Distressed assets (part 1): Rebecca Pacholder predicts new super-cycle

Distressed debt is not an asset class that most private investors would be overly knowledgeable about or even have access to – but they should!

The new super-cycle that is likely coming our way in the distressed debt and high-yield sector may also affect public equities and other asset classes.

This exclusive three-part series will explore the subject from a variety of perspectives, including questions such as:

• What are the major trends in high-yield investing over the next years?
• How will distressed debt investing play out across different geographic regions?
• Which investments can you use to take advantage of these trends?

The series will feature three high-calibre portfolio managers from different geographies, and also dig into each manager's background. What made them who they are, how have they formulated and evolved their investment strategy, and what can any private investor learn from them?

Today's instalment features Rebecca Pacholder, founder of Snowcat Capital in New York, whose pedigree includes working for the legendary Leon Cooperman of Omega Advisors. In 2018, Rebecca set up her own firm and now manages nearly USD 500m.

Rebecca Pacholder.

Swen Lorenz: Rebecca, I am so glad that after an introduction by an old friend, you agreed to be available for this interview. We can't speak about your current work and Snowcat Capital without first telling my readers about your past work with Leon "Lee" Cooperman of Omega Advisors, a true legend that many of my readers will be familiar with and look up to. Tell us what led you to work for Omega Advisors at the time? What were some of your most valuable and memorable learnings from your time at Cooperman's USD 10bn+ hedge fund?

Rebecca Pacholder: Before Omega Advisors, I was an analyst at a large credit opportunity fund. I had found out that Lee was looking for a credit person. So I sort of invited myself into his office! He was gracious enough to meet with me and I really hit it off with him very quickly. He's an incredibly personable, very funny, open guy. And in the first 15 minutes of meeting with him, he made me an offer for a job. And, of course, I said: "Yes, I accept."

There was a little more process after that, but it was sort of a very quick decision process for him. I had never really managed capital before. I had some approximation, but I'd never really been able to touch capital before that. And I showed up at Omega Advisors with a USD 100m credit line, a Bloomberg terminal, and an opportunity to take risks for the first time in a direct way. An incredible opportunity!

I also at the time had two young children at home. I'm very comfortable that a rational person other than Lee would say that a mother with two young kids – two babies! – would probably not be a person to whom they would normally say: "Here's USD 100m of capital, go for it." But I think it just says a lot about Lee, that he just is that kind of guy. He makes good, intuitive decisions about people and is willing to just give people a shot. I'm incredibly grateful to him.

So I worked there for about seven years, and I went from having a credit line to having a layer between me and Lee. Then, about three years into it, the layer of people between me and Lee disappeared, and it was just me investing directly with Lee. My portfolio had grown to about USD 750m in total when all was said and done.

At the time, we did a lot of what we called co-investments, where we sourced, structured, and led a large deal, and the excess capacity ended up in a sidecar vehicle. I was there for seven years and incredibly happy.

SL: Why did you eventually decide to build your own firm?

RP: I think if circumstances hadn't changed in terms of Lee's firm, I'd probably still be there. I wasn't there saying, "Gosh, I really wish things were different." He decided to slow down, pay back his external investors' capital, become a family office, and focus on his charity. Initially, I tried to find a way to work within the ecosystem of the family office, and I tried to recreate as much as I could about my experience at Omega Advisors. But I ultimately came to the conclusion the only way to really have that same experience I had to just go off on my own and start a fund.

SL: I experienced Lee once, at the Project Punch Card Value Investment Conference earlier this year in New York, where he was one of the keynote speakers. He came across in exactly the way that you just described him. At age 80, he was full of energy!

RP: Yes, Lee is amazing. When I worked for him, he'd get these emails from these random people. Some person from some random country, and we advised him not to respond to that email. He said: "Oh, but maybe they have a good investment." He is a guy who loves chasing ideas. He loves finding the new thing. That's what gets him excited in the day, and it's just fun and infectious to be around that. Lee's success is entirely driven by his ability to take risks and to be a courageous investor. He is one of the most courageous investors I've ever had the opportunity to work for.

