Zach Lewy (pictured), founder, chief executive and chief investment officer at Arrow Global, explains why operational edge, capital structure control and cycle awareness define success in European distressed credit for institutional investors.
I have spent a great deal of time discussing where we are in the credit cycle with institutional investors and how their portfolios should evolve in response. Those conversations are shaped by a market environment in which equity markets have risen strongly for more than three years. Private equity allocations remain substantial, and direct lending is now deeply embedded in institutional portfolios. At the same time, investment grade spreads have, until recently, hovered near historically tight levels.
Against that backdrop, the question facing many allocators is not whether they have exposure to credit risk, but whether they have the right kind of exposure for the next phase of the cycle. A significant proportion of institutional capital is structurally positioned towards growth and is positively correlated to economic expansion, liquidity conditions and capital markets sentiment. That positioning has served investors well. However, it also creates vulnerability if valuations compress, refinancing windows narrow or macro volatility increases.
Why distressed credit behaves differently
Distressed credit sits in a different part of that landscape. When approached with discipline, it offers the ability to invest at a meaningful discount to intrinsic value, thereby embedding downside protection at the point of entry. Rather than relying on rising markets, elevated valuations or benign exit conditions, the investor is essentially underwriting asset support, legal structure and operational intervention. If the underlying situation stabilises or recovers through restructuring, refinancing or repositioning, the returns per unit of risk can be highly attractive.
Just as importantly, distressed strategies often behave differently from the rest of an institutional portfolio. Periods of stress, rising rates or constrained liquidity, which may act as headwinds elsewhere, are frequently the conditions that generate opportunity in our part of the market. In that sense, distressed credit can provide both compelling absolute returns and a degree of counter cyclical diversification. At a time when geopolitical risks have increased and asset prices in certain markets remain elevated relative to their levels four years ago, that combination merits serious consideration.
Focus, repetition and operational depth
None of this, however, suggests that distressed investing is simply about buying assets cheaply. It is fundamentally about understanding complexity and managing it better than others. At Arrow Global, as a leading European investment manager across private credit and real estate, we have chosen to operate with deliberate focus. We manage approximately €125bn (£108bn) of assets and employ more than 4,500 people, yet our geographic aperture is intentionally narrow. We concentrate on eight major Western European countries and have completed around 3,000 investments over the past two decades. That repetition within defined markets builds pattern recognition and sharpens judgement in a way that broad but shallow exposure cannot.
When assessing a distressed opportunity, we begin with fundamentals that are both simple and exacting. On an asset backed exposure, what is the loan to value at entry? How does the price per square metre compare with comparable transactions? What is the replacement cost and, ultimately, what is the underlying land worth? Deep familiarity with local markets allows us to determine whether we are entering at a modest discount or in genuine deep value territory. That assessment cannot be outsourced to a model. It is the product of having navigated cycles, restructurings and recoveries in the same geographies over many years.
Beyond valuation, we focus intensely on country risk, collateral risk and operational risk. The last of these is often underestimated. Data quality, borrower behaviour, servicing capability, court processes and regulatory requirements all have the potential to influence both timelines and cash outcomes. Experience does not eliminate risk, but it materially reduces the likelihood of avoidable mistakes. If you have experienced similar patterns before, you are less likely to be surprised by them.
There is also an organisational dimension that is critical in distressed credit. Successful investing in this area requires experienced teams and strong infrastructure. Transactionally experienced professionals are essential when negotiating acquisitions or complex restructurings, while disciplined portfolio managers are required to supervise assets patiently over extended periods. Strong governance, compliance and control functions are not ancillary, they are foundational. Our heritage, having been originally owned by a bank and subsequently listed, has instilled a culture that is calibrated, regulated and community oriented. In Europe in particular, building constructive and long term relationships with regulators and municipalities is part of executing effectively. It is far more effective to operate as a constant presence in a market than to arrive opportunistically without established dialogue or local understanding.
The three drivers of return
When I reflect on what truly drives returns in distressed credit, I think in terms of three components. The first, and by far the most important, is operational competitive advantage. Complex restructurings, bankruptcies and non performing portfolios require detailed analysis of claims, security packages and legal processes. We own and operate 25 underlying platforms, including regulated mortgage servicers, corporate trustees and credit bureaus, which provide capabilities that are integral to our strategy. We seek to generate the majority of our returns from this operational edge because it is the constant that can perform across different market conditions.
The second component is the rate cycle. Movements in interest rates have a direct impact on borrower affordability and lender behaviour. When rates rise sharply, debt service burdens increase and stress becomes more visible. At the same time, banks may prefer negotiated solutions to immediate enforcement, creating opportunities for bespoke restructuring solutions. When rates fall, affordability improves and refinancing windows reopen. If assets have been acquired at a discount to par, the ability to aggregate and refinance can crystallise gains. We view the rate cycle as a meaningful, though not dominant, contributor to returns.
The third component relates to thematic opportunity. Structural shifts such as the energy transition, the digital transition, including demand for data centres, or changes in patterns of work, travel and living can create pockets of opportunity within distressed markets. These themes matter and we pay close attention to them, but in our experience they tend to be a smaller contributor to overall returns in distressed investing than in traditional private equity. It is relatively unusual for an asset to benefit from a powerful structural tailwind and still be deeply distressed. Being clear eyed about that reality helps maintain discipline.
Capital structure discipline and institutional delivery
From a capital structure perspective, our philosophy is straightforward. We aim to be last money in and first money out. That means buying at a substantial discount and ensuring we are first in line for repayment, so intrinsic asset support protects our capital.
In real estate, for example, while you can debate optimal use or building valuation, underlying land retains enduring value. Over approximately 3,000 investments across two decades, our average loss rate has been around one per cent. Even where outcomes have fallen short of expectations, capital recovery has typically been high. That resilience is rooted in entry price discipline and structural positioning.
Timelines in distressed situations are influenced by both external and internal factors. Court systems operate at their own pace and planning permissions depend on municipal processes. Caution requires budgeting time conservatively and acknowledging constraints that cannot be accelerated. Within our control are matters such as understanding leasehold and freehold dynamics in the UK, securing necessary regulatory permissions when acquiring mortgage portfolios, and maintaining servicing systems capable of managing complexity at scale. Experience ensures that lessons are learned once rather than mistakes repeated.
Finally, delivering distressed credit in an institutional format requires transparency and sophistication in reporting. The discount at which assets are acquired must be recognised properly over time, asset improvements reflected accurately and accounting standards applied rigorously. Modern IFRS frameworks and tax regimes are far more nuanced than they were decades ago, and fair value accounting can introduce fluctuations in valuations that do not always reflect underlying cash performance. Building the expertise to navigate these complexities transparently is an essential part of serving long-term institutional partners.
Distressed credit is not about opportunism in the casual sense. It is about disciplined underwriting, operational depth and clarity about where returns genuinely originate. For investors seeking diversification, capital protection and the potential to generate attractive returns across cycles, it is a compelling allocation. The key is to approach it with focus, humility and a clear understanding of the specific advantage you bring to the table.
Sponsored content created in partnership with Arrow Global.
