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Dan Zwirn on the State of Credit: ‘Amend, Extend and Pretend’
Having steered clear of much of the corporate private credit bubble, Arena is now slowly swooping in on fund managers’ troubled legacy investments as well as other post-Covid opportunities.
Although Arena Investors is still being patient about putting money to work, Dan Zwirn, chief executive officer and chief investment officer, says the firm is weighing opportunities in several areas of credit.
Arena is looking at buying legacy investments from private credit firms, investing in convertible securities, and doing transactions with entrepreneur-owned small businesses, small commercial properties, and subprime consumer credit shut out from government largesse, according to Zwirn. He says that the extraordinary fiscal and monetary moves by the government to save the economy is allowing companies to obscure the real states of their balance sheets and push the reality of their financial pain into the future.
But the CEO argues that he’s not staying on the sidelines because even with the enormous amount of liquidity being pumped into the market, there are still plenty of struggling companies in need of financing. He expects the pool of candidates will naturally increase over time, especially once government support starts to decline.
In a July letter sent to clients of Arena, which provides capital for special situations, Zwirn wrote, “the data looks bad, and in many cases is inconsistent with pricing, and yet money continues to search for yield, despite the picture being quite grim. So why not sit on our hands? Because the list of “have-nots” keeps growing.”
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Up until the Covid-19 pandemic, Arena had largely avoided corporate private credit because of concerns such as the lack of protections to investors, high leverage, and deals frequently involving junior debt. Now, though, many sponsors and business development companies are having trouble with investments they piled into over the years. Arena is buying loans at a discount, refinancing loans on better terms, and providing debtor-in-possession financing.
Still, the credit frenzy that existed long before Covid coupled with government bailouts and stimulus makes Zwirn skeptical about the industry’s health. “You see every kind of amend, extend and pretend strategy out there. Markets are just aping the fiscal and monetary authorities, whether they are saying a vaccine is coming or here’s ‘non-Covid adjusted EBITDA,’” said Zwirn in a phone interview. “They all just want to pretend tomorrow will be a better day but we’re content to wait 3-6 months when the reality of situation sets in,” he added.
In his letter, Zwirn explained that “in leveraged loans and middle-market credit we see lenders getting coerced by equity sponsors, hoping their circumstances can improve before they have to reckon with recapitalization, while credit investors are assuming equity risk (for which they are not receiving compensation) in the interim.”
Arena is also investing in public and privately negotiated convertibles. Troubled companies like cruise lines have seen the value of their collateral fall even as their stock prices have increased. They’ve used the equity rally to raise much needed new capital.
“We express these opportunities (including opportunities in other types of corporate securities) in several ways – through new issuance of convertibles (the cruise line example, where we can buy the convert and short the stock),” he wrote, and “in designing hedged positions at small premiums that expose us to being ‘long volatility’ as bonds and equity prices are skyrocketing in areas where there are very high chances of negative events.”
The low-risk opportunities have been rare until recently. “These types of ‘heads or tails we win’ exposures that require relatively little capital have not been available in large size for a long time. But the market will take what it can get,” he said. Convertible bond issuance, which is at the highest level since 2007, is likely to double by the end of the year, according to his letter.
Even as many alternative credit shops were putting billions to work in March, April and May of this year, Arena has been taking it slower. Now it’s deploying more capital. Still, the firm is being even pickier than it was in 2019. According to a footnote in the letter, about 5.6 percent of situations made it through the firm’s “Darwinian funnel” to become funded in 2019. This year through mid-July, that percentage has dropped to about 2.1 percent.
“Ironically, we’ve seen some of the most benevolent behavior on the part of creditors. They’ve created a level of false comfort that makes no sense. Allocators and other LPs don’t know what to think,” Zwirn told Institutional Investor. “They see grim stuff, but they also see that the value of their equity is almost all back. The reality is this stuff will grind through the market, and it always takes longer than people think.”