It was a pleasure and an honour to work for him, but it was also terrifying for the first six months. So every time I'd get a call from him for the first six months, I thought he was going to call and fire me. I didn't even want to pick up the phone. For the first six months, my hands would shake before I picked up a phone call from him.

But eventually I realised he was just calling me because he was trying to figure out something about a bond, or whatever. And then I realised he is really easy to deal with.

There are so many wonderful stories about Lee. Our firm's Christmas party wasn't just people sitting around. He said: "You've got to earn your meal. You've got to put up a recommendation." So we would have a Christmas event, and it was actually a stock picking idea contest. He'd pull out a piece of paper from last year on what peoples' recommendations had been that previous year. I showed up and everyone asked if I had brought my stock recommendation. I had expected this was going to be a Christmas party where you are supposed to get drunk and act silly, but it turned out it was a working event. That was just the way Lee was.

Anyway, he took a real risk on me and it's rare to see people do that for other people in our industry, or just in general. I had a really good time working for him, but sometimes things just have to shift in a new direction.

SL: Two very brief follow-up questions before we move on to your work at Snowcat Capital today. You mentioned that Lee was a very courageous investor. In the first instance, this can sound like he took silly risks. How would you define "courageous" in that context?

RP: I saw Lee making a lot of money when everybody else was selling. I remember the first investment I did with him, it was that we actually got crosswise with a private equity sponsor. The sponsor actually called Lee and said: "You should fire Rebecca because she's causing problems for us." Lee called me and he said: "Should I fire you?" I told him that I was not going to make any friends in this capital structure, but I was going to make a lot of money. For Lee, this was fine, and it was the end of the matter for him.

At another time, I made a recommendation, I bought something, and he talked to three people who all hated it. Lee called me and he said: "Look, these people all hate it. What do you think about that?" I replied: "Well, that's what makes the market and this is what I think." He said: "I don't mind people being contrarian. You just have to have a base for it."

That's how Lee made his money, by just being contrarian, being willing to buy when everyone was selling. He's the guy that will step into the burning building, if you will, from an investment point of view. He's unwavering in his courage. So I don't think it's that he takes silly risks, it was just being contrarian, being willing to buy when everyone was selling. Lee is not a gambler. He is a very disciplined value investor, but he has a real pattern recognition, and his pattern recognition is based on buying what people want to sell.

SL: You mentioned that you had simply sent him an email, and he was actually willing to meet with you. Would you advise young people to attempt the same? Any recommendations on how to go about that?

RP: I'm a big believer that standing in line doesn't necessarily help. It's fine to stand in line if you're going to be at the front of the line, but if you're somebody like me, a woman with two young kids, I'm never going to get to the front of the line. That's just not the way our industry works. I think at the end of the day, if I wasn't proactive, pushy, I would have never made it to where I am now. In terms of approaching people, I think it's absolutely not only a good idea, I think it's a requirement!

And I do think the allocation of resources is not necessarily efficient in our industry. Sometimes the people that are the most proactive are the ones that are actually able to get the resources, rather than the people that maybe are most deserving.

SL: In your own words, what does Snowcat Capital do and what makes it different from other firms in the space?

RP: What we do is what I would call credit activism. We work directly with companies on balance sheet problems, and we provide solution capital for those balance sheet problems. Sometimes that's within bankruptcy proceedings, sometimes it's out of bankruptcy. But generally speaking, we're working directly with a company to fix some element of the balance sheet.

We have a concentrated book. We are not an index of ideas. We have 15-20 names in the book, but the bulk of our focus is probably about six to ten names. This allows us to provide a truly idiosyncratic positioning. Given this concentration, what really differentiates us is our ability to drive the restructuring process and pay close attention to the deal, as opposed to a manager with a much less concentrated book.

SL: Let's delve into the entire subject of a new distressed credit cycle potentially being upon us. At your investor day earlier this year, you mentioned there could be a "tsunami wave of distressed debt" (your words!) coming our way. I have been picking up similar signals in my network recently, and you described it as an upcoming career-defining cycle for distressed debt investors. Distressed debt is not really an asset class that the majority of high-net-worth investors or even every family office would be all that familiar with. What are you seeing in the markets, and why is now the time to prep yourself for an increase in activity? How can investors benefit from it all?

