Yet history tells us that markets have an uncanny ability to make fools of those who believe the past no longer applies. From the rise of the automobile and telephone in the 1920s to the internet revolution of the 1990s, every period of disruptive innovation has fueled the same euphoria, leading investors to abandon arithmetic in favor of fantasy. Arthur C. Clarke famously observed that “any sufficiently advanced technology is indistinguishable from magic.” The problem is that investors, time and again, mistake this perceived magic for a license to ignore economic fundamentals.

Despite all the transformative technological breakthroughs of the past two decades – smartphones, e-commerce, cloud computing, automation, and now AI – both U.S. GDP growth and S&P 500 revenue growth have actually slowed, not accelerated. Since 2000, these measures have averaged just 4.5% annually, lower than in the preceding half-century.¹ One would think that with all the world-changing innovations since 2000, growth would be faster, not slower. It has not.

The lesson? The impact of innovation on markets follows a familiar pattern: early profits surge, valuations reach extremes, competition intensifies, margins compress, and the long-term benefits accrue mostly to consumers, not to speculative investors chasing unsustainable narratives.

Stock market gains have come disproportionately from a handful of mega-cap technology companies, just as past bubbles have been led by their own anointed winners. Investors convince themselves that this time, the winners are different – immune to the laws of competition and destined to outgrow the economy indefinitely. But history suggests otherwise. Every speculative peak has been defined by a cohort of “must-own” companies that were expected to dominate forever. Yet over time, market leadership is constantly disrupted. Consider:

• In 1929, the dominant companies were industrial titans tied to automobiles, oil, and consumer goods.
• In the 1960s and 1970s, it was electronics, aerospace, and the Nifty Fifty, with IBM, Kodak, and Xerox at the forefront.
• In 1999, it was internet pioneers like Cisco, Intel, and Microsoft, commanding valuations that assumed decades of uninterrupted dominance.

Each of these groups was seen as invincible at the time. Yet as the speculative peaks unwound, reality set in: profit margins normalized, growth expectations were revised downward, and stock prices suffered, sometimes for decades.

Today’s AI obsession is following the same script. Companies like Nvidia, Broadcom, Super Micro Computer, and Palantir have been propelled to astronomical valuations based on the assumption that AI will drive perpetual earnings growth. But just as with past cycles, competition will intensify, margins will contract, and much of AI’s economic benefit will accrue as consumer surplus rather than as permanent excess profits for investors.

A common argument supporting today’s elevated stock valuations is that corporate profit margins are structurally higher due to technology and globalization.² While these factors have played a role, they are not the primary drivers of margin expansion over the past three decades. The most significant driver has been declining interest rates. Since 1990, corporate EBIT margins (earnings before interest and taxes) have barely increased. The key reason net profit margins have expanded is that companies have enjoyed steadily lower interest expenses thanks to falling borrowing costs. In 2020-2021, many companies locked in historically low rates, further extending the illusion of permanently high margins.

Now, with interest rates back at more normalized levels, this tailwind is disappearing. Companies that relied on cheap debt to drive earnings growth will face rising borrowing costs, compressing margins and exposing just how unsustainable much of the past decade’s profit expansion really was.

Investors make the repeated mistake of basing valuations on excitement rather than arithmetic. When a company or sector is growing rapidly, it is tempting to project that growth forward indefinitely. But even in industries experiencing massive technological shifts, growth follows a trajectory that is not a straight line:

• In the early 1900s, the rise of the automobile revolutionized transportation, yet the auto industry soon became fiercely competitive, with margins eroding over time.
• The 1960s and 1970s saw the explosion of electronics and computing, yet even dominant players like IBM saw prolonged periods of underperformance as competition caught up.
• The 1990s internet boom saw enormous enthusiasm around online commerce and software, but investors who bought at peak valuations had to wait nearly 15 years just to break even.

Investors today, enthralled by the promises of AI, risk making the same mistake. Yes, AI will be transformative. But the assumption that AI will deliver indefinite profit expansion for a select few companies is an illusion. Capitalism ensures that competition eventually narrows the gap between innovation and economic reality.

