Many of the opportunities in the distressed market are in increasingly niche or specialised areas, based on current trends and themes, and this is opening a range of investment opportunities for fund managers.
“The problems caused by inflation and supply chain issues were already being borne out in a variety of idiosyncratic opportunities this year, including the provision of rescue financing for a biomass plant, an events company, a European shoe manufacturer and retailer, as well as various real estate situations,” says Andrew Amos, fund manager and head of restructuring and debt solutions at UK asset manager M&G.
“We had also seen an increase in banks selling portfolios of non-performing loans and assets that they have been forced to take onto their balance sheets.”
Some fund managers are looking to opportunistic credit opportunities. Others are repositioning themselves as providers of lending solutions for companies that may not be distressed but find themselves under greater stress for one reason or another.
Brendan Galloway, head of European opportunistic credit at asset manager BlackRock, says he does not feel markets are in the middle of a distressed cycle and believes there are more investment opportunities with ‘stressed’ companies that are “wounded, but trying to cure themselves”.
“The stage is set for what could be a distressed cycle unlike any seen in [several] decades”
FocusPoint Private Capital Group
“There’s definitely demand for stressed credit, but you’ve got to pick your spots,” says Galloway. “You have to bring a lot of creativity and a ‘solutions’ mindset to create an interesting high-yielding opportunity in situations where you’re transitioning a business back to a stable footing.
“I think flexible capital strategies can be compelling to investors; strategies that not only focus on distressed but can look at other opportunities including M&A, or infrastructure, or more growth-oriented opportunities too.
“In other parts of the market, you’ve got a lot of capital chasing more liquid distressed opportunities. We tend to work with entrepreneurs, wealthy families and directly with companies to try to solve something.
“We’ve seen others rebrand similar strategies as ‘capital solutions’, which suggests a broader mandate than just traditional distressed.”
Better opportunities can be found in ‘stressed’ areas driven by microeconomic factors rather than the macroeconomic backdrop, says Raphael Schorr, deputy chief investment officer and partner at global opportunistic credit investors HighVista Strategies, whose firm invests in a range of niche alternative strategies, including distressed and special situations.
Distressed real estate
Another area generating interest among distressed debt investors is commercial real estate, where investors are still struggling to deal with the lasting impact of covid-19 and high leverage levels. It’s an area where there has been more launch activity, with several new funds coming to market over the past year or so.
Last year, for example, London-based Signal Capital Partners raised €900 million for a credit and special situations fund – Signal Alpha II Fund – that the firm’s chief investment officer Elad Shraga said would support companies and real estate borrowers recovering from the pandemic.
“You have to… create an interesting high-yielding opportunity in situations where you’re transitioning a business back to a stable footing”
“We are seeing opportunities in US commercial real estate stemming from developments by foreign sources of capital that are no longer able to fund their projects for a range of structural reasons,” says HighVista’s Schorr.
M&G’s Amis adds: “The pandemic has led to a fundamental shift in thinking around the uses of differing types of real estate, and this is leading to value opportunities in various markets across Europe. In the last few months, we have witnessed this through opportunities to acquire retail park assets and a brownfield development scheme, to name but a couple.”
Different than before
While there are many challenges facing distressed debt investors, the appetite for attractive risk-adjusted returns is fuelling interest in the sector. However, not all fund managers are convinced that a bull market for distressed debt has emerged, with plenty of cash still on the sidelines waiting to be deployed.
The experience of the global financial crisis suggested there can be a delay of several years between market dislocation and investment opportunity.
Despite this, David Conrod, founder and CEO of FocusPoint Private Capital Group, argues that, unlike the GFC, covid is likely to trigger a wider range of defaults and restructurings in sectors where high debt and operational challenges now exist.
“Moreover, as the storms of record leverage levels pre-covid, combined with an unprecedented dislocation of the global economy and the end of short-term stimulus start to converge, the stage is set for what could be a distressed cycle unlike any seen in [several] decades,” Conrod says.
“Many other corporates have postponed what we feel could be inevitable defaults and downgrades with even more short-term debt to cover losses, further deteriorating fragile credit capabilities, and heightened global inflation will likely intensify a surge in defaults in 2023 and beyond.”
With the pandemic now largely behind us, the co-ordinated approach that governments and central banks took to protect economies has already begun to unwind. And this is creating the space for alternative lenders to move in.
“One factor that clearly stands apart from prior cycles is the quantum of capital and the breadth of capital that has been raised for distressed investing,” says HighVista’s Schorr.
“Traditional distressed debt opportunities continue to be an area of focus and will likely become more of an emphasis when the credit cycle turns, and companies have less access to capital,” adds Robert O’Leary, global co-portfolio manager and head of North America for Oaktree’s Global Opportunities strategy.
“Global investment approaches targeting more regions and countries with judicial efficiency, as well as structured opportunistic credit and equity investments, can offer downside protection and strong upside potential like that of traditional distressed debt opportunities.”
So, regardless of how this cycle compares with previous cycles, the role of distressed debt in portfolios is likely to remain unchanged.
The China opportunity
Distressed Chinese real estate is attracting serious interest.
“Growth in default rates for Chinese real estate developers and the debts of the country’s real estate sector are also a potential opportunity,” says Pedro Urquidi, global co-portfolio manager and head of global ex-North America for Oaktree’s Global Opportunities strategy.
The sector has hit the headlines as a potential source of weakness for the Chinese economy. The default by developer Evergrande highlighted the challenges facing the sector and the banks that have helped fund it.
A stress analysis of Chinese property developers publicly rated by Fitch Ratings highlighted a potential liquidity strain for almost one-third of the portfolio under a severe scenario involving a 30 percent decline in residential home sales revenue in 2022. Fitch said such a scenario could also worsen credit polarisation among public finance entities – such as banks – and have ripple effects on related sectors.
And it’s not just small or opportunistic investors: Bloomberg reported that Goldman Sachs Asset Management added a “modest amount of risk” via high-yield bonds from China property developers, denominated in dollars.