RP: We have had a four- or five-year period where between low interest rates and government intervention, companies that should have failed haven't failed. Now interest rates are obviously much higher than they were even a year ago and government subsidies for consumers and businesses have gone away. This is now laying bare all these bad balance sheets and bad business models. It is forcing companies to fend for themselves, and these limitations are now exposed to the market for review and rejection.

But to fail means a bunch of different things. It means default, it means filing for bankruptcy, or it means doing things proactively with their balance sheet. Basically, companies that can't afford their capital structures anymore have to find some sort of solution, and they have to do so in a market that is incredibly hostile. That's where we are right now.

The difference is in the US versus other parts of the world. We believe the US economy is doing okay. So the process of US companies finding solutions, whether it's in court or out of court, is less challenging than in other markets where there's just not an economic backdrop that's supportive. You are going to have a lot more failures and a lot more catastrophic issues.

In the US, we are going to have a three-year cycle. We are now in the first year of this three-year cycle. In each year, it is going to look like the prior year, which is going to be a 5-6% default rate, and a lot of noise in between. If you have capital, your earning opportunity for the next three years in credit is going be outsized. Massively outsized, probably double what you've been able to earn in the last three years.

SL: As far as I understand, Snowcat Capital is not as such geographically constrained in any way, but you seem to have a US bias. Is that where you see the majority of your work in those next couple of years?

RP: The conflict in Ukraine led to a lot of dislocations in the European chem sector, and in Ukraine itself. We were able to invest in direct reaction to some of those dislocations. But for the most part, we have harvested those positions or are in the process of harvesting them, and we are now much more focused on the US. That's because we're going to have all the dislocations and disruptions of a default cycle, but we have a healthier economic backdrop in the US.

Also, I think from the point of view of the legal regime, the US is absolutely the best place to be a creditor. There is not a lot of debate about what happens when you are a creditor in the US, but in other parts of the world it is. It's just a much more obtuse process elsewhere, whereas in the US you can simply say that you bought this bond at 20 and that's the end of the conversation. In other places, there can be a lot of stigma. There can be political environments associated with people buying dislocated instruments in the secondary market in a way that they are not in the US. The US is an easier place to be a distressed investor.

SL: Regarding those investments in Europe and Ukraine last year, can you elaborate what investments you did over there? How did you come across them? What was involved with working out the investment case? And how did it all evolve and then work out in the end?

RP: One was a company that had an industrial base in Ukraine. It was located relatively close to the border in the eastern part of the country, the Donbas region. At one point, it was 20 kilometres from the front line. The concern was that the assets would ultimately be lost to the Russian invasion. This was in a sector that I had done a lot of work on in the past. When we got deeper into the analysis, we realised they had a lot of assets outside of Ukraine. And in the unfortunate event that they lost the assets in Ukraine, we felt comfortable that the value of the assets outside Ukraine would be enough to cover the value of the bond. So by buying the bonds in the 40s, given the value outside of Ukraine, we felt like we were getting an opportunity to really bet alongside the Ukrainians in the sense that as they have been more successful in pushing back and thwarting the Russian invasion, the bonds have actually recovered beyond the 40 cents that we were able to buy them at. So where we are right now, I think there are probably still more opportunities there. But our focus is much more US-based, so we've harvested those investments to be much more focused on the US going forward.

SL: Let's speak in more detail about that new cycle. Everyone has recently been hearing a lot about banks being in trouble. However, I guess going forward, it will be different sectors that are going to create negative headlines. You probably have some very specific ideas about which sectors are going to offer opportunities in the next 12 or 24 months?

RP: When these banks started getting in trouble earlier this year, everybody thought: "Oh gosh, we're on the edge of the next great financial crisis. Our next Lehman moment." But I don't think that's the case at all. What has happened is that the banks are sort of like water. They touch everything, they flow everywhere. Banks not being healthy – which is not the same thing as saying the banks are blowing up – has definitely changed the profile of credit and capital allocation. What is going to happen is that everyone who interacts with the banks – which is pretty much any company in the US – is going to find that credit is less available, if available at all. And they're going to find that the services that they used to get from banks are also more limited. The economic picture is going to shift pretty dramatically.

