Could distressed investing leave LPs out of pocket?

Distressed debt firms will be hoping to win big in our awards, which were launched this week. But some warn that LPs could lose out if the opportunity set is delayed much longer.

It’s that time of year again. Yes, the festive season approaches but, arguably even more importantly, here come the Private Debt Investor Awards 2020. Once again – with countless firms having lent a helping hand by reminding us of their highlights from the past 12 months – we have studied activity throughout the year and, after much deliberation, drawn up our shortlists. Until 8 January, these will be waiting for your votes HERE.

It has, of course, been an extraordinary year. Plenty of LPs tell us they’re generally impressed with how private debt managers have been coping with the stresses and strains of the pandemic. Defaults have begun to rise but not to panic-inducing levels, and GPs have been rising to the challenge of keeping their investors well informed. Yet there are concerns that this has been a phoney war to date. Central bank intervention has held economic disaster at bay – but when that support is eventually withdrawn, will the whole edifice crumble?

Those who have been committing large cheques to distressed strategies may be hoping it does. Both in 2017 and 2019, distressed debt fundraising was at unusually high levels, meaning there’s a lot of dry powder waiting in the wings. This could be a problem. As we have discussed previously, if the distressed opportunity has been effectively deferred for months, or even years, investors may find themselves in the uncomfortable position of having committed capital sitting idle as cash and earning precisely zero for longer than expected.

As one distressed debt sceptic pointed out to us, LPs won’t necessarily share the glee of a fund manager achieving a 20 percent return if their own capital was making no return at all for a year or two before the vehicle began investing – substantially dragging down their overall return in the process.

There are mitigating actions that can be taken, such as over-commitment strategies and diversifying across vintages. But these are more effective in mature asset classes, such as private equity. In the relatively nascent private debt universe, they are harder to achieve. Some would advise building a distressed debt portfolio only once you have the solid bedrock of a performing credit portfolio, so as to avoid putting all your eggs in one basket.

Another cautionary note provided by our sources concerns dealflow. Some distressed managers have been eyeing mid-market debt portfolios in the expectation that managers may offload distressed assets on to the secondary market. However, there is a view that the offloading of such assets will be a rare occurrence as managers fight hard to demonstrate their ability to turn companies around.

One thing’s for sure: as with direct lending and private debt strategies of all stripes, 2020 has only begun to provide glimpses of the consequences of the global pandemic. Next year should provide plenty more clues.

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