The Credit Cycle Is Turning. These Investors Are Taking Advantage.

A slew of expected defaults and downgrades presents opportunities in venture debt, DIP financing, and structured real estate products, investors say.

Illustration by II

Illustration by II

A paradigm shift has occurred in the credit markets — and some investors are ready to capitalize on it.

According to a new white paper from Marathon Asset Management, the size of the corporate credit market — and the amount of direct lending in the middle market — have both swelled since 2008.

Rising interest rates and inflation have in turn raised prices and wages at corporations, shifting the credit cycle, according to Marathon. “In essence, everything is pointing toward a profitability squeeze,” said Jason Friedman, global head of business development at the $23 billion credit manager.

The firm predicts that some 2,000 downgrades and 200 issuer defaults could take place between 2023 and 2024. Credit managers say that these defaults and downgrades will present opportunities in niche investments, from debtor-in-possession financing to venture debt.

“We’re in the process of a very big swing that won’t show itself until the back end of next year, where you’re going to see a significant number of defaults, [with] much more severity than people anticipated,” said Dan Zwirn, CEO and chief investment officer at Arena Investors, a $4 billion credit manager.

“The defaults are going to take a while to show because the covenants are so weak, but the value diminution has already happened,” he added.


Loan covenants — contractual provisions that set the terms of debt issuance — have become more relaxed in recent years, according to the Marathon paper. In fact, as of August 2022, 88 percent of leveraged loans are “covenant-lite,” meaning that they don’t have maintenance covenants, which require borrowers to maintain a certain level of activity.

This also encompasses “weak negative covenants,” which Marathon says can harm lenders by allowing the borrower to incur more debt and engage in transactions that aren’t in the lender’s best interest.

Amid these conditions, borrowers are relying on pro forma earnings projections to inform their leverage ratios. These earning projections often include adjustments for what a corporation believes will be a one-time event that will only affect the company over the short term. In the recent past, for example, some organizations adjusted earnings for Covid-19-related conditions.

“There is a higher level of leverage in the market,” Friedman said. “And it’s pro-forma-adjusted leverage. That’s typically a recipe for problems when the cycle turns.”

HighVista Strategies’ deputy CIO Raphael Schorr summed up the market conditions: “Asset values are dropping, EBITDAs are dropping, [and] the add-backs and tricks that people were playing [are] part of the party that’s ending,” he said. “At the same time, the price of a treasury bond has changed dramatically. The yields are higher.”

Given the credit market conditions, these investment managers are hoping to take advantage of some of the new opportunities that have begun to emerge. Both Arena and HighVista recently raised capital to deploy in credit investments. In August, Arena announced that it had raised $930 million for a special opportunities fund that would invest in asset-backed credit strategies. Zwirn said that tactical arbitrage opportunities exist in the convertible bond markets and added that venture debt also looks attractive.

HighVista, meanwhile, announced the close of a $450 million fundraise for an opportunistic credit fund on Monday. According to Schorr, HighVista is looking with a keen eye at special situations real estate and venture and growth lending through structured capital.

Within venture and growth, the “party is winding down,” according to Schorr. “It creates a pretty interesting dynamic. The party is over, and now those companies need financing.”

Marathon, meanwhile, is taking its time to invest, because the firm believes that it’s still too early to take advantage of some of the opportunities that will be available next year. “There are ways to invest early, which is more in capital solutions or rescue financing, where you’re stepping in senior and secured,” Friedman said. He noted, for example, that Marathon is looking at debtor-in-possession financings, which offer senior secured loans to companies in bankruptcy.

“It’s a bit early for defaults,” he added. “We think we’re going to see better bankruptcies later on.”