People have talked about the regional banks, in particular, becoming more conservative on credit decisions. We are now seeing the impact of a 50-100 basis point tightening, on top of what the Fed has already done. The ubiquitous nature of the regional banks providing support for our economy is now basically gone. In terms of how that rolls to the next layer, I think the banks being more conservative and behaving in a way that is more rational is going to affect everybody. They haven't been behaving rationally over the last five years, but now the banks are becoming more rational in terms of allocation decisions. The first place that we are seeing the dislocation is in any kind of specialty finance company, anybody that does the same thing that the banks do, but they're not a bank, so they don't go to the Fed window. What we are finding with those companies is that it is much less competitive for them in terms of buying and financing whatever assets they finance. So that's the first thing. And then from there, it's really the next layer of companies that are being impacted. It's the industrial base, it's the chemical companies, it's people that need access to cheap capital to keep growing their business. And then from there, it's probably going to affect every company in some form or fashion the way forward.

Net-net, the price of risk for credit has essentially doubled in the last 12 months. The price of risk a year ago was 5% for credit, generically speaking, and now it is 10%+. That affects everybody, not just the banks and adjacencies. It is really going to affect the entire economy.

SL: What I am hearing is that you are getting much higher returns and you have many more options to choose from, which really is the ideal scenario for the kind of fund that you're running, right?

RP: It is exactly so. Our business is highly cyclical, and for the last few years we have been doing other things. But now this is really our core mandate, our core strength, which is distressed debt. Once every seven years, you get a window that looks like this. This is the best opportunity we've had probably since 2014-15. This is the best cycle we've seen in a little less than ten years.

SL: In my amateurish and simplistic view of the world, I would say we have just gone through 12 years of credit being way easier than it was supposed to be and, as a result, zombie companies being kept alive artificially. That's well over a decade of accumulating bad decisions and avoiding the moment of truth. Surely, what is now coming our way must be potentially one of the biggest, if not even the biggest ever opportunity in that space ever. Or is that a simplistic and exaggerated way of looking at it?

RP: No, not at all. I think that's absolutely the right way. I think what we're dealing with are the sort of companies that should have failed but haven't yet. Also, there are companies that should have not been able to put as much leverage on their balance sheet. We saw a lot of LBOs happen during the cycle of easy credit. They are probably fine businesses, but they probably should have had 20-40% less debt on them.

Yet other companies have a cyclical nature to their business. If you put debt on their balance sheet based on how they look in a healthy market, when you go into the bottom of the cycle, which is where we are right now, they're all of a sudden not going to be able to afford their debt. All those things are happening at the same time. It is like tectonic plates where there has been all this pressure that has built up, and now it's going to get relieved. And that pressure getting relieved is companies going out of business, or their balance sheets are crushing them and forcing them to make decisions about how they allocate capital and resources in a way that they haven't had to in the last five, ten years.

SL: How is this going to differ from the Global Financial Crisis we saw in 2008/09?

RP: I would say that the destruction we had in '08 and '09 was different. We are going to have some level of destruction, but probably not on the same order of magnitude. Also, the difference is that this time, things are not going to happen over nine months. In '08 and '09, it was a nine-month cycle. We are going to have some version of it, let's say it might be 70-80% of that destruction, but this time it is going to happen over three years. This is very different in terms of how the cycle is going to feel. It's like the frog in the water that is slowly getting hotter. Essentially, that is where we are right now. From the outside looking in – when you look at high yields and equity markets – it may not be as perceptible as it was in '08 and '09 when we were all afraid that our banking system was failing.

If the Fed hadn't intervened back then, we would have had a failed banking system. Today, we don't have a risk that our banking system is going to fail. What we have instead is, we have banks that have been making bad decisions, bad investment decisions, because they didn't have to mark to market their assets. And they had a huge amount of free capital in the form of deposits. That trade is over, and it's getting unwound. And the effect of that is all these other things that we were talking about coming to the forefront, because bad decisions now get laid bare in the market in a way they haven't historically. So, net-net, we're going to have a cycle over three years that in the past we have had over nine months. It's going to look and feel different, but ultimately it is going have the same impact. Namely, that you have the bottom 20-30% of the companies go out of business or reprofile their balance sheet. That's essentially what it means.

