“We’re in the seventh year of a six-year cycle,” is a view you often hear expressed by private debt professionals. The point being made is that it normally takes around six years for a benign credit environment to start turning bad (or vice versa). Taking historical precedent as the cue, it should be about time for distressed investors to be rubbing their hands together in anticipation of the opportunity.
So why does the chart accompanying this article show both the volume of fundraising for distressed debt, and the number of funds in the market, continuing to fall? If the bad times look as if they’re about to roll, shouldn’t we be seeing a fundraising uptick by now?
The answer appears to be that the normal rules no longer apply. The “lower for longer” interest rate environment looks as if it’s here to stay for a while yet, and this is helping to sustain a global corporate default rate of around 2.0 percent (compared with a 35-year annual average of 4.1 percent, according to S&P).
In Europe, where a big distressed opportunity had been forecast as the banks struggled with toxic balance sheets and growing regulatory demands, better rather than worse times appear to lie ahead. “The Eurozone is very slowly recovering,” notes Faisal Ramzan, a London-based partner in the corporate department at law firm Proskauer and a member of the firm’s private credit, finance and distressed debt groups.
“Many expected it to tip the other way, but there are green shoots of recovery,” he adds. “People have been waiting for depressed asset values, but it hasn’t really happened yet to the extent predicted or hoped.”
With the UK having thus far proved resilient to a post-EU referendum downturn, attention has focused mainly on the southern European markets of Italy and Spain. But with Spanish banks having done a lot of balance sheet cleansing already, some observers think only Italy – of the major European economies – continues to have a big problem with asset quality.
However, as one fund manager (who wished to remain anonymous) observed: “Even there [in Italy], there is usually a big disconnect between what investors want to pay (the perceived market value) and the book value, or price at which the asset is provisioned. It’s very difficult for the banks to sell in a satisfactory way, without taking a hit to their P&L.”
False dawns may be nothing new when it comes to expectations of a surge of distressed dealflow. Justin Mallis, a principal in the London office of placement agent First Avenue, only has to think back to 2013/14 when “there was significant data pointing to a downturn – lots of triple C issuance, PIK/toggle issuance, covenants going down. Everyone thought defaults would increase significantly but it only happened in certain sectors, not across the board”.
However, Mallis also notes that US high yield bond defaults have been increasing (reaching their highest level for six years in the middle of last year), and covenant-lite issuance has been rising dramatically. One or two signs, perhaps, of dark clouds on the horizon. But not enough, it seems, to convince fund investors that distressed is the way to go.
A longer version of this article will appear in the July/August issue of PDI