When a bleak global outlook is great news

Distressed debt fundraising in 2018 was itself in distress, numbers from PDI show, sinking to an eight-year low of $25.4 billion. Raises for funds focused on North America were particularly meagre, dropping to $2.5 billion, the lowest since before the financial crisis, although this number should be read with caution since the majority of money in most years is for multi-regional funds.

The lack of new capital for distressed fund managers was all the more striking when set against 2017, a bumper year, with $67.1 billion raised, the highest tally since at least 2008.

Peter Martenson, partner at the placement agency Eaton Partners, in San Diego, California, attributes this to a wholesale change in mood from one year to another. “In 2017 sentiment was strong that within 12-18 months there was going to be a recession or downturn, so limited partners felt they should allocate money to those future opportunities,” he says. “But in 2018 sentiment changed to the sense that we would grow slower but longer.”

This change in mood itself took a knock at the end of the year, he acknowledges, but “for about three to six months there was a feeling across the globe of nirvana”. Ted Goldthorpe, partner at BC Partners Credit in New York, thinks the 2018 numbers are not puzzling when placed next to the 2017 figures. To the contrary, they are explained by the 2017 numbers.

“In the low-rate environment, investors really shifted their allocations to private credit, starting a few years ago,” he says. “But by the end of 2017 a lot of people had filled their asset allocation mandates.”

This theory is supported to an extent by the total numbers for direct lending, encompassing a range of strategies, which also dropped in 2018, according to PDI data – though not by as much as the slide for distressed.

Looking up

What the two men do agree on, however, is that the prospects for distressed fundraising are picking up.

Martenson sees storm clouds on the horizon of the global economy. He cites a wide variety of factors that have politics at their core. These include tensions between China and the US, which Martenson, a former US naval officer, thinks could even start to generate fears about “actual physical wars” between the two powers.  They also include the spill-over of Brexit beyond the UK. In a sign of Brexit’s ability to generate gloom even thousands of miles away, he cites the February visit to the US by Nicola Sturgeon, Scotland’s first minister. While there she warned, as Martenson put it, “about how there’s going to be an apocalypse – it’s going to be terrible for the UK economy”, in the event of a no-deal Brexit. Such talk “hits the world because of the psychological effect”, says Martenson.

Against this darkening of sentiment, which historically both increases interest in distressed and increases opportunities for distressed, Martenson’s central scenario is that distressed fundraising will “jump from a low base” to a total somewhere between the 2017 and 2018 numbers. However, he thinks fundraising could rise to 2017 levels if the world sees a hard Brexit, another government shutdown in the US and an increase in trade tariffs. He notes there is currently “quite a number of funds” looking for stressed or distressed strategy capital.

Goldthorpe thinks the global capital markets volatility in Q4 “really helped distressed fundraising”.  Another fund manager, who has just finished a successful raise for distressed, says that when it comes to limited partners, “there’s not just talk – there’s action”.

As well macroeconomic factors, market observers also believe that opportunities in particular sectors, disrupted by structural change, will buoy fundraising again.

When talking about Europe, Anthony Robertson, CIO of Cheyne Strategic Value Credit, part of Cheyne Capital, an alternative asset manager in London, makes an interesting observation. For all the political problems in different countries, he describes the opportunities as “more sector-specific than country-specific”, when asked to choose between the two alternatives, though he emphasises the existence of “geographic nuances” to opportunities.

In retail, aspects generating distress include higher rents, lower footfall, rising wages and e-commerce. In auto these include more tariffs – between the US and EU, and between the UK and the EU. They also include both lower diesel sales and the growth of electric vehicles, which will produce winners but also many losers. Slowing Chinese growth will create specific stresses by impairing sales of European luxury vehicles, says Robertson.

Eyes on supply chain

But what if markets return to a protracted period of calm, and the economic storm clouds drift further into the distance? Distressed fund managers play down the fact that default rates are low on both sides of the Atlantic, arguing they are a lagging rather than leading indicator of distress. On the other hand, a possible leading indicator for distress among mid-market and larger companies is distress in the smaller firms that supply them with parts and services.

But this part of the economy is faring fine too, says Albert Periu, co-founder and CEO of Nepfin, a fintech lender specialising in US firms with between $1 million and $8 million in EBITDA. “Our customer base is largely the companies that put the pieces of equipment together for larger companies, so they’re hit first when their customers pare their orders to them,” says Periu. When it comes to signs of trouble among the potential borrowers in his firm’s market, “the data is not there yet”.

Market participants counter-argue that distress can still take root in particular sectors, even if economies continue to grow healthily. Many of the stresses mentioned by Periu do not depend on a worsening of the global economy or of geopolitics, although any broad economic downturn would clearly increase the pain of these stresses.

The same is true for the US, say observers. “Typically, stress is driven by economic weakness, but the US economy is very strong,” says Goldthorpe. “A lot of the current stress is caused by other factors, including the rise of technology, which has implications for retail and other sectors.”

Renewed concerns about opioids in the US are also triggering corporate stress in pharmaceuticals, he notes. This is an excellent example of his point that “a lot of distressed themes are not correlated with the economy”.

General partners can also respond to the absence of an economic downturn by broadening the investment base beyond distressed investment styles to include stressed debt, value and opportunistic. These styles are all slightly different, but all intermediate in risk and return between senior secured and distressed lending.

“The attitude of limited partners has shifted from ‘I’ll go 100 percent after distressed’ to ‘I want an all-weather distressed fund manager, who can buy into a company in a stressed situation, add operational value and grow the EBITDA’,” says Martenson.

But the proliferation of funds offering this only makes life harder for anyone looking for classic distressed investments, say some observers. “There’s a wall of opportunistic credit funds competing to lend to weaker businesses which, in the past, could have been expected to go straight into the hands of distressed investors,” says Richard Thomson of RLT Advisory, a turnaround specialist in London.