Distressed: Is it worth the wait?

Timing, fees and manager differentiation are among the key issues for limited partners prepared to take a punt on GPs that thrive on turmoil.

Over the past week, three funds with the common objective of targeting stressed or special situations – raised by Cheyne Capital Management, CVC Credit Partners and HIG Bayside Capital – reached final closes in the billion-plus bracket.

After a slump in fundraising for distressed and special-situations vehicles last year – which accounted for 17 percent of total global private debt fundraising, compared with more than 31 percent in 2017 – is faith once again being placed in the turning of the cycle? With investment bank UBS expressing the view that a global downturn may be “one step” away and triggered in large part by the US-China trade war, it would be no great surprise.

However, it’s also fair to say that investors have been here before. Since the global financial crisis erupted more than a decade ago, there have been periodic volatile events – from commodity price routs to stock market rollercoaster rides – that have briefly shaken confidence. But none have segued into a slump sufficiently deep and long to feed the hungry appetites of the vultures.

In the July/August issue of PDI, our cover story on distressed debt has some key questions for investors to chew over. Here are a few of them:

What to do about the lack of distressed opportunities? Some LPs will sit on their hands until the next downturn appears to be just around the corner and commit their capital at that point. The problem, as noted above, is one of false dawns: who really has confidence in the imminence of a lasting downturn? Others will commit to special situations, where the stress is more related to the individual business than the economy, as a kind of proxy.

Does distressed debt deserve its place in the portfolio? This is a rather more fundamental question. Pitchbook data cited in our cover story revealed one-, three- and five-year net IRRs of less than 9 percent. Although these seem like respectable returns in today’s environment, they are still lower than many investors would assume or expect from a strategy typically associated with ‘private equity-like’ performance.

Can I identify the cream of the crop? Reflecting on distressed debt investing through the GFC, Chris Gort of Zurich-based consultancy SIGLO Capital Advisors told us: “The dispersion of manager performance and their risk appetite was significant, from returns of 200 percent at one end of the scale to marginal gains at the other.” In any corner of the private debt universe, manager selection is important. Here, it’s perhaps more important than anywhere else.

How do I ensure alignment? Fees are always a big talking point, and distressed debt is certainly no different in that respect. As a strategy where the capital may spend a long time on the sidelines as optimum conditions take time to materialise, LPs may worry about fees being charged on committed capital. On the other hand, invested capital-only fees may fuel concerns about whether the capital is being invested wisely, especially during periods less conducive to distressed investing. Unsurprisingly, perhaps, this area sees a wide range of hybrid arrangements, which bring with them a complexity that LPs need to be on top of.

Write to the author at andy.t@peimedia.com.