30 Sep Go Where the Capital Isn’t (Q3-18)

September 2018 marked the tenth anniversary of the collapse of Lehman Brothers, when the last credit cycle came to an abrupt and violent end. The rebound in credit markets has been spectacular and gave birth to a new asset class, private debt, that continues to be the most popular alternative investment strategy among pension funds, endowments, and family offices around the world. Preqin estimates that private debt funds globally have a record USD$251 Billion in dry powder reserves available to invest. This does not include funds currently in the market raising capital.

The size of the U.S. leveraged loan market has nearly doubled since the end of 2007 to USD$1.1 Trillion. Already this year, the market has grown another USD$133 Billion through to the end of August 2018 (according to S&P LCD). There are now at least 306 unique, nonbank institutional loan groups participating in the primary loan markets; there were a similar number in 2007, according to S&P LCD, but less than half of those survived the GFC. The tsunami of capital accumulation has compressed credit spreads, pushed the boundaries of acceptable leverage, and given borrowers unprecedented bargaining power.

It has been relatively easy for borrowers, even the most distressed, riskiest borrowers, to access credit for opportunistic purposes; that is, credit not for growth and investment but rather to extend maturities, lower pricing, or enrich shareholders. For the twelve months ended September 30, 2018, loans for opportunistic purposes in the U.S. accounted for approximately 45% of new loans by dollar volume and 51% of new loans by number. According to data compiled by Bloomberg, junk-rated companies have reduced their bonds maturing in 2019 by more than 40% and most sub-investment grade issuers have successfully “kicked the can” to as far as 2025. This is a big paradox for debt markets today: the “smart money” is warning of a downturn (see our Q2-2018 letter) yet they are happy to postpone the inevitable reckoning for their most troubled borrowers. TEC does not lend money solely for opportunistic purposes. Our adage is to “lend money, to make money” and therefore we only invest to increase value in our portfolio companies.

Research from the Bank for International Settlements (“BIS”) shows that in the wake of the GFC, the prevalence of so-called “zombie companies” has significantly increased as a share of the total population of non-financial companies. Zombie companies, a term we first used at an investment conference in Toronto in October 2008, are companies unable to cover debt servicing costs from earnings and have assets with realizable values less than their debts outstanding. BIS suggests that “the ratcheting down in the level of interest rates” after the GFC reduced the pressure on zombie companies to restructure or exit. This reduced pressure does not reflect improvements in profitability; in fact, BIS results showed that zombie companies performed worse in terms of EBIT-to-asset ratios compared to nonzombie companies. Across fourteen advanced economies studied by the BIS1, the share of zombie companies rose, on average, from around 2% in the late 1980s to 12% in 2016. Canada’s outbreak might be worse.

Deloitte LLP analyzed financial data of 2,274 companies listed on the Toronto Stock Exchange and the TSX Venture Exchange from 2015 to 2017 and found that at least 16% could be considered zombie companies. This likely understates Canada’s zombie problem because of the narrow definition used by Deloitte to define zombie companies and the consideration of only publicly-listed companies. Regardless, there is clearly massive amounts of capital locked-up in underperforming businesses that misallocate resources, drag productivity, and lower economic growth. Credit Benchmark, a financial data analytics company, points out that over the past eighteen months, U.S. companies with debt ratios of greater than 75% have seen default risks increase by nearly 40%. Zombie companies are ticking time-bombs in the current credit markets.

Since 2013, S&P LCD has been tracking the queue of at-risk credits in the leveraged loan markets – meaning those loan issuers with a corporate credit rating of single B- or lower (excluding defaults) by S&P Global Ratings and that have a negative outlook or implication. S&P LCD has termed these at-risk credits as “Weakest Links” and found that their share of the U.S. leveraged loan issuer universe has now spiked to 7.2%, the second-highest level on record. Weakest Links can be thought of as issuers infected with the “zombie virus”. The one-year default rate after becoming a Weakest Link has steadily grown in the five-year history of the analysis despite the strong credit market environment. Of the 2017 year-end Weakest Links, a whopping 14% defaulted or restructured. Contrast that to the one-year default rate for credits rated single B or higher, which is under 1% for the comparable time period. So far in 2018, the leveraged loan issuers that have defaulted had been Weakest Links for an average of 2.5 years. So while the credit bull market has bought time for weaker credits, it has not allowed them to avoid the inevitable. The combination in today’s economy of rising interest rates and higher wages (zombie companies likely must pay more to attract talent than uninfected firms) risks a major wave of defaults in the next recession.

Zombie companies need copious amounts of capital to survive and will therefore tend to swarm where capital is abundant and desperate to invest. It is certain in our minds that a lot of zombie companies are lurking inside the legion of private debt funds and other institutional loan portfolios that formed after the GFC. The market focus of the vast majority of private debt funds over the last decade has been the fabled “middle-market”2 where companies are presumed to be ignored by banks and other traditional sources of financing. Canada is a small and medium-sized enterprise market: 99.97% of businesses have less than 500 employees representing 90% of the workforce and 30% of GDP by province, according to Statistics Canada. It is where both Canadian chartered banks and alternative credit providers conduct most of their lending activity albeit on distinct risk parameters. In the U.S., middle-market companies represent just 3% of all U.S. businesses but account for a substantial one-third of GDP and employment, making the middle-market larger than the entire Canadian economy.