SL: I guess for an investor or for an investment fund, it's much better that it's a bit more stretched out this time, because that gives you more time to find opportunities, take advantage of them, and then recycle your capital and your gains into the next opportunity.

RP: Yes, correct. The last cycles, i.e. the pandemic and '08/'09, were really a trade rather than an investment cycle. What we are dealing with now is the process of cleaning up the excesses over the last five to ten years. And it's happening now.

Now, you can stick cash in a bank account and get close to 6% p.a. So if you can get 6% in cash, it begs the question of what do you need to earn in order to take risk? If you are going to provide the incremental dollar of capital to a company in the form of credit, then you have to get a return that is incredibly attractive compared to just putting your cash in a bank account. That equation hasn't existed with interest rates at 0%. You were penalised if you weren't making investments and taking risk. Now it's the opposite.

SL: What are one or two of the specific investments that you're holding right now?

RP: We tend to focus on where the dislocation is. Last year, the dislocation was driven by Ukraine and the gas crisis in Europe. So that's where we focused last year. This year, the point of dislocation emulates from the banking system. The areas that we've been most focused on right now have been people who finance assets that are normally at banks, i.e. specialty finance companies. The other thing we are focused on is commercial real estate financed by banks.

Right now, we are most focused on the adjacency to the crisis. That's companies that are adjacent to the dislocation, i.e. adjacent to the regional banks. We are looking at specialty finance and commercial real estate.

In the commercial real estate space, we are looking at office buildings, malls, and multifamily homes. At this point, we are looking at some of the busted REITs that have raised high-yield money to go out and buy commercial real estate assets. And now, even though the regional banks don't have to mark to market their commercial real estate, these companies that have public bonds do! It's all pretty clear when their bonds are trading in the 60s and 80s that the value of commercial real estate on their balance sheet is very different than the valuation at the regional banks that keep the commercial real estate on their balance sheet at par. And then there is specialty finance. If the regional banks are not making loans against mortgages – or against any kind of hard asset – then all of a sudden companies that used to earn a high single-digit return can now earn a double-digit return.

So those are the two areas that we are most focused on right now. And then the other thing we're focusing on are chemical companies that have been LBOed recently. Everyone always thinks that there is this thing called "specialty chem". When it comes to specialty chem, once you have an economic slowdown, it doesn't really look all that special anymore. It just looks like a chem company. The sponsors put a lot of debt on these businesses during the good times. Now, given the fact that you have inflation and an economic slowdown, these companies really are too levered. There are going to be some pretty hard decisions that have to get made over the next few years.

So those are the three areas: specialty finance, busted REITs, and over-levered LBO chem/industrial names.

SL: The sort of cycle that you describe is obviously going to have ramifications for other parts of the investment industry, and for the economy as a whole. My readers are predominantly long-only equity investors. They'll be very interested in what you describe because it's something that they're aware of but not knowledgeable about. In a way, the obvious decision for them would be to say, we should really diversify and hedge by getting some exposure to the sort of fund that you're managing. However, there may be other ways to play these trends. Do you have any advice on how investors can prepare for this sort of potentially quite violent wave of debt defaults that is coming our way?

RP: There are two things that I think every investor needs to think about before they put a dollar at risk. The first one they have to think about is what's their time horizon, i.e. how patient can they be. If they can be patient and hold on to an investment for three+ years, they can play through a cycle. So that's the first thing.

And the second thing I would tell investors is they should think about their risk tolerance, how much money are they willing to lose on a mark-to-market basis. It's important to have a clear sense of both of those things before any dollar goes into any investment, whether it's distressed debt or equity or anything. I think those are just basic house rules that every investor should have.

When we created Snowcat, we were very conscious to make sure that our capital base was designed so that the investments that we're making fit with our capital base. So we have basically an 18-24-month capital base. And my experience has been that that's consistent with how we like to invest.

