Since the turn of events that took place earlier this year, it is clear that in alternative assets there is one strategy demanding more attention than most: distressed debt. While the current market dislocation seems to be pushing distressed debt managers to the forefront of capital raising, is it as simple as assuming this strategy will be the most successful over the next two to three years given the market dynamics?
LPs increasingly want to discuss distressed debt strategies within private debt in more detail and are keen on increasing their exposure to the strategy. If history is anything to go by, it is easy to see why. The public credit markets are providing attractive discounts on the credits of blue-chip, well-run companies that would not have been in this situation pre-March. When this happened in 2001 and immediately following the global financial crisis (GFC), we saw stellar returns being achieved by distressed managers.
During a recent meeting with a pan-European debt manager, its pipeline and opportunity set was described as increasing five-fold since March, with the change taking place within a matter of days. It was not a surprise that the manager concluded: “I don’t think origination will be our problem for this fund; investing it all will be.”
With attractive pricing and rising default rates in the leveraged loan markets suggesting this is the right time to invest in distressed players, and the clear message from LPs that they do not want to miss the boat, why should we think it is any different this time around?
The simple answer is that now there are more differences than similarities in both the public and private markets. For one, the macro debate continues about whether the recovery will be V-shaped or a more protracted downturn. This will have a spillover effect on the types of distress that underlying credits will experience over the next two to three years, which means the type of distressed strategy will matter.
When we look at the prior golden era of distressed investing (post-GFC), the number of distressed players in Europe and the volume of capital raised was only a third of what it is today. If we include the targeted raises for 2020, we get to total capital being targeted or raised by European-focused distressed managers that is five times larger than the equivalent post-GFC period. It is not just the sheer total of capital being raised or targeted that is larger, but also the number of different funds in the market that are ramping up efforts with ever-increasing target fund sizes.
The diversity within these numbers is also different. We are seeing traditional existing distressed players returning to market and platform extensions in the form of dislocation funds, as well as new entrants and first-time funds coming to market. Perhaps one of the bigger indicators of this new “gold rush” is that some existing private equity firms are relaxing the wording in their LPAs to take advantage of more distressed and turnaround situations. So, although the initial exogenous shock may resemble prior events, there are now more players on the pitch capable of playing the game, as well as new players joining from a different sport.
The type of distress we are seeing in the market is also different. While there is no doubt a ballooning opportunity set given the dislocation, the nature of the distressed credits being invested in today will change over the next 12 months due to the anticipated slower recovery. This will be critical because, although there are a number of value-creation levers within distressed debt, purchasing credits at a discount is only one of them.
Over the course of the next 12 to 24 months, managers will require more operational expertise to execute the required restructurings and turnaround strategies that will drive value beyond the initial purchase. This ability relies on having larger and more experienced teams that have executed these before on multiple occasions. Buying at a discount may not be sufficient to drive the returns that LPs are expecting in the distressed sphere, especially as the downturn may be prolonged. With a number of LPs benchmarking distressed returns to their private equity portfolios, being able to use all value-creation levers is vital.
So, while the opportunity set is larger today and offers attractive pricing, the focus should not be on the immediate execution, but on the ability of the manager’s strategy to continue investing throughout the duration of the investment period and to have the requisite tool set to fully carry out the restructuring and associated operational changes. With an investment period of two to three years, the original entry price is only one such tool.
Alex Odysseos is a senior vice-president, Private Funds Group at Houlihan Lokey, the Los Angeles-based investment bank and financial services company.
Statements and opinions expressed herein are solely those of the author and may not coincide with those of Houlihan Lokey.