Today we continue to expand the perspectives we offer by adding another investor voice to the mix. We welcome for this Notice of Appearance, Eitan Arbeter, a Portfolio Manager and Partner at Oak Hill Advisors, an investment firm with $53b in AUM across performing and distressed credit strategies in North America, Europe and elsewhere.

PETITION: Welcome Eitan. Let’s jump in. You’ve been at OHA for 16 years and so you’ve been through the GFC and now whatever it is we’re calling 2020. Tell us about how OHA approached 2020: where did you get active? What did you look at and pass on? What are your big wins and your big losses? Anything you didn’t get in on that you really wish you had? How did the lessons you learned from the GFC inform your view on ‘20?

Eitan: Thanks Petition. Wow, 2020…feels like a lifetime ago. Remember, in March of last year, all asset-classes were correlated, so we really started at the top from a quality perspective. First we bought IG-type credit and high quality secured loans in non-stressed borrowers that had begun to trade with distressed-type discounts; second we added to high-conviction names in our existing portfolios; and by late April we were almost exclusively focused on directly COVID-impacted credits. We were exceptionally active in “rescue /liquidity capital” financing solutions (both on a public syndicated basis and private/direct) where one could negotiate terms and structural protections (think collateral, incurrence limitations etc.) that just weren’t available in existing instruments. We also re-underwrote numerous credits and picked our spots in the secondary markets in sectors tied to travel and leisure, autos, transportation, healthcare and energy, trying to identify survivors during a very uncertain time. We were really busy, deploying over $4bn in capital from March through December, 2020. In hindsight, you always wish you bought more and went wider, particularly when the world rebounds with the ferocity we have witnessed over the last 6 months, though remember that many of these business models would have been severely challenged had science not threaded the proverbial “vaccine needle”. My biggest regret is perhaps not being more aggressive in the aviation sector. Given the cash burn rates of the airlines and associated counter-party risk to the asset-owners, in addition to potential obsolescence risk associated with certain types of metal, we were cautious, anticipating further bankruptcies in the space. Even today, I am not sure many of the “survivors” will necessarily remain solvent, given all the additional leverage incurred, however security prices (and asset values for that matter), have increased materially, limiting the opportunity. As for lessons learned…sometimes technicals trump fundamentals. And government intervention can trump all (no pun intended).

PETITION: And now, what the heeeeeeeell are you guys doing in 2021? PETITION: Given (a) how quickly the 2020 cycle came and went, (b) how much money is in the system, but also (c) how much new leverage is now on balance sheets, what’s your crystal ball tell you about the future of distressed investing? Tell us what you think the rest of ‘21 will bring and then what you foresee in ‘22, ‘23 and beyond. What catalysts do you see out there?

Eitan: The market environment is generally benign and so our activity has shifted to private, directly negotiated (often structured) solutions for borrowers in need. I wouldn’t call it classic distressed by any stretch but we are seeking ways to manufacture opportunities with debt-like down-side protection, while sharing some right-tail optionality for industries and companies that are still undergoing operational challenges or sectors experiencing a void of traditional capital. I suppose in some respect, the outcome is not too far off what investors look to capitalize on in your typical control investment. The difference here is we are doing it out of court, with no formal process, and perhaps a more book-ended outcome. Absent esoteric events, such as geo-political shocks, major cyber-security breaches etc., it seems like market should remain reasonably stable in the near-term. As alluded to above, I think there will yet be a day of reckoning as the leverage in the system for certain sectors has increased significantly as companies incurred debt to bridge the pandemic. Real-estate and aviation, by way of example, are two sectors that seem ripe for future stress.

PETITION: One thing everyone seems to be talking about is inflation. Do you have a take?

Eitan: Are you a Game of Thrones fan? Cause, like Winter, it’s coming. Economists and central bankers point to “transitory” inflation…which I think is the notion that once pandemic-induced bottlenecks clear, inflation should be range-bound. But, for example, commodity inflation…I don’t believe that is pandemic-induced. We’ve had a long period of underinvestment and if demand fully recovers, it will be very hard to keep a lid on commodity prices. Labor is another one. We hear from companies on a daily basis that you can’t find labor. While that may be the result of folks drunk off of stimulus, human behavior evolves. Will everybody return to the workforce? Have social movements exposed inequalities in pay? That doesn’t revert when the pandemic alleviates. Everyone talks about our increasingly “service-based” economy, but it seems like you need willing people to provide that service. So, I think inflation is real and probably worse than the markets currently expect (future break-evens at 2.4%). The ultimate question is whether the consumer can, and is willing to, absorb that inflation. Because if not, certain business models potentially become severely strained!

