools and guides to help sustain operations and drive rapid improvements to their cash position. While there is no glass to break in case of emergency, our borrowers have the solace of our involvement to help them navigate through challenging circumstances.

We are focusing our priorities on protecting our investments and not allowing any temporary liquidity issues wrought by the crisis to upend our borrowers. This includes, in some cases, providing short-term cash injections and payment moratoriums, optimizing working capital, and eliminating certain spending. I believe we have a shared social responsibility to prevent the unnecessary failure of good businesses. We have the resources to do this. We also have the flexibility and advantage of having no fund-level leverage and owning our loans outright so that we can control the outcomes without competing with divergent interests.

Now to opportunity. Our experience has shown that maximum uncertainty usually leads to maximum returns. We believe we at the beginning of a 12-24 month period during which credit markets will be paralyzed following a wave of defaults and larger than expected losses. The fragility in the credit markets far predates the COVID-19 crisis. For over the past two years, we have been writing and speaking loudly about our concerns over credit market excesses, including low cushions of safety, high leverage, and no covenants, all of which would lead to meager loan recoveries for many lenders when the debt cycle ends. We asserted our view by staying senior secured, focusing on asset values over earnings projections, and tracking key performance indicators of our borrowers’ businesses so that we could intervene to course correct if necessary. We also upgraded the type of borrowers we wanted to back: larger companies with scale in revenues, greater operational flexibility, and established market positions. Our deliberate actions will preserve our portfolio and allow us to deploy dry powder to take advantage of other lenders tapping out. We are already witnessing a rise in inquiries from companies and their advisors to underwrite restructurings, provide M&A backstop financing, and help repurchase or refinance debt at discounted levels. We have been waiting for this opportunity to come and started raising capital last year to exploit it. We are convinced that the best returns for our investment strategy are now on the horizon.

Race car drivers are taught to look at the horizon to avoid getting into accidents. When faced with the fear of the unknown, our natural instinct is to panic. But panic causes our brains to go on flight mode and we make rash decisions that usually result in mistakes. It is important to look ahead. We encourage our investors to act prudently and invest for the long term. Avoid the hysteria around you and focus on the factors that make private debt worth investing in.

The path to normality is still blurry but we promise to make sure we give you as much certainty and transparency about what we are doing at Third Eye Capital as possible. Thank you for entrusting us with your financial success. It’s a tremendous privilege and responsibility that we take very seriously. As always, we look forward to partnering with you no matter the market conditions and helping you reach your investment goals.

In the meantime, please be safe and take care of your team, families, friends and community. Should you have any questions, please do no hesitate to contact us.

Yours very truly,

Arif N. Bhalwani
President & CEO
THIRD EYE CAPITAL MANAGEMENT INC.

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