PORTFOLIO INSIGHTS
Global Special Situations
Private credit: Time to consider special situations?
January 2018
AUTHORS
Leander Christofides
Co-Chief Investment Officer,
Global Special Situations
London
Brad Demong
Co-Chief Investment Officer,
Global Special Situations
New York
IN BRIEF
• Private credit direct debt gained popularity among investors searching for yield in the low
rate environment brought about by extraordinary central bank easing.
• Now the unwinding of quantitative easing, a late-cycle economy, stretched valuations,
rising rates and initial signs of weakness in credit quality point to the potential for market
disruption, displacements and distress.
• Private credit special situations strategies, which combine distressed credit and event-
driven/stressed debt strategies, are designed to thrive on such uncertainty. They can
extract value from market disruption across the economic cycle and, in particular, in times
of distress.
• Investors willing to diversify their private credit allocation may find the risk/return profiles
of these opportunistic, return maximization-focused strategies to be a strong complement
to private credit allocations in anticipation of market instability ahead.
ARE YOUR PRIVATE CREDIT ALLOCATIONS POSITIONED FOR UNCERTAINTY?
Extraordinary central bank monetary accommodation since the global financial crisis has
spurred and sustained a prolonged economic expansion, bolstered risk assets and suppressed
interest rates. In this still-low rate environment, many investors have turned to private credit
direct lending strategies in a search for yield. How should investors now be thinking about their
private credit allocations? It’s not a simple question.
Special situations strategies—extracting value from market disruption
In this late-cycle economy, equity valuations are stretched, the Federal Reserve has begun to
raise rates, and the unwinding of unprecedented quantitative easing has begun. The
normalization of central bank balance sheets is likely to create a sizable displacement in credit
markets. There will be nothing “normal” about this normalization process.
At the same time, the seeds of a traditional distressed market are being sown, with over
$4 trillion of growth in global credit markets since the last cycle,1 a loosening of lending
standards and an expansion of covenant-lite lending.
An environment of increased volatility and disruption is precisely one in which special situations
strategies can thrive. Indeed, among investors surveyed, 48% see special situations/distressed
credit strategies as having the best risk/return profile within private credit at this stage of the cycle.2
1
J.P. Morgan Securities LLC, November 2017.
2
Preqin Investor Outlook: Alternative Assets H2 2017. Special situations includes results for special situations and
distressed credit.
 GLOBAL SPECIAL SITUATIONS

And industry data suggests that as of September 2017, aggregate
capital raised in special situations/distressed credit funds
accounted for 43% of the private credit total.3
Investors willing to diversify their private credit allocation and
increase their targeted yield may find special situations
strategies—at the more opportunistic and capital appreciation/
return-maximizing end of the private credit spectrum—
a powerful portfolio component.
PUTTING SPECIAL SITUATIONS CREDIT STRATEGIES
IN CONTEXT
Private credit encompasses a spectrum of strategies, varying in
their risk/return profiles, the parts of the capital structure they
invest in and their investment objectives. Strategies can be
classified as income/capital preservation (senior debt/direct
lending, mezzanine debt); return maximization (distressed
credit, capital appreciation); opportunistic (event-driven/
stressed debt); and niche (e.g., aviation finance). Different
strategies can be used to exploit market conditions at varying
points in the economic cycle (EXHIBIT 1).
A closer look at special situations strategies explains why these
strategies may be well suited to extract value across the cycle
and particularly in periods of distress. Uniquely, these strategies’
returns are driven by both income and capital appreciation.
DEFINING SPECIAL SITUATIONS
Special situations strategies can source opportunities
throughout the economic cycle by aligning with specific
situational events, but their ability to capitalize on distressed
credit opportunities when they arise truly qualifies them as all-
weather strategies.
These strategies employ two sub-strategies (distressed credit
and event-driven/stressed debt), both targeting fund-level
returns of 15% to 20%—at the high end of the private credit
return spectrum. They are inherently opportunistic strategies
that offer flexibility across geographies, industries and all
levels of the debt capital stack.