PETITION: You led the group that provided the Brandco 1L financing and roll-up to Revlon Inc. ($REV) last year. To refresh people’s recollections, in ‘19, REV (a) transferred IP (American Crew brand) out of the reach of existing ‘16 vintage term loan creditors to foreign unrestricted subs (“BrandCo”) and (b) entered into a $200mm term loan secured by a first lien senior to existing secured debt on the transferred IP (and pari passu on other assets). The lenders then licensed back the IP to the opco. Then in ‘20, REV transferred the majority of remaining IP collateralizing the ‘16 term loan, including the IP supporting the Elizabeth Arden brand, to the BrandCo and used the transferred IP (coupled with the previously transferred IP) to secure a first priority new term loan facility to refi out the ‘19 term loan. It was a savage move that set off a whole slew of dominoes that we’ve covered at length in our “💄Revlon: Lipstick on a Pig?💄” series. Walk us through how that deal came together and give us your two cents on everything that’s transpired since including, if you will, the Citigroup Inc. ($C) vs. hedge funds fiasco.

Eitan: We were lenders to Revlon (both bank and bonds) and had been in dialogue with the company for many months prior to COVID around a financing to help with near-term maturities and provide capital for the company to fund its operational turnaround. This only amplified with the onset of the pandemic as the company had a third urgent need…liquidity. Our view was that the consequence of not providing capital would be dire for the company’s fortunes (a likely free-fall filing) and consequently, our investments. As such, we structured a transaction that provided the company with the necessary funds. But recall, these were extremely precarious times and we priced the new capital (in both rate and structure) to reflect the risk at the time. One of the major underpinnings behind our original exposure was the enormous flexibility in the existing credit documents. We levered that flexibility to create a rock-solid new-money instrument, whilst using the roll-up feature as an enticement for all lenders to participate. This was not some coercive structure…everyone had the opportunity to participate. In fact, several of the dissenting lenders were part of our ad-hoc group at one point, but ultimately had different views on what would be best for the company’s prospects (not to mention their positioning). As the for the Citi blunder, while it is fascinating, we don’t really have a horse in that race. Judge Furman seems to have adhered strictly to the Second Circuit precedent. However, this is just the beginning. Even after the appellate process has been exhausted, if Citi ultimately loses, its not clear whether they simply subrogate into the paid-off lenders’ claims. I’ve got my popcorn…

PETITION: You were involved in the Valaris Ltd. ($VAL) restructuring (in which the company eliminated $7.1b of pre-petition debt and culminated in a $520mm new capital injection by way of ‘28 secured notes). The company emerged from chapter 11 early in May and is back on the NYSE. Walk us through the thesis there. How, when and why did you get involved and what was the outcome for OHA (aside from having someone on the Board now)? In broad strokes (since it is a public company) what is your outlook for the business and why? We’ll note for our readers that the stock is up quite a bit since re-listing on may 3.

Eitan: We have been reasonably active in the oilfield services sector for a couple years now, while largely staying away from upstream. Last year, given the sudden abundance of distressed names, OFS became the proverbial baby thrown out with the bathwater (the commodity backdrop also provided an assist). That is not to say the industry is without headwinds, but due to last year’s dislocation, we were able to enter the position at a time when one was creating the world’s largest drilling rig company at close to the historical newbuild cost of a single drillship! And while it wasn’t lost on us that this industry is a huge consumer of capital when non-operational, the create was just too compelling to ignore. But, this was not merely a value play. The offshore drilling industry has been ripe for consolidation for many years but had an inability to consummate mergers and contract the global fleet due to large over-levered capital structures and the desire to preserve equity options. Well, the pandemic almost facilitated the slew of restructurings that were already necessary. Most large offshore drilling companies (ex. Transocean) have now gone through, or are going through a bankruptcy processes. My colleagues, Joe Goldschmid and Mike Lee played a significant role in the construction of the plan to restructure Valaris and now we will remain active in forging the company’s future strategy through our Board representation. New equity holders, like us, in the sector (with lower bases), will allow for M&A activity and asset retirements to put the industry on better footing. So, our investment was in large part a thesis predicated on both supply rationalization and an improving demand picture as the lack of global investment in reserve development catches up.   

PETITION: Canyon Partners’ Josh Friedman recently told Bloomberg that he sees a lot of discipline breakdown. In particular, he thinks that the aggressive bids pursued by PE shops and SPACs are going to come back to bite and lead to distressed opportunities. Do you agree or disagree and why?

Eitan: I think valuation inflation is a real problem because capital structures are often set up off of LTV. Well if “V” increases, leverage usually does too. Therefore, if we see a re-rating of equity valuations, there’s likely to be reasonable pain in the debt markets. Low rate environment = low coupons. Widening risk-premia with low coupons = principal pain. So I think we may see a reasonable trading opportunity if some air comes out the system. It also makes it extremely important to pick credit correctly, because there will be winners and losers. One word on SPACs...the misunderstanding in the market is that the SPACs themselves will be candidates for distress. While they are certainly culpable for inflating valuations (particularly in growth stage companies), SPACs are not aggressively levered. So I don’t believe we’ll see a huge opportunity in the SPACs themselves, but they have certainly added kindling to the fire.

