Oaktree Capital Management expects to see a “flood” of opportunities to provide finance to good companies with bad balance sheets over the coming year.

Jordan Kruse and Matt Wilson, co-portfolio managers in the investment giant’s special situations team, point to a surge in opportunities to provide rescue financings to companies that took on too much debt through leveraged buyouts during the pandemic. They noted that these companies have strong underlying fundamentals, despite short-term liquidity issues.

“Companies that took on too much debt through leveraged buyouts in 2020-21 are increasingly struggling in a higher interest rate environment. While this is a familiar market story, it includes some novel elements that are creating an especially attractive environment for special situations investors,” explained Kruse and Wilson in Oaktree’s latest outlook.

By the end of 2021, upwards of 80 per cent of leveraged buyouts (LBOs) had leverage exceeding more than six times EBITDA, Oaktree noted. This became a problem in 2022 when the Federal Reserve started to raise interest rates to combat higher inflation.

“Suddenly, pesky credit statistics – things like the fixed charge coverage ratio and EBITDA-to-interest ratio – didn’t look quite as good for a large swathe of companies,” Kruse and Wilson wrote.

Companies with unsustainable capital structures, rising borrowing costs, and upcoming maturities would typically have defaulted and restructured. However, private equity sponsors are often seeking to avoid this outcome by taking on new partners in the hope of salvaging some of their original equity value, Oaktree noted.

This explains why there has been a surge in opportunities to provide rescue financings over the past year.

“Importantly, we expect this opportunity to persist even if interest rates have already peaked in this cycle. Our base case assumption is that the Fed will cut rates by 25 to 50 basis points in total through the end of 2024.

“If this proves to be correct, then we expect the large pool of overleveraged LBOs to continue providing a steady stream of opportunities to special situations investors. If our expectations prove to be too dovish, then that stream could easily turn into a flood,” Wilson and Kruse concluded.

Read more: Arixa and Oaktree expand JV as pipeline reaches “highest level”

Brace yourself for distressed real estate cycle

Elsewhere, Oaktree’s global head of real estate John Brady believes we are on the precipice of one of the most significant distressed real estate investment cycles of the last 40 years.

He believes this is the case because many traditional lenders, particularly US community and regional banks, face substantial balance sheet challenges due to their exposure to commercial real estate, much of which has declined in value since 2020.

“These traditional lenders are now less willing and able to lend, just as the real estate market is facing an imposing maturity wall,” Brady wrote.

Read more: Oaktree: Private credit “likely to weaken in near term”

Oaktree noted that commercial real estate exposure is concentrated among banks with under $250bn (£198bn) in assets and there are around 4,600 banks with under $50bn in assets.

“While the latter represents only around one quarter of all US banking assets, they hold over half of the commercial real estate assets in the system,” Brady wrote.

To determine the extent of the potential risk, Oaktree conducted an analysis of all federally insured US banks in the sub-$50 billion cohort.

“Even if we assume that US commercial real estate values have only fallen by 20 per cent from their recent peaks, the number of US banks ‘at risk’ and the collective assets they hold would exceed what we saw during the global financial crisis,” he explained.

The Federal Deposit Insurance Corporation defines “at risk” banks as those with an equity-to-asset ratio below 6 per cent.

“While CRE values have plummeted across many asset types in recent years, we don’t believe that fundamentals have eroded nearly as much in most sectors, with the notable exception of office.

“Consequently, real estate investors may have the opportunity to lend at depressed valuations, while financing properties with strong fundamentals,” Brady wrote.

However, doing so will only translate to superior returns if investors have the ability to properly assess risk and structure investments with strong downside protections, Oaktree’s global head of real estate added.

Read more: Commercial real estate debt crisis looms as loans mature