24 Mar Managing the Impact of COVID-19 (Q1-20)
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.