Prepare to ride the distressed wave

The distressed opportunity does not appear to be in doubt. Consider these words from Karim Cherif and Jay Lee, strategists in UBS Global Wealth Management’s chief investment office, in a new report entitled Opportunities in Distressed Credit Markets:

“We estimate that about half a trillion dollars across credit segments are trading at distressed levels. Stress in the credit market has expanded the opportunity for hedge fund and private managers to deploy capital towards dislocations, provide liquidity and help restructure balance sheets.”

Evidence of interest in distressed strategies has been confirmed by fundraisings over the last couple of weeks, with Bain Capital raising $3.2 billion for a global distressed and special situations fund and Balbec Capital closing on $1.2 billion for a niche non-performing loan strategy. As the nature of new opportunities in the credit world become apparent, fundraising has quickly got back to business as usual after the nadir it reached in the first quarter.

What’s more, the UBS report indicates that this is a long-lasting opportunity, which was not necessarily assumed in the early days of the covid outbreak when some economists were predicting a rapid v-shaped recovery. The downturn in the debt markets and pick-up in default rates still have some way to run and there are plenty of troubled companies to be helped.

There is a hint in the report that the opportunity set could be even bigger had the monetary and fiscal policy response not been quite as dramatic. This intervention has succeeded in bringing the number of distressed credits down from the high point seen in March. However, the report also indicates that these actions are unlikely to save economies from long-term damage.

The first phase of ‘dislocation’ was on the public markets where issues showed up first, prompting the likes of KKR and AlbaCore to offer flexible mandates spanning the public and private markets. However, public markets were also quickly shored up by injections of liquidity from governments and central banks and have already more or less normalised.

The ‘next phase’ relates to the longer-term issues that companies are facing and is where distressed specialists come in with their understanding of company fundamentals, capital structures, operating models and legal frameworks.

Of course, backing the right managers is easier said than done but few would argue that now is not the right time to be taking a punt in this part of the investment world. A graph in the UBS report shows a close correlation between high leveraged loan defaults and median internal rates of return for distressed funds.

The highest returns for such funds in modern times emanated from 9/11 (2000-01) and the global financial crisis (2007-09). A decade on, the distressed wave is once more visible and building in size.

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