In the second half of 2020, as COVID-19 lockdowns eased, pent-up demand for M&A and a flood of cheap debt fueled a surge of private equity buyouts. The quantum of capital put to work surpassed even the deal rush preceding the 2008 global financial crisis.

In 2021, North America buyout volume reached a record USD 521bn, a 116% year-on-year rise. It was one-fifth more than the previous all-time high notched in 2007, according to Mergermarket data.

The tide turned in 2022, as interest rates began their upward climb. Many companies acquired via LBOs during the 2019-2022 cycle – and others not involved in M&A yet still carrying significant debt – were quickly beleaguered by over-levered balance sheets and mounting financing costs.

Oaktree Capital Management believes these market conditions have provided fertile terrain for its special situations strategy. “The market for special sits has presented an opportunity that we just haven’t seen in decades,” said Matt Wilson, a managing director and co-portfolio manager of the sponsor’s special situations group.

In this environment, Oaktree has been deploying its third special situations fund, which closed on USD 3bn in December 2023, above its USD 2.5bn target.

Recent deals for the strategy include investments in NexGen Financial, a Malibu, California-based specialty finance firm that provides capital solutions to the debt resolution industry, and Mesquite Gaming, owner and operator of the Virgin River Hotel & Casino and the Casablanca Resort in Mesquite, Nevada.

The sponsor also teamed up with B Riley Financial to create a holding company – Great American Holdings – that invested in a USD 385m holdco absorbing B Riley’s appraisal and valuation services, retail, wholesale and industrial services, and real estate advisory businesses.

The special situations strategy typically writes checks of USD 100m-USD 300m per deal. It focuses on finding good companies facing balance sheet challenges, although it also invests in healthy businesses. As a hybrid between distressed credit and private equity, the onus is on flexibility, utilizing structured equity, direct equity, and distress-for-control to invest in different scenarios across market cycles.

“What we’re not is your traditional LBO strategy,” said Jordon Kruse, also a managing director and co-portfolio manager of Oaktree’s special situations group. “We’re not participating in auctions, paying double-digit multiples for businesses, or levering them to the hilt. What we’re trying to do is find businesses that we think have a good reason to exist.”

Strategic evolution

Kruse and Wilson joined Oaktree in 2001 and 2007, respectively, and have been leading special situations for around the last decade. The strategy has seen considerable evolution, not least through lessons learned along the way.

“We oftentimes talk more about our mistakes when we talk to our clients than we do about our wins,” said Wilson. “You’re supposed to win in this business, but when something goes wrong: why did it go wrong, and what do you learn from that?”

Special situations investing was part of the business when Los Angeles-headquartered Oaktree was founded in 1995. It had evolved from the distressed debt strategy that founders Howard Marks and Bruce Karsh oversaw at TCW in the early 1990s. The focus back then was largely on distress-for-control.

Nearly three decades later, distress-for-control remains a facet of the strategy. In January, as part of a lender group alongside Ares Management and Bayside Capital, Oaktree agreed to a restructuring of Trimark, a provider of equipment, supplies, and design services to the foodservice industry. The deal included a cash injection of approximately USD 350m.

However, in the current cycle, Oaktree is seeing most deal flow in structured equity transactions, or rescue financing. These are direct investments into a business in need of cash, typically comprising a fixed income component with an attractive coupon and conversion or warrant package enabling some equity upside.

“This opportunity set presents itself across a spectrum of very stressed businesses to very healthy businesses that need cash for some reason,” said Kruse.

Stressed businesses, including those from the 2019-2022 cycle, might be performing well but they are weighed down by over-levered balance sheets or higher-than-anticipated interest costs. On the other end, healthy businesses need capital for other reasons – founders wanting to buy out majority shareholders or sponsors looking for partial monetization of investments made at high valuations.

In one recent example, in July 2023 Oaktree made a majority growth investment into Charlotte-based Magnolia Wash Holdings, an owner and operator of car washes located throughout the southeast US. The company has since rebranded as Whistle Express.