The psychology of speculative bubbles follows a predictable sequence:

1. A real, transformative innovation emerges.
2. Investors extrapolate early successes into an unsustainable growth trajectory.
3. Capital floods into the sector, driving valuations far beyond reasonable levels.
4. Margin pressures, competition, or macroeconomic forces begin to erode profitability.
5. The unwinding begins, leaving latecomers with steep losses.

This pattern has played out in every major speculative cycle – from the railroads of the 1800s to the dot-com crash to the SPAC frenzies of recent years. It is unfolding again in today’s AI-driven stock boom.

Speculation thrives on narrative, not numbers. When investors begin justifying extreme valuations with phrases like “new era,” “paradigm shift,” or “this time is different,” history warns us to be skeptical. Yes, technology is evolving rapidly. Yes, AI will reshape industries. Yes, some of today’s dominant companies will continue to succeed. But that does not mean profit margins, revenue growth, and market leadership will defy gravity indefinitely.

Ultimately, long-term wealth is built not by chasing momentum, but by respecting arithmetic, recognizing cycles, and maintaining discipline. The history of markets is clear: those who buy into speculative frenzies based on the belief that they are witnessing magic will, in the end, find themselves in the disappearing act.

[1] John Hussman, November 2024
[2] “AI stocks aren’t in a bubble”, Goldman Sachs, September 18, 2024

The post Now You See It (Q4-24) appeared first on Third Eye Capital.

Stale valuations, or delayed adjustments to asset prices, are an inherent characteristic of private credit due to the market’s illiquidity. Unlike publicly traded debt instruments, private credit loans do not benefit from regular price discovery, making it difficult to gauge their true market value. This creates several systemic risks. For instance, in evergreen or open-end funds, where investors can request redemptions at periodic intervals, stale valuations can create a first-mover advantage for better informed investors. Those with insights into a fund’s overvalued assets may choose to redeem their investments early, leaving remaining investors to bear the brunt of eventual markdowns. This dynamic increases the risk of “runs” on evergreen private credit funds, which are popular with retail high-net-worth investors, potentially destabilizing the segment. Such a risk is minimized in closed-end funds, the preferred vehicle for institutional investors, since limited partners do not have the option to redeem at will. Any attempt to exit would require a secondary market transaction, which inherently involves price negotiation, limiting the ability to exploit stale valuations.

The combination of illiquidity and infrequent valuation updates makes it challenging for external stakeholders to assess potential losses in a timely manner. This lack of transparency can undermine trust in private credit markets, particularly during periods of stress when accurate information is most critical. In such moments, market conditions shift rapidly, borrower creditworthiness deteriorates, and valuations need to reflect these realities to provide a true picture of portfolio risks. However, the lack of real-time price discovery and limited transparency leaves investors reliant on fund managers’ reporting, which is often delayed or incomplete. This lag can obscure risks, leading to poor decision-making and an inability to act swiftly to protect capital.

This challenge is further exacerbated by the incentives fund managers have to maintain high valuations, especially during fundraising periods. Strong historical returns are one of the most persuasive marketing devices managers can leverage to attract new commitments, and valuations play a critical role in shaping the narrative of a fund’s performance. By keeping valuations elevated, managers can enhance reported metrics, projecting a sense of stability and profitability that appeals to prospective investors. For institutional investors wary of the inherent opacity in private credit, such performance metrics can be reassuring, even if they are not entirely reflective of underlying realities.

The reliance on historically higher returns to market funds also aligns with the financial incentives of fund managers. Most evergreen private credit funds structure management fees as a percentage of the net asset value (“NAV”) of the fund. This creates a direct economic benefit for managers who maintain elevated valuations, as higher NAV translates to higher fees. In cases where valuations are closely tied to perceived fund size, delaying markdowns or impairments becomes not just a defensive strategy but a financial one.