I think if you're in equities, you need to have a much longer time horizon to make that investment because equities can be very, very violent, and most cycles last between three and five years. If you're an investor that really needs to have performance within a matter of months, it's a pretty scary asset class to be in equities right now. But I think for a person to be patient and survive the market, then equities are probably perfectly fine. I do think for the amount of risk that you'll take in the next three years, you're better off being in credit. The nice thing about credit is that if the asset you underwrite is good, then the downside protection is specific. You won't lose your principal, but you have the ability to create an equity-type return, provided you are buying the instruments at the right price. So you get an equity-type return on the upside and a debt-type protection on the downside. You don't always get that, but that's where credit is today. That's why it's a good credit cycle. What we've had over the last few years was you had very limited upside in credit. You didn't have a lot of downside but you just weren't really making a lot of money. But now the dislocation is such that you have an equity-type of upside, which people call convexity, where you have the ability to get real capital appreciation and make an equity-style return, but your downside is pretty protected. So, in summary, what I'd say for an equity investor or any investor is to just make sure that person has an incredibly clear sense of what their investment profile and horizon is. Lastly, with all the volatility going on, they probably shouldn't check their stocks every day. They should check it once a month, once every six months, because otherwise it just becomes something that is all-consuming.

SL: That's all-round useful advice for people who, like myself, have their head mostly focused on equities. Let me throw you a bit of a curveball. With everything that's seemingly coming our way, there are bound to be a couple of publicly listed companies that are going to benefit from all of this. For example, I am thinking rating agencies, or operators of pawn shops. Do you have an idea or two what someone could look at in terms of conventional companies and long equity plays that could benefit from this new credit cycle? Who benefits from this dislocation?

RP: Interesting question! I think the people and companies that will benefit from the current cycle are the ones that, first of all, have good balance sheets. If I were looking at an equity name and thinking about an equity investment, the first thing I would make sure is that the balance sheet is in good order. The reason is that when debt becomes more expensive and becomes much less available, there's this point where the debt ends up taking over the equity and the equity can get smushed. If I was going to make an equity investment, I would just want to make sure the weight of the debt and the capital structure was not so great that it would crush me. The best way to check and confirm that is to just look at companies that are investment grade. I would not be making any equity investments in a company that was a high-yield issuer. Instead, I would look at companies that had the ability to be an acquirer. There are going be incredible deals if you have capital and you can buy some of the businesses that are going to come under pressure right now.

What spaces could that be in? I think there's going be more consolidation in the asset manager space. I think there's going be more consolidation in the regional bank space. I think there's going to be consolidation in broad industrials, and chemicals in particular. I'd look for companies that had investment grade balance sheets and had the ability to do acquisitions in their space. Those are the two things that I would look for. I have no view on AI or crypto or anything like that, of trendy stuff, but I would really look for people that have a good platform and are going to use their platform to take advantage of the dislocation right now.

SL: When you are not knee-deep in analysing distressed debt opportunities, what do you like to spend a few hours on outside of that particular field? What else are you passionate about?

RP: We are big lovers of winter sports. My kids are ski racers, and my number one passion is to spend time with my family in winter outside in the cold.

Other than that, I'm a big reader. I spend a lot of time reading. I have all my favourite libraries in various places around the country. So that's my big thing. I have this like little reading nook in my house, and that is my favourite thing to do in the evening. It's just to sit there with a good book, with my family and my dog.

SL: Do you have one particular investment-related book that you've maybe read a couple of times already or which you have owned for ages that you particularly love and recommend?

RP: I would say anything written by Michael Lewis is just a must. I think he's just amazing.

SL: Thank you, Rebecca, for sharing these insights with us!

For more information: during the first six months of 2023, Snowcat Fund International Limited was up an estimated 5.5% net of fees and expenses. Qualified investors who would like to receive more information about the work of Rebecca and her team can email Brandon Ali on [email protected]. (Undervalued-Shares.com does not have an economic relationship with Snowcat Capital and investors have to make their own decisions.)

Next week: the next interview will cover the distressed debt and high-yield cycle from a European perspective.

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