In early 2020, distressed debt suddenly became the strategy du jour as covid shattered the global economy. Billions flowed into the strategy as lockdowns brought economies to a standstill. Today, with levels of uncalled capital at an all-time high, experienced distressed investors are still waiting to make their move.
Yet as the storms of record leverage pre-covid, dislocation of the global economy and the end of short-term stimulus measures start to converge, the stage is set for what could be a distressed cycle unlike any seen in several decades. Liquidity needs, downgrades and defaults are already double their heights in the global financial crisis. Many other corporates have postponed inevitable defaults and downgrades, and taken on even more short-term debt to cover losses. Increasingly fragile credit capabilities will intensify a surge in defaults in 2022 and 2023.
Amplifying the opportunity for distressed investors are the passive lenders whose structural limitations give them few options – to sell or identify partners – in bankruptcy or restructuring processes. Most leveraged loans and high-yield debt are held by passive market participants: collateralised loan obligations, ‘shadow lenders’, exchange-traded funds and mutual funds. Non-bank lenders hold approximately 86 percent of new issue syndicated US leveraged loans, while direct lending has quadrupled in the US and grown 12.9x in Europe since 2007.
In general, downgrades, defaults and bankruptcies create turmoil for traditional and passive lenders. CLOs must manage mandatory payment obligations and rating thresholds. Direct lenders lack the flexibility to provide incremental cash to support restructurings and commercial lenders are required to maintain capital ratios and are subject to increased regulatory pressures. These participants will be attractive restructuring partners with experienced distressed debt investors.
At the end of 2020, there were $6.4 trillion of distressed opportunities across the US and Europe, almost 3.5x the level in 2007, according to the LCD Quarterly Leveraged Lending Review and LCD Quarterly European Leveraged Lending Review. With BBB- and lower-rated corporate debt up 8.7x in the US and 17.7x in Europe since the GFC – and representing 55 percent of all investment-grade debt – further downgrades could crowd out the high yield market, thereby exacerbating a liquidity crisis for corporates across the credit spectrum. Demand from CLO managers has evaporated, with record downgrades as covenants were breached and credit-quality tests fail.
Skilled distressed-for-control investors are better positioned than ever to acquire businesses by accumulating senior secured and ‘fulcrum’ securities, typically below liquidation value with unlevered positions. By protecting collateral and enforcing creditor and shareholder rights, talented investors can mitigate downside risk, while creating significant upside opportunity.
Distressed investors also have a broad universe of targets, since no company can prevent distressed investors from buying its claims. After encouraging portfolio companies to use their best collateral to take on additional debt to cover losses, many private equity sponsors will have some portfolio issues with distressed managers in their capital structure. The priority through the pandemic for the equity sponsor and management was focused on ‘making the interest payment’. However, with this pressure to service additional levels of debt, the speed and tilt on the treadmill has increased, and this is providing distressed managers with additional entry points.
In what can be viewed as a systematic misallocation of capital, many businesses have used cash to cover losses throughout the health crisis. This has caused them to underinvest in long-term digital capabilities and deprioritise environmental, social and governance goals – which, ironically, have been notable drivers of business growth through the pandemic.
As we move through the beginning months of the re-opening of the US economy as mask mandates are lifted, economic growth begins to gain momentum and inflation expectations rise, we expect a distressed cycle that will be more drawn-out. This cycle will also be specific to certain pockets of industries and segments of the economy that have been overlevered and that have underinvested in new technologies.
We also think it will be important for distressed investors to take an agile approach via investment specialists seeking asymmetrical risk-reward opportunities that are positioned and focused to be able to drive the outcome of a restructuring process.
Furthermore, certain companies and industries will provide rich value opportunities for agile managers to enhance their business operating efficiencies, improve capital allocation, rationalise costs, implement growth initiatives, and boost competitiveness. This in turn will drive multiple expansions and the creation of outsized risk-adjusted returns.
Distressed managers seeking to acquire, restructure and transform these distressed businesses will need to adapt their strategy and understanding of how technology and ESG will drive these companies forward. Fund investors are likely to be asking these focused questions.
In a post-covid environment, we think management teams will need to use best-in-class ESG practices to drive future growth and turnaround and transform target businesses that have deprioritised this critical area. A critical element of the ability to drive operational transformation of distressed companies will be to strengthen the operating model with an emphasis on using corporate board strategy, governance, operations, corporate charter, code of conduct and procedures. All these areas are critical advances to driving higher, long-term, risk-adjusted returns by creating businesses with increased sustainable downside protections to their operations and higher upside growth scenarios.
I saw some parallels when on a recent visit to the Galapagos Islands, one of the harshest climates in the world. What was clear was that it does not matter how smart you are or how strong you are: only those animals that could adapt were able to survive.
Likewise, distressed managers will have to be able to adapt to this post-covid world. They will need to understand how companies can reimagine and redesign their businesses through the application of technology to facilitate their exit from bankruptcy. They will also need to reduce their exposure to risk while changing the focus of their core business as they seek to generate extraordinary financial returns.
David Conrod is chief executive of FocusPoint Private Capital Group, a New York-based private fund placement business