Not surprisingly, the middle-market in Canada, and to a lesser degree in the U.S., is where TEC has historically trafficked. Unfortunately, the middle-market has become in our opinion the ultimate graveyard for zombie companies. In the U.S., non-bank financial companies and private debt funds today hold 91% of all middle-market loans based on S&P LCD data. So many private debt funds have calibrated their size, structure, and strategy to the middle-market that it has created a positive feedback loop of more capital leading to more borrowers leading to more capital, and so on until eventually lenders are lending based on future expectations rather than current cash flow or values. This is an example of reflexivity, a theory popularized by successful speculator and failed philosopher George Soros3, in which participants’ expectations about a market and the actual state of the market create a “two-way connection” where the behaviour of the participants shapes the market. This is readily evidenced by the steady climb in total leverage multiples for middle-market lending transactions over the last few years; according to Refinitiv LPC (formerly, the Thomson Reuters Loan Pricing division), average debt-to-EBITDA was almost 6.5x in Q3-2018. Private debt funds are still raising capital on the premise of opportunities in the middle-market yet they do not realize that it is the aggressive lending actions of their peers influencing such opportunities.

Private debt funds and their investors are ignoring Wayne Gretzky’s advice, “I skate to where the puck is going to be, not to where it has been.” The premium in spread that lenders in the middle-market expect to get paid has narrowed significantly. The average yield premium for middle-market loans above larger loans in the U.S. has been a paltry 1.20% between 2011-2017, according to Refinitiv LPC. We believe the puck in loan markets today is heading toward larger companies (with enterprise values more than $200 Million). Banks have increasingly shifted from being principal investors in larger loans to brokers or arrangers that prefer to make highly profitable syndication and transaction-oriented fees in distributing these loans. This works especially well when market liquidity is high; however, turnover has substantially decreased since the GFC reflecting structural changes in bank’s marketmaking and proprietary trading activities. We have noticed that larger financings ($100 Million or more) are taking longer to execute in the Canadian bank market. This means larger companies wanting to access debt may be facing greater uncertainty in timing and execution than smaller firms despite their bigger scale and generally higher credit quality. Larger companies have performed better than smaller companies during the past three default cycles according to Morgan Stanley research. Given our late-cycle view, we believe large company loans are where risk-adjusted returns are most attractive and will provide the best cover when defaults climb again. Private debt funds with large committed pools of capital, established reputations in their target markets, and long-term skills and experience in managing complex loan workouts have an advantage in this environment.

Potential Lost

According to official survey data, businesses in Canada and the U.S. appear to have finally bought into the demand recovery story and are raising expectations of future capital investment spending. Apparent strength in the economy and job growth are encouraging firms to upgrade their revenue and profit outlooks, and any tentativeness caused by trade tensions was removed after Canada, U.S., and Mexico recently reached a pending free trade agreement. With business loans easy to obtain, we would not be surprised to see capital expenditures accelerate through to the end of 2019. This will especially help manufacturers, materials companies, and energy producers which have lagged other major industrials in the post-GFC recovery. BCA Research notes that the average age of non-residential capital assets has risen to the highest level since 1962. Cautious investment sentiment in the aftermath of the GFC has created pent-up demand for fixed assets, meaning the replacement cycle for business investment may be in the early stages.

The IMF estimates that global investment in 2017 was at least 20% below the level implied by the pre-GFC trend. The IMF blames reduced bank credit availability, but the problem is more about the choice made by companies to prioritize shareholder friendly actions (like share buy-backs and dividend recaps) over business investment. In order to fulfil capital spending intentions, businesses need access to credit, and as readers of my quarterly letter know, there is a lot of credit available today. Based on data tracked by the Bank for International Settlements, non-financial corporate debt is outpacing GDP growth in the developed economies (Figure 1). Corporate debt in Canada is at record highs and is more than 40 points higher as a percent of GDP than in the U.S.

Unfortunately, the aggressive releveraging by Canadian businesses has not coincided with an increase in spending on new machinery and equipment (“M&E”), a category of spending that C.D. Howe Institute, a non-partisan economic research organization, says affects Canadian prosperity. Relative to the U.S., which accounts for approximately one-half of total OECD investment, Canadian M&E investment per worker has had a dismal record.

Today, Canada’s gap in investment is the widest it has been in thirty years, which the OECD calculates to be a record 40% less than what U.S. businesses invest per worker. This trend is worrisome for the future competitiveness of Canadian businesses. By stalling investment for a prolonged period, businesses risk permanently reducing their long-term potential. The resulting loss of output cannot be regained.

The C.D. Howe Institute estimates that post-GFC Canadian businesses have mostly chosen to use internally generated funds to increase liquidity buffers, presumably, to insure against another economic downturn. Investment intentions, however, appear to be rebounding and a majority of businesses surveyed by the Bank of Canada are planning to increase investment spending in response to anticipated strength in demand, capacity pressures, and the “need to keep up with competitors.”4 In order to achieve investment levels more in line with their counterparts in the U.S. and other OECD countries, Canadian firms will need to borrow more and increase external financing. However, there is little spare capacity for banks to finance business investment in Canada given the extended run in the current credit cycle. This further enhances the business case for experienced non-bank, alternative lenders in Canada, who can provide creative financing solutions to make companies more competitive.

Excerpted from Third Eye Capital Management Inc.’s Q3 2018 Investor Letter.