Distressed debt investors are still waiting for the rich choices of the pandemic

A dozen years after the collapse of Lehman Brothers, some of its remaining creditors learned that a payment was coming to them.

The announcement last month that the holders of twocapital enhanced preferred securitiesIssued by Lehman with a face value of $ 735 million – although it now trades at pennies on the dollar – will soon receive $ 33 million was a timely reminder that money can be made by betting even on bankruptcies the most turbulent and convoluted.

Digging through the wrecks of bankrupt businesses for bargains is one aspect of investment strategies known as “troubled debt” or “special situations.” This ranges from short-term bets on or against the debt of distressed companies, to providing emergency business loans at hefty interest rates, to the takeover of stricken but fundamentally sound businesses by the government. restructuring bias.

For some of the biggest players in the industry such as Apollo Global Management, Blackstone, Oaktree, and Elliott Management, the past decade has been largely frustrating for their struggling debt businesses, thanks to rocketing interest rates and to a resilient global economy.

However, the economic disruption triggered by the coronavirus crisis is raising hopes that debt funds – and their investors – could be placed for their richest choices since the financial crisis, even as executives stress they will not be. on the scale of ten years ago.

“This is a time when the opportunity set is so rich,” said Victor Khosla, director of Strategic Value Partners, a struggling debt investment group based in Greenwich, Connecticut. “But this is a once-in-a-decade opportunity, not a generation-once opportunity.”

The main reason for the industry’s more cautious optimism is the response of central banks – both in terms of speed and scale – to the crisis. Spurred on by the Federal Reserve, monetary authorities bought trillions of dollars worth of bonds, easing borrowing costs for stricken companies.

Bank of America estimates that central bank asset purchases have averaged around $ 1.5 billion an hour this year, which analysts say is likely to be a sharp increase in business failures.

Line graph of the performance of the Bloomberg Barclays Global Aggregate Corporate Index (%).  showing that corporate borrowing costs fell after central bank intervention

As a result, even global junk bond yields fell by more than half, from a high of over 12% in March to 5.6%. U.S. companies alone have issued around $ 2 billion in bonds this year, breaking previous records for the entire year.

It’s not just aggressive economic stimulus that blurs the picture for troubled debt investors. The gradual erosion of legal protections that creditors have traditionally insisted on means that capturing the value of struggling companies may prove more difficult.

Many more indebted companies are controlled by private capital, which will likely take advantage of more lax legal clauses to resist attempts to take control of their investments.

As a result, industry executives say troubled debt funds will be left to fight each other for leftovers, risking longer and more deadly restructurings. The cases of US mattress maker SertaSimmons and California beachwear group Boardriders show just how quickly things can go wrong.

Struck by the pandemic, the two companies sought financial bailouts that left rival creditors to scramble to provide new loans. Creditors groups that have been left out have since sued SertaSimmons and Boardriders, claiming the deals they reached violated the terms of loan agreements and unfairly reduced the value of their debt.

Investing in troubled debt previously consisted of “doing due diligence and making judgments on companies,” said Ty Wallach, a longtime hedge fund investor who now heads the troubled debt group of Atlas Merchant Capital. Now it’s more of a ruthless legal game, he says.

“There is a lot more to dig into the documents to see how you can be overwhelmed. It’s a market development that I don’t really like, because it can reward people for their complicity. This can, however, provide opportunities for those who know what to look for, he stressed.

Line chart of the Bloomberg Barclays Global High Yield Index (%).  Even junk bond yields plunged despite economic devastation

And there are still plenty of over-leveraged companies that will struggle to stay afloat for years to come, analysts say. Satellite company Intelsat and car rental group Hertz are among those that have filed for bankruptcy this year. Both have viable businesses, but unsustainable leverage has given struggling funds the opportunity to restructure them creatively.

Fitch Ratings predicts that the junk bond default rate will remain at around 5% until 2022, for a three-year cumulative default rate of 15-18%. This compares to a three-year cumulative default rate of 22% in 2008-2010.

The IMF remains concerned about the fragility of many companies, warning this month financial stability report the danger of further bankruptcies if the stimulus-induced bond issuance boom fails to dampen businesses until economies recover.

Even this fails to capture the degree of distress among many companies that do not or cannot issue bonds, leaving them unable to benefit from central bank support and also facing a winnowing of stimulus measures. of the government. Euler Hermes, the export credit agency, expects business bankruptcies to increase by 35% globally by 2021, the biggest increase since the financial crisis. ‘Covid-19 hit the global economy like a meteorite,’ company said Noted.

12-Month Rolling High Yield Bond Default Rate Linear Chart Showing Standard & Poor's Predicting a Gigantic Increase in Junk Bond Defaults in the United States

So far this year, troubled debt hedge funds haven’t had much to say about it, returning an average of 0.8%, according to Eurekahedge, a data provider. But the strategy tends to struggle in the midst of a crisis – when the prices of riskier corporate debt can be volatile – and fare better as the economic recovery builds. Distressed debt hedge funds, for example, recorded gains of 36% and 23% in 2009 and 2010 respectively.

It’s a story that means there has been a rush to launch new troubled debt funds and special situations. Nearly $ 29 billion has been raised by 31 funds this year, according to Preqin. But 140 other funds are currently soliciting investors and targeting an additional $ 100 billion. If even half of them achieve their goals, then 2020 will be as remarkable a fundraising time as 2008, the record year before.

“We love the scenery right now,” said Claire Madden, managing partner at Connection Capital, a UK investment group that looks to distressed debt funds on behalf of its clients. “The problems are disguised because of various government programs and the money flowing through the system. But in 2021, there will be a lot of pain to come, ”she added.

Preqin data does not include the launch of related strategies, such as opportunistic credit funds like Goldman Sachs’ new $ 14 billion West Street Strategic Solutions, a cornerstone of the investment bank’s goal of growing its ‘alternative’ investment business, and part of a larger industry effort to capitalize on the chaos caused by Covid-19.

Standard & Poor's column chart has taken more than 2,000 negatively rated stocks this year.  showing that rating agencies rushed to revise outlook after Covid-19

However, some executives argue that the response of central banks and governments to this crisis has a lesson for the industry: get more flexible mandates from investors and bounce back faster when investment opportunities arise.

Historically, a typical cycle of troubled debt can last up to a year, giving funds ample time to deploy their firepower. But shorter, more acute distress attacks are now more common, which means funds need to be faster. For example, Apollo invested up to $ 10 billion in March, of which all of the capital held by the third tranche of its Accord Series “Dislocated Credit” Fund, and is now looking to raise funds for a fourth.

“Central banks have really put an end to the old business model where you could invest for a long time, mitigating all the volatility,” said John Zito, co-head of Apollo’s global business credit division. . “A lot of people have broadened their mandates because they realize that it is very difficult for them to use their old business model.”

While most say mandates are becoming more flexible, some argue that the ability of central banks to quell volatility and turmoil in asset markets instead means there will be a more moderate but longer window of opportunity. for investors to take advantage of corporate distress.

“Central banks and governments have supported markets and companies very well, but this cannot solve solvency issues, only liquidity issues,” said Remko van der Erf, co-head of alternative strategies at Kempen. . “So the default cycle will be longer and longer. “

Carol M. Barragan

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