Hustle in sourcing

A robust deal-sourcing function is required to find these opportunities. The special situations group leans on a firm-wide origination apparatus that serves several strategies, while Oaktree’s trading desk also makes recommendations, given the quantum of debt that it trades. Rather than simply rely on Oaktree’s muscle, however, Kruse and Wilson place a heavy emphasis on networking and relationship-building.

“At the core of the formula is hustle,” said Kruse. “You’ve got to cover every potential intermediary out there and be in regular dialogue because you have to be at the top of mind when something comes across that intermediary’s plate that fits our mandate.”

Even so, Oaktree only pursues a handful of deals each year. According to Wilson, the historical pattern has been to screen hundreds of opportunities over a 12-month period and act on four or five on average.

The special situation strategy’s recent investments span industrials, consumer, healthcare, financial services, and business services. It doesn’t have a sector focus, preferring to avoid sectors – such as retail – where external factors outside of its control often weigh on revenue and earnings of entire industries.

“We don’t chase industry-level distress because, more often than not, it involves a melting ice cube,” said Kruse. “The question is: how fast is the ice cube going to melt?”

North America is the key geography. A small portion of the special situations strategy’s exposure – no more than 5%-10% – is earmarked for Australia, where the firm has a team on the ground. “There’s a lot of private equity in Australia, but for special situations, we believe there just aren’t a lot of players that understand the model,” explained Wilson. “Australia reminds me of the US 15 years ago.”

In September, Oaktree acquired a majority stake in AZ NGA, the Australian accounting and financial business of Italy’s Azimut, investing AUD 240m at an AUD 690m valuation. AZ NGA had 2022 EBIT of AUD 50m, and was projecting around AUD 60m for this year, depending on if it undertook M&A, according to a Mergermarket report prior to the deal.

Hands-on ownership 

Post-ownership, Oaktree plays a hands-on role in the operations of its special situations portfolio companies, with an emphasis on rapid acceleration of revenue and earnings. The firm deploys an internal operations team comprising talent from consulting and operations backgrounds who work with management teams.

“The path to ownership is very oriented to special situations. Once we get to ownership, it is absolutely a private equity strategy,” said Kruse, adding that this approach helps differentiate Oaktree from traditional distress-focused investors.

The sponsor’s 2023 investment in Magnolia Wash Holdings offers a case in point. The business was renamed Whistle Express Car Wash, bringing together 90 car wash outlets under the one brand. Another 60 have been added since then via acquisitions and new store openings. Notably, the purchase of Fins Car Wash in July contributed 15 locations across the Carolinas.

Whistle Express sees the potential to grow to thousands of locations in the long term, CEO Jose Costa told Mergermarket in a recent interview. Alongside the acquisitions, Whistle Express also revamped sales and marketing efforts, including the introduction of a new mobile application.

At Mesquite Gaming, Oaktree has invested heavily in the company’s two properties, while pre-pandemic offerings such as concerts and buffets have also been reinstated, according to an article in trade publication CDC Gaming. Justin Moore, general manager of the properties, was quoted in the article as saying the initiatives had helped to drive “phenomenal numbers.”

The firm has also been active on the exits front, recently selling the oil and gas operations of Caerus – a Denver-based company it backed from inception in 2009 – to Quantum Capital Group for USD 1.8bn. “Right now, the name of the game is giving back investors their capital from your past vintages, which a lot of folks are not doing,” said Wilson. “DPI [distributions to paid-in] is paramount in this market as exits have been more scarce over the past two years.”

Typically, Oaktree holds special situations investments for three to six years. Kruse highlighted the importance of creativity in finding paths to monetization in the current environment, observing that it isn’t as simple as hiring bulge bracket investment banks to run auctions. Oaktree aspires to be as flexible as possible on exit as well as on entry, which means GP-led secondaries are inevitably on the agenda.

“We do look at continuation vehicles for assets where either the fund has become long in the tooth or where it’s time to get money back to clients, and we think there’s more runway, or if we have an asset that requires significantly more capital because the growth prospects look very enticing,” Wilson added.