This approach, however, creates a dangerous misalignment between the interests of fund managers and those of investors. Inflated valuations, while advantageous in the short term for raising capital and maintaining fees, can mask underlying risks. When economic conditions worsen or borrower performance declines, these risks can become suddenly visible, leading to a rapid deterioration in trust. Investors who relied on optimistic valuations may feel misled, particularly if losses materialize without sufficient warning. This erosion of trust damages not only the specific fund in question but the broader credibility of private credit as an asset class.

During periods of financial stress, the impact of delayed or inflated valuations becomes particularly acute. Accurate valuations are critical for investors to evaluate portfolio health, rebalance exposure, and make informed decisions about future commitments. If valuations are consistently slow to reflect impairments, investors may begin to suspect that managers are prioritizing their own interests over those of the fund’s stakeholders. This perception can lead to reduced confidence in the market and, in the case of open-end funds, redemption pressures that exacerbate liquidity challenges.

When high valuations attract new commitments, managers may be incentivized to continue delaying impairments, creating a cycle where reported performance diverges increasingly from actual portfolio health. Eventually, the delayed recognition of losses can no longer be sustained, leading to sudden markdowns that damage investor confidence and destabilize funds.

This dynamic highlights the need for private credit managers to adopt more transparent and consistent valuation practices. While accounting standards such as GAAP (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Standards) provide general guidance, they stop short of prescribing specific techniques for asset valuation, leaving managers with substantial discretion in how valuations are determined.

Business Development Companies (BDCs) in the U.S. offer a unique window into otherwise opaque private credit valuation practices due to their granular reporting requirements such as position-by-position accounting fair value marks. BDCs are specific investment funds created in the United States to encourage the flow of capital, primarily in the form of secured loans, to smaller companies.

A benchmarking analysis by the International Monetary Fund (IMF), which focuses on promoting global financial stability, assessed BDC valuation practices.¹ The study revealed that private credit prices tend to be less responsive to credit shocks compared to high-yield or leveraged loans, despite the higher risk profile of BDC loan portfolios. This reduced sensitivity in valuation adjustments is offset by a significant discount applied to the market prices of BDC shares (relative to their NAV). Notably, the discount tends to widen during stress periods, driven by the general market repricing of credit risk, as reflected by traded proxies for loans such as the LSTA US Leveraged Loan Index.

Evidence suggests that adjustments to private credit loan valuations are not only smaller but also slower than those observed in public markets. Such deviations often persist for several quarters, during which time share prices and net asset values gradually converge. This lag in valuation adjustments highlights the inherent challenges of assessing private credit assets, particularly in volatile market conditions. As private credit attracts more retail investors, concerns about valuation have grown. Retail participants often lack the sophistication and access to information that institutional investors possess, making them more vulnerable to the risks posed by inaccurate or inconsistent valuations. This has led to increased regulatory scrutiny and calls for enhanced disclosure and governance practices.

The regulatory framework for private credit funds has historically been light, focusing on policy documentation, governance standards, and investor disclosures, without prescribing specific valuation methodologies. This leniency reflects the assumption that institutional investors, such as insurance companies and pension funds, possess the sophistication and resources to independently assess valuation practices and make informed decisions. However, these same investors often prioritize portfolio stability and may lack the incentive to rigorously challenge fund managers’ valuations, even in cases where discretion leads to significant discrepancies in asset pricing across funds.

In response to growing concerns about valuation risks, regulators have begun intensifying oversight. The U.S. Securities and Exchange Commission (SEC), the UK Financial Conduct Authority (FCA), and the European Securities and Markets Authority (ESMA) have all taken steps to tighten governance and enhance transparency in private fund valuations. Measures include stricter requirements for independent audits, more frequent supervisory inspections, and greater scrutiny of valuation practices. Regulators are also emphasizing the importance of timely and accurate loss recognition, particularly for semiliquid funds or those approaching the end of their lock-up periods. Where valuation risks are deemed high, policymakers are considering mandates for independent external audits and more rigorous internal governance frameworks to improve valuation reliability and investor confidence.

