There has been so much talk (or indeed hype) around direct lending that it’s easy to assume the strategy is dominant and investors captivated by little else. But our 2017 fundraising figures revealed that distressed debt nosed ahead of direct lending last year – accounting for around a third of total money raised for private debt as a whole. Moreover, the $61 billion total for distressed almost doubled the $32 billion the strategy accounted for in 2016.
Perhaps it’s to do with investors recognising what now appears to be a sustainable rather than fleeting opportunity. In Europe, where most attention is currently focused, distressed investors tell us – almost disbelievingly, as if they can’t quite acknowledge their good fortune – that the commercial banks really are now dealing with the distress on their balance sheets. It’s a region where decisive action is a refreshing novelty.
For several years following the global financial crisis, say market sources, no more than around €10 billion of problem loans were sold off per year by European banks. Over the last few years, that figure has risen to hundreds of billions. Moreover, the value of the total opportunity is estimated at around €2 trillion, which is expected by some to provide dealflow for the next five to 10 years. For a strategy associated with opportunism, LPs investing in it now can be confident that a good investment rationale will exist over the long term.
While the bad loan legacy provides a promising backdrop, political developments can also play a part. One source we spoke to recently referred to the “fault lines” that continually appear in Europe – Brexit and the German elections being two recent examples. At the individual business level, events such as these will not necessarily have negative effects – but it seems fair to assume a volatile environment will fuel more distress overall than a benign one.
But while the stars appear to be aligning, those firms that have invested in the space through changing times will tell you that having the right infrastructure as a business and the ability and willingness to do some heavy spadework are unchanging constants.
Sources say origination skills are vital, since banks often like to sell problem loans privately. Building banking relationships over many years can help with introductions to opportunities that others will not see. Those without the requisite experience and relationships may choose to believe in the miracle of “low hanging fruit” suddenly available to everyone – failing to miss the point that there is normally a reason for something being touted around to all and sundry at a large discount.
Operational skills can also be underestimated. On the strategic spectrum ranging from passive to fully hands-on, many imagine distressed investing to be more of a “buy low, sell high” trading type of activity situated towards the passive end.
But that’s not the impression formed from conversations with market veterans. They will tell you that distressed investing is often about pulling businesses up by the bootstraps – perhaps by identifying a hidden jewel in the crown that can create a sustainable future and working incredibly hard to make it a success, while (perhaps with equal difficulty in countries where union power is strong) shutting down whatever parts of the business have no prospect of a profitable future.
The question then becomes how many of those funds targeting the distressed space today have the experience, resource and skills required to hit a return expectation typically in the mid-teens? Given that fundraising has doubled in the space of 12 months, it’s a question that should be at the front of limited partners’ minds.
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