2016 the year of distress?

Predictions about increased defaults, restructurings and bankruptcies in the US are coming true. While this is creating opportunity, trend followers should be careful.

When PDI surveyed industry experts a few months ago about their predictions for 2016, almost everyone said they saw more credit defaults, bankruptcies and restructurings on the horizon in the US. Four months into the year, those forecasts are proving to be true.

Unsurprisingly, most of the pain is being felt in the energy sector, where many companies challenged by low oil prices have filed for bankruptcies or are pursuing debt restructurings with creditors. According to a recent survey from Reuters, US restructuring deal activity was at $7.7 billion in the first quarter, a 61 percent rise from the same quarter in 2015. The energy and power sector accounted for 32 percent of the US debt restructuring market, the largest share.

Renewable energy company SunEdison filed for Chapter 11 bankruptcy protection yesterday (21 April) after its aggressive growth and acquisition plan proved unsustainable. Coal producer Peabody Energy also filed for bankruptcy earlier in April, following other producers including Arch Coal, Alpha Natural Resources and Patriot Coal. The list goes on.

Moreover, the turmoil is not limited to energy: several once-popular retailers have filed for bankruptcy as well. Retail experts say some of this is driven by competition from online businesses and the pressure for bricks and mortar shops to convert to online. Pacific Sunwear filed for bankruptcy in April. Sporting goods stores Sport Chalet and Sports Authority also sought bankruptcy protection earlier this year, while Quiksilver and American Apparel filed last year.

Given the market dislocations, distressed debt players must be salivating at the opportunity. But where does it leave traditional direct lenders? Most have been saying for months, if not longer, that it’s time to be more cautious around lending to new companies. Most of these firms have continued lending at record volumes and arguing that the businesses they pick are still sound and will be able to pay their loans back. But the Goldman Sachs BDC stood apart from the pack last quarter, showing an unusually low deployment volume at $7.4 million.

With the credit cycle seemingly set to turn, LPs tell PDI they are more interested in distressed and special situations strategies, rather than direct lending.  At the same time, billions of dollars have been raised (and are still being raised) for direct lending funds. Will all that capital find a home, especially during such volatile conditions? That’s questionable.

Industry observers point out that there are far too many copycat direct lending products in the market and some managers are suspected of just hopping on the gravy train, having spotted a strategy that LPs are putting a lot of money in. But not all of these firms appear to have the origination capabilities to successfully manage direct lending products.

It would be even worse if debt players started creating “me too” products in the distressed and special situations arena. Bankruptcies and restructurings are often long, burdensome, drawn-out processes. Few investment firms have the patience or expertise necessary to go in and operate their borrowers, should it come to that. Firms looking to capitalize on what now seems to be an increasingly popular strategy should at first make sure they have the right people, experience and risk controls in place to pull it off. Or the agony will be widely felt on both the GP and LP sides.