The increasing trend of retail participation in private credit has raised concerns about herd behavior during stress periods, where redemption pressures could destabilize the market. To mitigate these risks, securities regulators are recommending measures such as longer settlement periods, closed-end fund structures, and the adoption of liquidity management tools. Under the Alternative Investment Fund Managers Directive II (AIFMD II) in Europe, which went into force in April 2024, funds that substantially engage in the granting of loans must adopt a closed-end structure. Clear and comprehensive 10 International Monetary Fund, Global Financial Stability Report: The Last Mile: Financial Vulnerabilities and Risks. April 2024 disclosures on redemption limitations and potential risks are also being emphasized by regulators worldwide to ensure retail investors are adequately informed.

These developments underscore a broader shift toward enhanced regulatory scrutiny and governance practices in private credit. As the market continues to grow and evolve, aligning valuation and liquidity practices with heightened transparency standards will be essential to maintaining trust and resilience in the asset class.

[1] International Monetary Fund, Global Financial Stability Report: The Last Mile: Financial Vulnerabilities and Risks. April 2024

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This asset-centric model is appealing for its simplicity – after all, it is easier to quantify collateral than character. Character, in the context of credit analysis, refers to the integrity, reputation, and trustworthiness of the borrower – in this case, the management team. It is an assessment of whether the borrower has the ethical standards and commitment to meet their obligations. Character is subjective and often becomes a secondary consideration in asset-based lending. In fact, many of the structural features of asset-based loans, such as lockboxes, blocked account agreements, and customer notifications, are designed to make management irrelevant. However, in our experience, character should hold equal if not more weight in the determination of making a secured loan. We have learned, sometimes the hard way that, no matter how promising a business model may appear or how attractive an asset might seem, the quality of management can determine the success or failure of an investment.

Asset values are not static, but they are generally more stable and less prone to volatility than earnings or cash flows. This relative stability is another reason why asset-based lenders often consider management quality to be of secondary importance. Unlike earnings, which can fluctuate with various market or industry conditions, and can be subject to aggressive accounting practices, assets have an intrinsic value that is less susceptible to short-term market fluctuations or management manipulation. This perceived reliability makes it tempting for lenders to focus primarily on the value of the collateral, with the assumption that even if management falters, the assets will hold their value and can be liquidated to recover the loan.

Management character is the cornerstone of how a business is run. Even the most valuable assets can quickly become worthless if mismanaged. A management team that lacks integrity, transparency, or the ability to make sound decisions can erode asset value rapidly, leaving lenders with far less than they anticipated. Poor management can lead to the misuse of assets, neglect of maintenance, or engagement in risky business practices that diminish the collateral’s worth over time. While collateral value is central to asset-based lending, the interaction between collateral and character is what ultimately determines the success of the loan. A strong collateral base can mitigate some risks, but it cannot substitute for poor management. Conversely, a management team of high character and competence can sometimes compensate for weaker collateral, using their skills to enhance asset value over time.

The synergy between these elements is where true security lies. A prudent lender recognizes that while assets provide a buffer, it is the character and quality of the management team that determines whether those assets will retain or increase their value. Evaluating management’s track record, their response to past challenges, and their overall business acumen is as important as assessing the current market value of the collateral.

The character of the management team is a non-negotiable criterion in our investment process. We believe that you cannot make a good deal with bad people. If we begin to question the integrity or character of management, our course of action is clear: we either exit the investment or replace the management. This principle is rooted in the reality that character flaws in leadership inevitably lead to deeper problems down the line – problems that can erode value, destroy trust, and ultimately lead to the failure of the business. We have observed time and again that leaders who lack integrity are more likely to engage in practices that are harmful to the business and its stakeholders. These practices can range from financial mismanagement and fraud to unethical business dealings and poor corporate governance. Such behaviors create an environment of mistrust, where stakeholders, including employees, customers, or lenders, become wary and disengaged. This erosion of trust can be fatal, especially in situations where a company is undergoing change, challenge, or complexity – the TEC “Cs” of credit!

