Recent events have created a significant opportunity in private markets for proactive investors. Historically the best performing private markets vintages have been in the years following significant market volatility; most recently the 2008 Global Financial Crisis and the bursting of the tech bubble of the early 2000s.
Whilst the outlook for private markets broadly is likely to remain very attractive for the next few vintages, the immediate opportunity set is most concentrated within opportunistic distressed debt strategies.
Whilst it remains early days, the indications are that a substantial distressed opportunity is emerging with experienced and well-resourced distressed debt funds well placed to generate strong returns for investors.
What is Distressed Debt?
Distressed debt investing is a term used to cover a wide range of different strategy types, though the common theme is an underlying debt security that is either widely expected to default, or has already defaulted. This can include both public and private instruments issued by corporates or backed by assets such a real estate or other hard assets. Distressed debt investors seek to buy these loans and bonds at significant discounts to their par value in order to benefit from either; (i) a recovery in pricing should the outlook for the borrower improve and avoid default, or (ii) in the event of default, the claim on the company or asset that is due to the owner of defaulted debt instruments.
Distressed debt investing is predicated on several factors that result in large numbers of investors seeking to sell loans and bonds at the same time, exacerbating price declines – often to a level below the true value of the assets. This is generally driven by an expectation of an increase in default rates prompting a decline in prices – as would be the case for any asset class when the economic outlook changes. However, unlike other asset classes, there are unique characteristics within the cross-over and sub-investment grade debt markets that result in price declines to levels well below fundamental value. These include;
Motivated Sellers – Holders of debt securities that have become distressed are often motivated sellers – frequently for reasons outside of the investment case for a specific asset, driving down prices. For example, many institutional investors can be forced to sell debt securities that have been downgraded below a certain rating. Others, such as mutual funds, can have short term capital and be required to sell positions to meet redemption requirements. Finally, many debt investors also rely on leverage and are forced into selling distressed assets – at almost any price – in order to meet covenant requirements of their own leverage structures. In extreme scenarios, these effects can lead to such widespread selling of debt, especially by mutual funds and CLOs, that performing credits are also impacted – creating a liquidity driven “stressed debt” opportunity.
Limited Demand – Distressed debt investing is complex, requiring expertise across a range of areas including restructuring, and there is therefore a relatively small universe of active buyers at any one time. The liquidity of these securities also restricts the number of willing investors.
Sentiment – Widespread distress normally occurs at times of broad market declines, creating an environment where many investors are looking at reducing risk. Negative sentiment can result in distressed debt being viewed and priced pessimistically.
Perhaps even more so than other parts of the private markets, the attractiveness of distressed debt investing is heavily impacted by the prevailing supply of opportunities in the market; i.e. the scale of distress in the debt markets at a given point in time. Whilst there is a relatively small universe of specialist investors providing the demand, the supply of opportunities varies widely – and often changes very quickly. In buoyant markets there generally remains a base level of distressed debt as the result of either issuer specific events or sector specific trends. Supply of opportunities and demand from investors is broadly aligned in these periods.
However, at times of market turmoil the volume of distressed debt can increase very rapidly and far outstretch the available capital for investment. The concentration of forced sellers of distressed debt results in periods where the supply significantly outstrips demand. This disconnect that occurs between supply and demand creates the opportunity for distresses debt investors, who benefit from access to long-term capital at a time when liquidity is at a premium.
Distressed debt investing is a cyclical strategy. Over the last decade, steady economic growth and low interest rates resulted in a period of persistently low default rates. However, the seeds of the next distressed opportunity were being sown – most notably in the rapid growth of the BBB and sub-investment grade debt markets. Within this backdrop of widespread growth, other trends, such as the emergence of so-called “cov-lite” loans, further helped expand the supply of potential future distressed opportunities.
Ultimately, a catalyst was required that would expose the weakness of some companies that have been the recipients of excess credit over the last decade. The COVID-19 crisis has, unexpectedly, proven to be that catalyst. Whilst credit markets are not yet fully adjusted to the new environment, it is clear that a wide range of companies face severe cash flow issues in the coming months which will result in a wave of corporate defaults, both payment and technical.
Whilst there is little doubt that there will be an uptick in default rates, the question remains as to how large the distressed debt opportunity will be. Since the last crisis in 2008/9, the universe of sub-investment grade credit has doubled in size to stand at c.$4.5 trillion. In the last three major crises (1990/1, 2001/2, and 2008) the default rate on high yield bonds has increased to at least 10% over one or two years. If you combine a 1% default rate on BBB credits with a 10% default rate on sub-investment grade credit, the estimated distressed debt opportunity totals over $500 billion of par value. This scale of distress would not only dwarf the “dry powder” focused on distressed debt investing (estimated at about $62 billion), but also significantly exceed the size of the distressed debt opportunity seen in 2009.
Given the cyclicality of the opportunity set for distressed debt funds, it follows that the returns generated are equally cyclical. As illustrated in the chart above, the performance of distressed debt funds has peaked in vintages raised during, or shortly after, major market corrections. Given the volume of opportunities distressed debt managers are already seeing in the market, the indications are that 2020/21 has the makings of another strong vintage.
Strategies & Managers
Distressed debt can incorporate a wide range of strategies. Some funds have a narrow focus on one part of the market, whilst others seek to combine expertise across different, often complementary, investment types. Some of the most common distressed debt strategies are described in the table below.
Investing in distressed debt is a highly specialised activity that requires a specific skill set to originate, due diligence, execute and manage investments. Whilst large numbers of assets will be trading at distressed prices during periods of market stress, simply “buying the market” is not likely to generate the returns investors are seeking given a material proportion of the distressed debt universe will not see a recovery in value on a timely basis.
Consequently, it is important that investors allocate capital to the distressed debt managers best positioned to capitalise on a market opportunity. Three key characteristics to consider include;
- Appropriate Fund Size – If a fund is too big, then it can be harder to fully invest due to requirement for greater deal flow. Too small, and it may lack the resources to originate, execute and manage investments effectively. The appropriate fund size for a particular manager should be assessed relative to what they have successfully invested in similar markets historically.
- Flexibility – Funds with very specific strategies can excel when the opportunity set in their niche is especially attractive. However, given the opportunity in distressed investing tends to peak at different points in time in different markets, funds with broader or more flexible strategies can find themselves better placed to deploy capital as they can pivot between different parts of the market and make ongoing relative value assessments.
- Experience – Whilst no two financial crises are the same, having collective experience of investing through prior crises and recoveries is invaluable for distressed debt managers.
|Non-Control Distressed||Buying single name credits at steep discounts to par value.||Acquiring debt that has been oversold, with the expectation of a full or partial “pull to par” effect. Investment not made in anticipation of restructuring.||This strategy is most sensitive to capital flows and is therefore highly cyclical. Investors with long-term capital can benefit from the liquidity needs of others.|
|Control Distressed||Buying single name credits that are either in, or are expected to, default.||Seeking to acquire control of the company or asset through a restructuring, effectively creating equity positions with low entry valuations.||Requires defaults to act as the catalyst for debt holders to initiate a restructuring process. Increased cov-lite lending may reduce instances of default and hamper efforts to obtain control.|
|Non-Performing Loan Portfolios (“NPLs”)||Portfolios of distressed loans, typically sold by banks or other financial institutions.||Buying large complex portfolios of loans allows investors with the required servicing infrastructure to generate value not available to the seller.||Large volumes of NPLs have transacted since 2008, with banks looking to deleverage. Given the relative improved health of the banking system today, it is not clear whether the current crisis will create a widespread NPL portfolio opportunity.|