Distressed isn’t what it used to be

Global distressed activity has fallen, but signs point to a re-emergence of opportunities.

No-one has ever said that fundraising is easy, but for distressed managers, it was certainly less of an uphill struggle a few years ago than it is now.

With the global economy on the brink of ruin, a handful of general partners with experience investing in distressed debt managed to stockpile $101 billion in committed capital in the five years leading up to and through the financial crisis. That amassing of dry powder proved fortuitous, given the circumstances. With many large companies poised to breach their debt covenants, “distressed investors had a choice array of companies in which to invest”, according to Bain & Company’s 2010 private equity report.

Adding credibility to that claim, Bain went on to report that distressed funds had $50 billion in dry powder going into 2009, a total that shrank to $41 billion by the end of that year. Firms were spending capital faster than they could raise it.

Times have changed.  The economy has improved, and investor demand for distressed debt funds has declined. Bain’s 2014 report found that falling default rates and an improved global economy contributed to a 16 percent decline in commitments to distressed private equity funds last year.

This week, Thomson Reuters released data confirming that decline in fundraising was mirrored on the deal front. Global distressed debt and bankruptcy restructuring activity fell to $22 billion during the first quarter, a 6.8 percent decline from Q1 2013 totals.

In the US, deal activity fell by 26.2 percent to $4.5 billion during the first quarter. Asia-Pacific deal volume declined by 71.2 percent from Q1 2013 totals to $1.7 billion.

The only region to see a spike in activity compared to the same period last year was EMEA, though more than half of that region’s volume was accounted for by the $10 billion restructuring of UAE-owned investment company Dubai Group, which was the largest single transaction of the quarter.

But even as investor demand for distressed debt funds has fallen, concern over the possibility of another crisis on the private equity front has grown. Earlier this week, The California Public Employees’ Retirement System released an investment memo indicating that they were cautious about deploying too much capital into the asset class. The retirement system will consider decreasing its target allocation to 10 percent at its meeting next week.

They have good reason to be cautious. Private equity firms have amassed record amounts of dry powder, driving up prices on buyout assets and pushing debt-to-EBITDA multiples to decade highs in the US, according to Pitchbook. 

And although the economy is slowly recovering, the pace of that recovery has been far from robust. Should the market experience another shock, the data on increasing leverage multiples will be cited as evidence of the industry’s failure to learn lessons from the crisis. In a precursor of what may be around the corner, S&P has already reported that Europe’s leveraged loan market is overheating. 

Of course, that same environment would also provide a boost to distressed managers. Although commitments to distressed funds fell last year, distressed firms were sitting on an estimated $76bn in dry powder as of December, according to Preqin. Should the market take a turn for the worse, managers would still be very well positioned to acquire troubled assets.

Demand may not be what it used to be, but that’s the beauty of a cyclical investment product. New opportunities may arise sooner than one would expect.