Eye of the storm

Distressed debt funds are attracting a lot of capital at the moment. But with banks apparently in denial about the extent of their problems, deals remain thin on the ground, writes Oliver Smiddy 

Banks stuck with substantial portfolios of under- or non-performing loans, under pressure to fix their balance sheets; companies (including some backed by private equity) struggling with debt burdens in the face of a widespread economic slowdown. For distressed investors, this really ought to be a perfect storm. 

Investors certainly think so. LPs have been eagerly committing to distressed debt and restructuring-focused funds ever since the end of the boom years. In the period since 2007, managers have raised 109 distressed debt funds, garnering a total of $163 billion in commitments, according to Private Equity International research. Fundraising peaked in 2008, when 25 funds raised $51 billion. Last year, 22 funds raised a combined $29 billion.

LP respondents to Coller Capital’s latest Global Private Equity Barometer survey still seem bullish. About two thirds of North American and Asia-Pacific LPs now invest in distressed debt, and just under 40% of European LPs. All told, 89 percent expected medium-term net returns of more than 11 percent.

So GPs and LPs alike appear to be sold on this sub-segment of the asset class. There’s clearly an abundance of capital. But where are all the deals?

Not enough defaults 

At the end of 2011, the combined default rate in Europe stood at just 4.8 percent, according to ratings agency Standard & Poor’s. In fact, since peaking in mid-2009, default rates have actually been falling, with only a modest uptick at the end of last year.

“Surprisingly, default rates haven’t been that high on corporate debt,” observes Rory O’Neill, managing partner of TPG Credit Management, which has bought 14 pools of non-performing loans since the 2008 financial crisis. “Banks and CLOs are restructuring, but on the whole they’re amending and extending to avoid defaults.  Because the rate is so low, there’s not much supply of defaulted corporate debt, so the pricing when loans do come to market is pretty competitive,” he adds.  

Susan Long McAndrews, a partner at Pantheon and head of the firm’s North American fund investment activity, agrees. “There have been moments of technical corrections when managers have been able to deploy capital selectively over the last few years. But those moments are limited and fleeting,” she says.

Howard Marks, founder of longstanding distressed debt investor Oaktree Capital Management, thinks the holders of debt just haven’t felt sufficiently pressurised to offload it – even in the last year, as the macroeconomic news has got steadily worse.

“The deluge of asset sales that was expected nine months ago hasn’t materialised – the selling pressure hasn’t developed as buyers would have hoped,” he tells Private Equity International. “In Europe, the central bank has helped to recapitalise financial institutions, meaning those institutions haven’t been pushed to sell assets.”

Pricing is one of the main checks on deal activity at the moment, says John Sinik, founder and managing partner of Metric Capital Partners – and has been since2009. “There’s still a pretty material gap between the price at which banks are willing and able to sell, and the market clearing price. The appetite for banks to take a material capital impairment is limited; if banks sell loans at distressed prices, the capital loss they would incur would be significant.”

The net result, according to David Lamb, a partner and head of European investments at Vision Capital, is that the amount of capital raised is disproportionate to the market opportunity.

“For conventional distressed debt, way more capital has been raised than the opportunity suggests is appropriate. There is probably the opportunity to meet it in volume terms, but not if the sort of returns that had been promised are going to be delivered. Banks just aren’t quite as distressed as people think. Although there’s a sense that banks do want to refocus, I don’t think there’ll be any fire sales,” Lamb says.