Special situations strategies create value across the cycle by flexibly shifting between two sub-strategies: event-driven/
stressed debt and distressed credit
EXHIBIT 1: SELECTED PRIVATE CREDIT STRATEGIES ACROSS THE ECONOMIC CYCLE

Economic Late Early

Contraction
Expansion Expansion Expansion

Senior debt: Typically an all-weather strategy; more headwinds in late-stage expansion

Special situations: Best opportunity set in contraction/early expansion;

ability to capitalize on distress makes almost an all-weather strategy

Distressed credit: Requires financial

distress, localized or widespread,
to expand opportunity set

Mezzanine, Mezzanine,
Capital appreciation Capital appreciation

Source: Cambridge Associates LLC and J.P. Morgan Asset Management.

Illustration does not take into account relative value across credit or relative value between credit and other asset classes. Specialty finance strategies will have different
experiences during the credit cycle depending on the type of asset in which they are invested. Committing to drawdown strategies requires a longer investment horizon than
investing in open-ended strategies that allow for immediate capital deployment and regular liquidity.

3
Preqin Private Debt Online; data as of September 2017. Special situations includes results for special situations and distressed credit.

2 P O R T F O L IO IN S IG H T S
 GLOBAL SPECIAL SITUATIONS
• Distressed credit strategies are return-maximizing, with
returns driven primarily by capital appreciation of distressed,
non-performing assets purchased at a deep discount.
Investment selection is based on an in-depth analysis to
assess the probability that a turnaround or a catalyst (such
as a debt/equity swap) will help realize attractive returns
and to gauge the balance between this upside and the
downside of default. Ensuring the performance of these
investments often requires a high level of fund manager
involvement in working with the borrower through a
turnaround or restructuring. These strategies perform best
in the late-expansion through contraction stages, when
financial distress generates an expanded opportunity set.
• Event-driven/stressed debt strategies are opportunistic.
They seek out stressed but still-performing assets—often
obligations of healthy companies—that are underpriced as a
result of illiquidity, market disruption or particular issue/
issuer nuances. It is also important that a catalyst to unlock
value, such as a refinancing, is planned or can be negotiated
with the borrower. Positions in these often-illiquid assets are
built strategically over time. Event-driven/stressed strategies
identify and creatively exploit these unique opportunities at
all stages in the economic cycle.
Critical to achieving targeted returns is the flexibility to shift
between the two sub-strategies as market opportunities dictate
throughout the economic cycle.
THE IMPORTANCE OF MANAGER SELECTION
As with all alternative strategies, manager due diligence and
selection are critical to investment success. Investors should
consider the idiosyncratic and varied nature of the special
situations these strategies invest in, the pool of potential
opportunities to sort through and the extensive fundamental
analysis needed to identify those assets worth pursuing. Think
about the broad skill set and ingenuity required to structure
these idiosyncratic transactions and actively participate in
managing a turnaround or restructuring to ensure a successful
exit. And this does not even address the ongoing risk
management of the investment portfolio as these special
situations unfold. “An investor checklist for selecting special
situations managers” highlights the manager characteristics
essential for extracting value from adversity and realizing the
advantages of these opportunistic, return-maximizing strategies.
AN INVESTOR CHECKLIST FOR SELECTING
SPECIAL SITUATIONS MANAGERS
• A highly skilled investment team with experience across the
capital structure, geographies, jurisdictions and sectors, and
through multiple market cycles
• A platform allowing access to global resources, knowledge
networks and deal flow
• Fundamental analysis to evaluate the specific merits and nuances
of each situation
• Ability to influence the restructuring process and take part in
company management
• Flexibility to focus on distressed or stressed strategies as market
opportunities suggest
• A disciplined, ongoing process for risk management and portfolio
management
CONCLUSION
The economy is already in extra innings; central banks are
unwinding quantitative easing policies; valuations are
stretched; and banks are holding a store of underperforming
assets likely to come for sale. Investors interested in
positioning their portfolios for what is likely to be a period of
market disruption, displacements and distress may want to
consider special situations strategies.
Industry data indicates that investor commitments to special
situations/distressed credit strategies are increasing, and
almost half of investors interviewed see these strategies as
having the best risk/return profiles among private credit
strategies at this stage in the economic cycle. Investors seeking
to diversify private credit allocations and increase targeted
returns may find that they agree.
J.P. MORGAN ASSE T MA N A G E ME N T 3
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