Assets that are well-managed, well-maintained, and strategically deployed tend to appreciate or at least retain their value. Conversely, poorly managed assets can rapidly depreciate, become obsolete, or be misused in a way that diminishes their market value. Poor management, driven by short-sightedness or desperation, can effectively burn the very assets that were intended to secure the loan, leaving little to no value upon which to recover. Moreover, liquidation is not a straightforward process. The assumption that assets can be easily liquidated to recover the loan overlooks the complexities and costs associated with this process. In a distressed scenario, the market value of assets can be significantly lower than their intrinsic value due to the need for a quick sale, lack of demand, or the condition of the assets at the time of liquidation. Additionally, the legal and administrative costs of liquidation can further erode the recoverable value. If the assets are integral to the business’s operations, their value may be deeply intertwined with the company as a going concern, meaning that their maximum value can only be realized if the business continues to operate effectively – a task that requires strong management.

Furthermore, the broader impact of poor management extends beyond just asset value. Bad management often leads to deteriorating relationships with customers, suppliers, and employees, all of which can further harm the business and, by extension, the value of the assets. For instance, customer contracts may be lost, supplier terms may become less favourable, and key employees may leave the company. These are intangible losses that can have a tangible impact on the overall value of the business.

Reflecting on our firm’s history, it is evident that the majority of our defaults can be traced back to one common factor: bad management. Whether it was due to poor decision-making, lack of foresight, or unethical practices, bad management has been the root cause of many of our challenges. In several instances, we entered into deals with companies that, on the surface, appeared to be solid investments. The assets were valuable, the market opportunity was clear, and the potential for growth was significant. However, what we underestimated, and did not fully anticipate was the impact that poor management would have on these businesses and more importantly our collateral.

In one particular case, we invested in an established oilfield maintenance, transportation, and surveillance company that used helicopters and fixed wing aircraft to service rural and remote energy infrastructure for blue-chip oil and gas companies. The company was a leader in its industry that provided essential services but due to an overleveraged balance sheet had to delay critical aircraft capex. Our financing was used to restructure existing debt and provide growth capital. The financial projections were promising, strong asset values were verified through third-party appraisals, and the initial due diligence did not raise any red flags. However, as time went on, it became clear that the CEO and his management team were misallocating resources and starving critical parts of the business such as pilot training and aircraft maintenance. Management was not forthcoming about spending decisions, was resistant to feedback, and overly optimistic about their ability to execute their strategy. Despite our efforts to provide guidance and support, the management team’s poor decision-making and lack of transparency ultimately led to the company’s downfall. In their desperation, they began to cut more corners and mismanage resources, effectively “burning the ships” – the very assets that should have secured the investment – leaving us with far less than anticipated.

This experience reinforced a critical lesson for us: no amount of financial engineering can compensate for bad management. A company’s success is inextricably linked to the quality of its leadership. Strong management teams are proactive, transparent, and willing to confront challenges head-on. They are open to feedback, willing to admit mistakes, and committed to finding solutions. In contrast, weak management teams are reactive, opaque, and often in denial about the reality of their situation. They are more concerned with preserving their own image than with addressing the issues at hand, and this inevitably leads to failure.

One of the key metrics we use to evaluate the quality of management is their level of transparency. We have a “no surprises” rule at our firm – a principle that we believe is fundamental to any successful business relationship. We implore management to communicate openly and honestly with us and all other stakeholders, especially when it comes to bad news. We understand that even the best leaders and the most well-run companies can encounter difficulties. Challenges are a part of business, and mistakes are a part of being human. What matters is how those challenges and mistakes are handled.

When management is transparent about the challenges they face, it allows us to work together to find solutions. It enables us to offer our expertise and support in navigating through tough times. However, when management chooses to hide or mask bad news, it not only undermines our ability to help but also signals a deeper issue: a lack of integrity and accountability. This is unacceptable to us, and we will not tolerate it.

Transparency is not just about being honest when things go wrong; it’s about creating a culture of openness where information flows freely, and all stakeholders are kept informed. It’s about ensuring that everyone is on the same page and that there are no hidden agendas or surprises. When transparency is absent, it creates an environment of uncertainty and mistrust, which can be just as damaging as the issues being concealed.

