Insights series / 19 August 2021
Distressed debt - It will be back
As the economic cycle progresses, the next recession, and with it, the next downturn in the credit cycle, beckons.
Distressed debt managers offer their investors a compelling mix of in-depth, long-term financial analysis and expert knowledge of contract terms, clauses and other legalities. Their returns are generated through this combination of analysis, forecasting and a thorough understanding of the legal rights and potential remedies conferred on them by the relevant paperwork. Middle to large cap corporates are typical targets: those with good business models but with heavily discounted debt securities are favourites.
Yields are high for such strategies, with many targeting gross IRRs in excess of the mid-teens. But these returns rely on timing the opportunity precisely: strike too soon and the asset may not have hit the bottom, wait too long and the opportunity may no longer exist. Acutely aware that timing is everything, managers have been quietly building dry powder for their distressed debt funds over a period of years, whilst investors increasingly turn to the asset class in anticipation of the next opportunity. Though it may feel like the asset class is in hibernation, many of the world’s largest investors have allocated capital to distressed debt, most recently aiming to capitalise on market misalignments arising from the global pandemic and potential further defaults and bankruptcies that may follow in the months and years to come.
Defaults and restructuring could stay elevated or even rise as European economies unlock following the pandemic - and governments inevitably turn off the tap to emergency loans that many businesses have needed to stay afloat (monetary and fiscal stimulus for the USA alone amounts to $12.3tn by some counts, easy money that has muted defaults). Predictions for such defaults range between a 2% and 8%, across high and speculative grade European debt. Given this context, there have been many headlines in the media this year that note the asset class’s big opportunity was postponed, with headlines variously heralding the death of distressed debt and calling an end to the usual credit cycle, at least for the time being.
However, even if mass defaults don’t occur, managers see another way to invest in the opportunity, by searching for less liquid deals or stressed rather than distressed opportunities – which could be key to delivering on target 15%+ gross IRRs. There is less competition for such assets after all so returns will be higher, as the main fray takes place in the more liquid parts of the market.
Further, one market participant noted that if the stress following the pandemic is anything like that which followed the Global Financial Crisis (GFC), such high-yielding deals will continue even five years after its “end”, as the aftermath of such an economic event causes a long tail of attractive opportunities available to those looking for them.
As such, the aftermath of Covid-19 has the potential to transform balance sheets, with an ever-increasing amount of distressed lending taking place. Non-performing loans (NPLs) were at all-time lows by mid 2020, but there are signs that this will change. S&P Global reports that there is strong evidence of rapid stage migration of loans through IFRS 9 in some jurisdictions, suggesting an increased risk for the financial institution writing the loan, which in turn implies an increasingly stressed loan and the formation of new NPLs. Current data suggests these opportunities would most likely start to materialise late 2021 or early to mid 2022.
The situation could be further complicated should economies return to lockdown this year, with governments and corporates having to make decisions around how much more debt they can take on, already being pushed to or beyond record levels. Further lockdowns are not unlikely: Covid-19 incidents all around the world have increased for 8-consecutive weeks, except in Europe, with the largest increases coming from India, as at April 20, 2021.
There is further potential threat to public health through various mutations of the strain too, including the Indian strain talked about in the media, which is currently a “variant of interest.” This label means scientists suspect a strain in this category to be more transmissible, causing a surge in cases, or has the potential to escape people’s immunity from infection or vaccination. A variant of interest can become a “variant of concern,” a label already attached to strains from the UK, South Africa and Brazil, if there is hard evidence that it has done one or more of these things. According to recent published research, it is becoming more likely that newly mutated Covid variants are less likely to be affected by the current set of vaccines.
Whilst no-one wants another lockdown, not intervening in some fashion if incidents continue to rise will likely lead to a higher impact on already strained and pressurised health facilities, according to international medical organisations.
Poised to take advantage of the potential opportunities and help companies post-pandemic regain a stable footing are a record-high 79 distressed debt funds. The vast majority of these are headquartered and focused on North American opportunities, with just around a dozen focused on Europe.
As of Q1 2021, special situations and distressed debt funds comprise 40% of total private debt assets under management (‘AuM’), up from 16% in 2009, with the largest distressed debt fund currently seeking $15bn of assets, according to Preqin data.
There is a considerable amount of dry powder in these AuM figures and managers are looking to add to that, in order to provide last-minute financing for distressed companies. The ability to move quickly and provide liquidity when a company needs it most is a particularly effective way to establish a position and perhaps gain control later see Alex Di Santo’s earlier article on debt for control.
Distressed debt will be back. But for now, we are seeing managers build up a war chest and biding their time – cries of the death of distressed debt are very premature. It's only a matter of time before the asset class gains more prominence once again - after all, timing is everything.
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