Equity markets are strong, credit spreads remain tight and yet stress is building across parts of the real economy. At SuperReturn International, Victor Khosla, CIO of Strategic Value Partners, explained why he sees an unusually wide disconnect between financial markets and corporate fundamentals, and why that is creating a growing opportunity set for opportunistic credit investors.

When strong markets hide real stress

Khosla has invested through more than three decades of market cycles. The current environment, he says, stands apart.

I’ve never seen a world where equity markets are this strong, credit spreads are this tight, and we have so many problems in the real economy
Victor Khosla, CIO of Strategic Value Partners

He points to high-yield default rates of around 6% over the past couple of years as one sign of that tension. Historically, he says, that degree of distress has not existed alongside markets this strong.

For an opportunistic investor, the disconnect is also expanding the potential investment universe. Khosla says SVP once worked with a pipeline of approximately $75 billion in potential deals. Today, that figure is around $365 billion.

The challenge is no longer finding situations that need capital. It is deciding which ones are worth pursuing.

Good businesses, bad balance sheets

SVP’s focus is on businesses where the underlying company may remain attractive even though its capital structure no longer works. Khosla describes the opportunity simply: good businesses with bad balance sheets.

Some companies need fresh capital to extend their runway. Others may require a broader restructuring of debt and equity. In each case, the investment thesis depends on separating problems in the financing structure from problems in the business itself. That distinction becomes increasingly important when capital is harder to access elsewhere.

Private equity (and private credit) face a bottleneck

Khosla uses characteristically blunt language to describe the pressure building in private equity.

Private equity today is constipated.
Victor Khosla, CIO of Strategic Value Partners

The underlying issue is liquidity. Since Covid, periods in which sponsors could successfully sell assets have opened and closed, making exits more difficult to execute consistently.

More recently, Khosla says parts of private credit have begun to experience their own pressures, pointing to redemption queues around some open-ended funds.

That combination can increase demand for flexible capital, whether to refinance liabilities, extend a company’s runway or support a debt-and-equity restructuring. Khosla does not see this as a brief dislocation that will disappear once the cycle turns. He believes the pressures have been building for roughly two and a half years and could continue to reshape businesses over the next three.

Why software distress looks different

SVP has historically focused on what Khosla calls the real economy: industrial businesses, consumer brands, chemicals and real assets such as power plants, aircraft and property. Software has not traditionally been part of that strategy.

The firm has nevertheless examined distressed software opportunities closely over the past two years. What Khosla has seen makes him cautious.

When software companies get into trouble, they don’t just have a gentle 10%, 20% decline in cash flow. There’s a cliff edge.
Victor Khosla, CIO of Strategic Value Partners

He is not suggesting the whole sector will struggle. Khosla says much of software will continue to perform well. But he believes a meaningful portion could face difficulties, and the speed at which some businesses deteriorate can make distressed opportunities particularly hard to underwrite. That makes selectivity critical.

The best opportunity may sit outside the crisis

Past sector downturns offer another lesson. Khosla points to energy in 2014 and telecoms in the early 2000s as periods when significant parts of an industry moved into distress.

But for opportunistic investors, the most attractive investment does not always sit at the centre of the troubled sector.

When big sectors get into trouble, the opportunity sometimes is not in that sector, it’s in the taint it causes right across.
Victor Khosla, CIO of Strategic Value Partners

Stress in one area can affect valuations and financing conditions elsewhere. Businesses that share some characteristics with the troubled sector, but not the same fundamental weaknesses, can be repriced alongside it.

For investors able to distinguish between fundamental deterioration and market contagion, that spillover can create opportunity.

Capital is being deployed across a wider range of situations

The breadth of SVP’s recent activity reflects that approach. Khosla cites loans made at yields above 15% to businesses that needed capital, acquisitions of real assets and significant positions in discounted debt.

Recent investments have ranged from a major shopping centre in Ireland to large-cap debt purchased at substantial discounts. The common thread is not a particular sector. It is the opportunity to provide capital to, or acquire, high-quality assets when market dislocation has created an attractive entry point.

Why Europe remains core

Europe has been central to SVP’s strategy since the firm established a presence in the region in 2004. Khosla says it now accounts for around 40% of the firm’s activity. For an opportunistic credit investor, Europe’s recurring periods of disruption can be particularly relevant.

While the US has experienced an extended period of strength, Khosla argues that Europe has gone through crises more frequently, periodically creating the kind of complexity and repricing on which an opportunistic strategy can act. Volatility, in that context, is not simply something to endure. It can be part of the opportunity.

An undercurrent beneath the optimism

Khosla noticed a similar tension at SuperReturn International itself. Private-markets gatherings are typically optimistic environments. This year, however, he sensed a different undercurrent, particularly during the credit-focused part of the event. That observation mirrors his broader market thesis. Financial markets may still look strong. Beneath them, companies, owners and lenders are facing more complicated financing decisions.

For investors able to provide capital into that gap, the disconnect between the market and the real economy may be precisely where the opportunity lies.