Management quality, reflected in the character of the leadership team, plays a pivotal role in safeguarding and enhancing the value of the collateral. A loan secured by valuable assets can still be a risky proposition if placed in the hands of poor management. Conversely, strong management with a commitment to transparency and ethical conduct can transform even modest assets into valuable, sustainable security. As such, the evaluation of character should be a core component of the underwriting process, ensuring that both collateral and leadership are aligned to protect and maximize the value of our investments.

PRIVATE DEBT MARKET AND OUTLOOK

Annual loan default rates have historically mirrored the trend in corporate bankruptcy filings. The number of U.S. Chapter 11 fillings in the first half of 2024 are 39% higher than the same period in 2023, and 46% higher over the number of first half of the year filings in the ten-year period 2015-2024.2

As we have indicated in previous letters,
the number of business insolvencies in Canada has also surged at record rates. Canadian corporate bankruptcies are up a whopping 70% in the first half of 2024 from a year ago. Yet, current empirical data and survey information about the credit risk of small and middle market companies report unusually low default rates, below the historical ten-year average. So what explains this surprising anomaly?

Professor of Finance at the NYU Stern School of Business, Dr. Edward Altman, recently penned a note aimed at dispassionately assessing where we are today in the credit cycle. His research since the 1970s has looked at the U.S. credit cycle’s associations with economic expansions, slow-downs, recessions, and depressions – essentially, the business cycle. According to Altman, the credit cycle has distinct stages characterized by varying levels of interest rates, default rates, recovery rates, liquidity, and required returns for investors:

• Benign Stage: Characterized by low interest rates, below-average default rates, high recovery rates, and ample liquidity. Investors require lower returns due to favorable credit conditions.

• Average Stage: Marked by moderate interest rates, default rates, and recovery rates that align with historical averages. Liquidity is balanced, and required returns reflect standard risk and reward.

• Stressed Stage: This stage sees increasing interest rates, higher-than-average default rates, declining recovery rates, and reduced liquidity. Investors demand above-average returns due to rising risk perceptions.

• Credit Crisis Stage: Defined by very high interest rates, extreme default rates, low recovery rates, and a severe lack of liquidity. Investors require significantly higher returns as risk becomes severe, with yield spreads much above average.

Based on this spectrum of credit market activity, we appear to be in the “average” stage of the credit cycle, which is contrary to where we expected to be today and certainly disconnected from the business insolvency data. Altman agrees and has his doubts about whether default rates will continue to stay at low levels. We have previously written about the unprecedented levels of liquidity support and intervention by governments and central banks in the financial markets over the past few years, which provided a critical lifeline to many businesses, enabling them to manage their debt obligations despite challenging economic conditions. At the same time, banks were obliged to forbear from enforcement and provided relief through indefinite waivers – activity which we termed “forced compassion.” We have also highlighted the recent rise in liability management exercises (LMEs), or the negotiation of debt restructurings, that prevent an immediate default and can extend debt maturities, further contributing to the low default rates observed.

The increase in corporate bankruptcies has been heavily concentrated in certain sectors that were more vulnerable to economic disruptions, such as retail, hospitality, and energy. However, many small and middle market companies, especially those in essential or resilient sectors, have managed to maintain stable cash flows and meet their debt obligations. According to the Golub Capital Altman Index, U.S. middle market companies experienced positive year-over-year growth in sales and profits throughout the second half of 2023 and into the second quarter of 2024. This sectoral disparity has contributed to the lower overall default rates. But the presence of large, secured liabilities at bankrupt borrowers begs a different explanation.

We believe the anomaly in the relationship between loans defaults and corporate insolvencies is primarily due to the delayed impact of broader economic conditions. The effects of economic downturns and rising interest rates on default rates often lag behind the initial triggers, such as increased bankruptcies. In our opinion, the full impact of current economic conditions has yet to be felt in terms of defaults, which could manifest more clearly in the coming quarters. Recent bank earnings reports in Canada reminded investors that business loan losses can be highly unpredictable and idiosyncratic. Some of the larger losses at Bank of Montreal, for example, were to commercial loans made during the pandemic – over three years ago!

