Distressed debt & special situations report
As the US economy continues to hum along, with delinquent commercial bank loans hovering around historic lows, institutional investors perceive a dark cloud lurking behind the silver lining. PDI data show the distressed debt share of total capital raised by private debt managers has increased year-on-year since 2015. Distressed accounted for 32 percent of capital raised in final closes in 2017, and 35 percent in the first three months of this year.
Meanwhile, of the $242 billion in capital targeted by private debt funds as of Q1 2018, around a quarter ($60 billion) is focused on distressed debt or special situations strategies. But while tens of billions have been committed to these funds, economic times are so good that opportunities for deployment are tough to find.
“The opportunity has not materialised the way most investors and managers thought it would,” says Jeff Topor, vice president of private asset research at California-based institutional investment advisor Cliffwater. “It is already one of the longest cycles in history. But there is a feeling that a turn could be more imminent. We are seeing some indicators: Looser underwriting standards; rising interest rates; spread compression in the loan market. It points to a frothy market.”
So far, dislocations have been scattered and secular and, in the case of oil and gas, short-lived. “We are not seeing much stress now, other than in retail and a few mini-sectors,” says Arthur Penn, founder and managing partner of New York-based mid-market lender PennantPark.
PennantPark participated in distressed deals during the last recession, including the purchase of distressed loans in the secondary market in 2009 at discounts. Penn says that although he isn’t currently doing distressed deals, he remains cautious, focusing on less risky first-lien loans as a defensive measure.
“Certainly, there will be a recession again,” Penn says. “That has not been outlawed. We are underwriting as if there will be a recession.”
Among those awaiting a recession or downturn with significant distressed debt war chests of commitments are GSO Capital Management, Oaktree Capital Management and Centerbridge Capital Partners.
But without a broad economic downturn, they may be waiting a while. Meanwhile, other managers are doing smaller, more sector-focused or one-off-type distressed deals as opportunities present themselves. For example, a trio of private debt lenders recently provided bankruptcy financing for Massachusetts-based shoemaker Rockport Company. Participating in the $60 million debtor-in-possession loan were Crescent Capital Group, GoldPoint Capital Trust and KKR’s Corporate Capital Trust.
Sourcing good distressed deals in bankruptcy or default takes some doing today. US Federal Reserve statistics indicate that the delinquency rate on all commercial and industrial bank loans in the US stood at 1.17 percent in the 2017 fourth quarter, down from a brief spike during the energy bust of 2016 and a fraction of the 4.35 percent peak during the recession in 2009.
Marc Lasry, CEO and co-founder of New York-based credit specialist Avenue Capital Group, says delinquency rates tell only part of the story. Many companies undergoing stress today are trying to avoid default and bankruptcy by doing restructuring deals early without ever going into default, he says. Lasry monitors corporate bonds trading at discounts for companies that might be candidates for distressed financing.
“Sometimes we come in and provide a senior secured loan to enable a company to not default,” Lasry says. “Ten years ago, people went straight into bankruptcy. Today, they are often staying out and paying interest to keep their options alive.”
“Ten years ago, people went straight into bankruptcy. Today, they are often staying out and paying interest to keep their options alive”
Chris Acito, founder and CEO of New York-based Gapstow Partners, an alternative investment advisor to institutional clients, says he believes most distressed players now try to get involved earlier in the process: “They have firms on their radar screens. They are often reaching out, trying to negotiate pre-settlement structures.”
Lasry and others say they still shop for deals among defaults and bankruptcies. The key is identifying a company with enough good opportunities and assets to justify the loan risk.
David Tawil, founder and president of distressed investment specialist Maglan Capital, says part of the challenge today is finding decent companies that are experiencing problems: “Interest rates have been very accommodating for a very long time. Because of that, we are not presented with a lot of good businesses with broken balance sheets. We are presented with bad businesses with broken balance sheets. That is the last thing you want to get into.”
Another problem for distressed investors is that one of the main sectors currently facing stress just now is retail, a sector in long-term decline. Lasry is among many distressed investors who steer clear of retail as a sector they believe has yet to hit bottom. By contrast, Lasry is bullish on energy, which he sees as continuing to improve since its slump so that companies going through restructuring should have better prospects.
The surprising staying power of the US economy has clearly confounded large distressed debt fund managers, leaving them with billions in commitments but not enough opportunities for deployment. The US remains the dominant player in distressed debt, with North America-focused funds accounting for a third of all capital raised in the first three months of this year.
Jason Mudrick, founder and president of distressed credit and event-driven specialists Mudrick Capital Management, says that even if the overall US economy continues to perform well over the next year or two, there may be secular disruptions like the energy shakeup.
“I think the economy is basically fine for the next year or so,” Mudrick says. “That does not mean we won’t have volatility.”
And if they can’t get a recession, distressed investment specialists will have to settle for a little sporadic volatility here and there to generate opportunities.