PETITION: Speaking of discipline and breakdowns, we’re wondering if you have a view on what’s been happening with the “meme stocks” and how that’s been affecting capital structure trades (i.e., the bonds in AMC Entertainment Inc. ($AMC))? How, if at all, has OHA navigated this?

Eitan: OHA employs a deep fundamental approach, so we have not been directly impacted by the meme stock phenomenon. Meme stocks (or is that “stonks”), are a technical dynamic…a greater fool theory if you will. I still think it ends badly for the person without the seat when the music stops, but in the interim it can create lucrative payouts for debtholders in these companies, and in certain instances, has proven to be a self-fulfilling prophecy, giving a second-life to many companies that had exhausted their liquidity. I’m not sure what will become of AMC three or five years from now, but the meme-driven rally has given them a shot to preserve overall equity value.

PETITION: You and your firm have a lot of experience sitting on committees. What has changed about committee dynamics over the years? What would you improve upon if you could?

Eitan: Each experience is unique and really is impacted by the group dynamic, the individuals, the advisors etc. I don’t know that so much has changed, but there’s probably an increased level of cynicism and distrust. With all investors trying to get an edge to create that additional ounce of value, even if you’re a part of the same ad-hoc, you’re always watching your back. Being big and influential helps in that regard.

PETITION: As a follow-up to that, you must have some thoughts about inefficiencies in the bankruptcy space generally. What is f*cked and needs fixing? Is there one subject that not enough people are talking about?

Eitan:

PETITION: We’ve commented about the need for relatively more activist judges (in the context of feasibility and bullsh*t projections) while at the same time criticizing certain judges for being overly power-trippy and punitive on the bench. What, as an investor, do you think the ramifications of this forcefulness/activism may be? To what degree are you and your investor friends fretting over various jurisdictions and judges?

Eitan: It’s always a consideration, and as you know, is often used as a bargaining chip or a leverage point for the Debtor. As such, we like to avoid situations that rely heavily on the subjectivity of a Judge. I, for one, prefer the Judges that call balls and strikes. Ones that look to the precedents and the expert testimony, as that is something an investor can analyze. It’s not always in your control but we try and assert influence on the venue if possible.

PETITION: Talk to us a bit about the asset management business. You’re a young(ish) guy whose been there for a long time. The distressed cycles seem to be getting shorter and shorter. What are you saying to the younger guys coming up the ranks as they fret over what their futures may look like?

Eitan: The last two cycles (COVID and the 2016 mini-cycle) certainly have been briefer than we’d historically come to expect. But that is merely a function of capital availability and a very long period of low risk-free rates. Despite employing a fundamentals-based investing strategy, these technicals have to be taken into account when thinking about entry points. You have to be more dynamic and assertive. However, at it’s core, I don’t believe the calculus has changed that much. The aim of the game remains finding good companies, with sound structures, that may be experiencing temporary dislocation or an unsustainable capital structure. My advice to the younger generation is to keep your head down, accumulate at-bats and build your repertoire. Every situation is unique but experience is the greatest tool in building a long, successful career.

PETITION: What is the best piece of professional advice that you’ve ever gotten and why?

Eitan: Apart from what I mentioned above, the best advice I have received is to find a place to work that offers intellectual stimulation, a culture that takes an interest in your development, and most of all, work with people you like. Oh…and have a short memory, both when it comes to losers and winners.

PETITION: What are some books that have helped you in your career?

Eitan: I’d love to sound really smart and tell you about all the academic material I have read, but truthfully, I’m not a big reader of non-fiction on serious subject matters. That said, one work-related book I enjoyed was Daniel Kahneman’s “Thinking, Fast and Slow”. If you dumb it down, investing is simply about processing inherently limited information and making buy or sell decisions. So exploring theory relating to how our minds work and what exactly shapes our judgement was fascinating to me. Definitely helped me slow down a little. Other than that, I’m a fan of stories about grit and perseverance. My experience has been that having the “grit-factor” is highly correlated with success in this industry.

PETITION: Finally, you’ve likely noticed that we like to snark “Long ABC” or “Short XYZ.” What are you “long” these days? What are you “short”? Feel free to be creative here. One rule: you cannot say that you’d “Long GOAT” or some other sneaker trading platform. 😜

Eitan: You didn’t really think this one would get through my compliance department, did you?

PETITION: Thanks for your time, Eitan. Cheers.