Annual default rate trends have been a leading indicator of recessions in the U.S. over the past forty years (but understandably less so in 2020, during the short-lived pandemic recession). Economic uncertainty persists on both sides of the border, but with the Bank of Canada well into its easing cycle and expectations mounting for the Federal Reserve to begin cutting rates in September, the “higher-for-longer” thesis is beginning to fade. The critical question now is not just the extent of these anticipated rate cuts, but more importantly, their timing and impact on
credit conditions, which, while not dire, are undeniably deteriorating. As we move forward, the focus will be on how effectively these rate reductions can stabilize and eventually improve the credit environment and keep loan defaults low.

The outlook for the credit cycle is anything but “average.”

Yours very truly,

Arif N. Bhalwani
President & CEO

The post Burn The Ships (Q2-24) appeared first on Third Eye Capital.

The rise in financing costs over the past two years combined with slowing economic growth have posed severe challenges for many businesses. Since 2022, the debt-servicing costs for publicly listed businesses headquartered in Canada have surged dramatically, following a period of decline in the preceding years (see Chart 1).

Chart 1: Interest expenses as a share of earnings, 4-quarter moving average
Source: Financial Stability Report 2024, Bank of Canada.
However, this data captures just 0.25% of the approximately 1.3 million active businesses with employees in Canada, and therefore understates servicing costs since most publicly-listed businesses primarily finance through fixed-rate bonds rather than floating-rate bank loans. In addition, about two-thirds of these bonds currently have a remaining maturity of five years or more, meaning for many listed firms, financing costs will not increase for some time. Although interest costs as a share of earnings remain below pre-pandemic levels, they are poised to escalate in the coming years as existing debt is refinanced at higher interest rates.

The financial strain on businesses is intensifying especially for smaller firms. The number of businesses in Canada filing for insolvency, which had been unusually low during the pandemic, has now surpassed pre-pandemic levels by a large margin. Business insolvencies in Canada surged by 87.2% in the first quarter of 2024 compared to the same period last year, marking the sharpest increase in the 37-year history of records from the Office of the Superintendent of Bankruptcy. This unprecedented rise underscores the profound economic challenges that Canadian businesses are currently facing. Over two thousand (2,003) businesses filed for insolvency in the first quarter of 2024, marking the highest volume since the recession in 2008.

The surge in insolvencies over the past 12 months has generally been: (i) concentrated among small businesses, (ii) broad-based across industries, and (iii) driven by bankruptcy filings rather than insolvency proposals. A rebound in business insolvencies from pandemic lows was to be expected. Some businesses may have been sustained throughout the pandemic by government support programs and the forced compassion of banks. Successive pandemic lockdowns also disrupted the insolvency filing process, particularly the use of bankruptcy courts, leading to a backlog of cases.

Notably, small and medium-sized businesses face unique challenges today, often lacking the resilience and access to capital that larger companies possess, leaving them with more limited options for restructuring. Moreover, some business owners may opt to cease operations altogether rather than pursue formal insolvency proceedings. These business failures are not included in the official insolvency statistics.

Filings for large debtor restructurings under the Companies’ Creditors Arrangement Act (CCAA) jumped over 40% in the first quarter of 2024 compared to the same period last year. For ten years until the pandemic in 2020, there were an average of 34 CCAA filings per year. In 2020, 60 CCAA proceedings were commenced, a record-high consequence of the pandemic. For the twelve months ending March 31, 2024, there were an astounding 72 CCAA filings, with 24 of them in the first quarter of 2024 alone. Given that the average length of a CCAA proceeding as measured from the date of the initial order to the date of the monitor’s discharge is 620 days (or slightly more than one year and eight months), the actual outcome of the latest proceedings is still unknown. The best CCAA outcome is when a debtor company uses the breathing space provided by the proceedings to restore solvency without needing to reorganize or liquidate. No plan is presented to creditors, no assets are sold, and the debtor company exits as a going concern business. Unfortunately, less than 1% of all CCAA proceedings result in such an ideal outcome. The total liabilities represented by debtors in CCAA filings during the first quarter of 2024 were $4.2 billion, $2 billion more than the previous quarter, and two-thirds of which constituted secured credit.

The rising number of insolvencies and CCAA filings highlights the growing strain on businesses and underscores the precariousness of the current economic environment. Given these conditions, significant losses should be expected for creditors of these debtors. the tendency by lenders to employ strategies to buy time and restructure quietly and informally is a historical precedent that goes back to the Babylonian Financiers. As businesses and their lenders engage in these quiet negotiations and restructuring efforts, the real scale of financial distress may not be immediately apparent, potentially leading to more pronounced financial repercussions down the line. In its latest Financial Stability Report, the Bank of Canada acknowledges that it is closely watching the rise of business insolvencies but believes that it does not currently represent a significant source of concern for the credit performance of banks.

Credit performance at Canada’s “Big 6” banks remains strong, with capital and liquidity buffers continuing to exceed regulatory minimums. Business lending comprises about 40% of the total lending by Canadian banks, with loans to small and medium-sized businesses (“SMBs”) making up a relatively small share. According to the Bank of Canada, loans to SMBs, categorized as loans of $5 million or less, account for only 8.5% of total business loans. The liabilities of insolvent businesses (as declared at the time of filing) totaled about $11.4 billion in 2023. Even under the extreme assumption that all of these liabilities were owed in the form of bank loans, this would represent only about 0.7% of all outstanding bank loans to incorporated businesses.

Banks have increased loan-loss provisions on their business loans, serving as an early line of defence to absorb credit losses. Allowances for loan losses at the Big 6, expressed as a percentage of loan balances, were 20% higher in the first fiscal quarter of 2024 (three months ending January 31, 2024) than before the pandemic. Banks also continue to maintain ample buffers to meet unexpected liquidity needs and absorb unexpected losses. As of the first fiscal quarter of 2024, the average common equity Tier 1 capital ratio of large banks was 13.4%, about 2 percentage points higher than just before the pandemic and the highest regulatory capital ratio they have ever achieved, largely due to the phase-in of mandated debt stability buffers.

Canadian banks appear to be weathering a softening economy brought on by higher interest rates, as evidenced by better-than-expected fee-based earnings from capital markets and wealth management offsetting weak credit performance. Given the lagging nature of credit, provisions for credit losses (“PCLs”) are expected to move higher in 2024 relative to reported targets. PCLs for Stage 3 loans (i.e., non-performing, impaired loans) have risen faster than expected, which is not surprising given the rise in business insolvencies and CCAA filings. Overall loan write-offs have spiked and are above pandemic peaks. All these factors portend weaker credit growth over the near term and the Big 6 anticipate continuing to build reserves on Stage 1 and Stage 2 loans (i.e., performing loans) through the year.

Non-bank lenders, including private debt funds, benefit from reduced bank credit availability through greater lending opportunities and higher spreads. However, these lenders also account for the largest proportion of CCAA filings. In Q1-2024, 61% of CCAA filings with affected secured creditors involved a private debt fund, half of which were non-Canadian. The filings with the largest liabilities usually involved a U.S.-based private debt fund. Non-bank lenders are more inclined to resolve defaults out-of-court since recoveries are higher and reputational risks are lower; thus, the higher proportion of private debt funds involved in expensive and potentially prolonged CCAA proceedings likely means greater losses for these lenders.

As the impact of higher interest rates ripples through credit markets, a larger number of firms will experience significant credit stress, whether due to individual circumstances or broader credit conditions. This suggests a greater need for managers with business turnaround skills and restructuring experience and a more permanent role for special situations investments in private debt portfolios.

The post Private Debt Market and Outlook (Q1-24) appeared first on Third Eye Capital.