Who dares wins

Distressed debt investors are a hardy bunch. They’re also among the smartest guys in the room, if the success of some of the marquee name firms is anything to go by. It takes a certain degree of bravery too to buy into failing, or failed, assets in the hope of generating a return. Even more so at a time when every other investor is running for the hills.

Distressed debt investors generally fall into two camps. On the one hand, you have firms who have the scale and resources to acquire large non-performing loan portfolios – such as Lone Star Funds, for example.

On the other, you have firms that target specific assets, often in an opportunistic way. The biggest firms are able to pursue both strategies. The dynamics in both markets are very different, but both cohorts have struggled to find sufficient opportunities to adequately deploy the huge amount of capital raised for this segment of the market in the wake of the downturn.

It certainly hasn’t been for wont of trying, though.

Howard Marks, chairman of Oaktree Capital Management, has been underwhelmed by the scarcity of opportunities. A little over a year ago, he shared his disappointment regarding the European market during an earnings call. “We had hoped for a deluge, but European Central Bank actions and statements precluded that. We have deal flow and, depending on the area, the country and the time, it ranges from a trickle to moderate,” he said.

Have matters improved, though? The European economy certainly has, and that isn’t necessarily bad news for distressed debt investors. Indeed, a number of other factors in their favour are at play, on both sides of the Atlantic. 

Banking reluctance

One of the biggest barriers in distressed debt funds’ way has been the banking community. US banks have generally been far more willing to take haircuts and clean up their balance sheets more aggressively than their European counterparts. 

“European banks didn’t want to sell impaired loans after the crisis because they didn’t want to crystallise losses,” says Natasha Labovitz, a New York-based partner at Debevoise who is co-head of the firm’s business restructuring and workouts group. “But we have now started to see some increased activity on that front.”

Some European banks have made significant headway since the crisis, although they tend to be those part-owned by the state. Lloyds Banking Group, for example, has reduced the amount of risk-weighted assets on its balance sheet by £210 billion since 2008, while RBS and Barclays have reduced theirs by £47 billion each, according to a report by DC Advisory Partners. 

Only a handful of managers are capable of sweeping up big loan portfolios, however, and pricing has been an issue.

“Our experience is that buying NPL portfolios from banks can be an extraordinarily complex process,” says Ian Borman, a partner at King & Wood Mallesons SJ Berwin. “Certain potential sellers have essentially just tested the market to see what sort of price they can could achieve for assets and changed their mind.  Pricing remains an issue. A lot of distressed debt investors have been dismayed at the price tags for some of these portfolios, with the result that some portfolios haven’t been traded in the end.”

The forthcoming Asset Quality Review of banks’ balance sheets by the European Central Bank this summer is likely to precipitate a further increase in NPL sales, however.  A recent report from PwC revealed banks in Europe sold €64 billion of non-core loans last year, a 40 percent rise on 2012’s figure. PwC estimates the amount will rise to €80 billion this year, with €30 billion already completed or nearing completion. Despite this, banks are sitting on an estimated €2.4 trillion of non-core loan assets.

A market awash with liquidity

Record low interest rates have also made life difficult, keeping repayments on floating rate debt reasonably affordable and thereby reducing the number of companies facing distress. Those low rates have also driven a torrent of capital towards the high yield market, which has been used by grateful borrowers to refinance existing (often loan-based) debt and so avoid a restructuring or default.
“There haven’t been as many defaults as people expected,” says Borman. “Interest rates haven’t moved for a long time and banks have held on to distressed assets. The high yield market has come in and is mopping up the larger transactions and “floated the boats” for many others. That in turn has underpinned a rise in valuations, which to an extent has justified the banks’ decision to hold onto impaired assets rather than take big write-downs. If interest rates rise, we will see more defaults, though.”

The same is true in the US, according to Labowitz. “Low interest rates and easy access to capital has meant many companies that would have been staring down the barrel of a restructuring or insolvency have been able to refinance instead,” she says. “As a result, distressed debt investors have had to be creative about finding deals. Creativity isn’t limited to the large funds, however – smaller firms have also been beating the bushes and finding interesting deals too. The trend generally has been toward mid-market deals, in fact.”

Patience and creativity

These factors have conspired to make life tough for distressed debt investors, particularly those looking to transact in Europe. The scarcity of assets on the block and the amount of undeployed capital in distressed debt funds means competition has grown fierce.

As such, firms have had to be both patient, and creative.

Leon Black, co-founder of Apollo Global Management, told delegates at SuperReturn in February that distressed debt investments were taking longer to identify and executive. “It’s not like shooting ducks in a barrel as in 2009,” he quipped. Apollo, one of the poster children of the distressed debt community, made hay in the downturn by buying up heavily discounted debt in ailing companies. Several years on, the firm has reaped huge returns after “selling everything that is not nailed down,” as Black said last year.

Other firms such as Oaktree have branched out into securitised real estate debt, for example.

“Although core real estate, which is not our focus, has recovered substantially, we continue to find opportunity in a number of other areas, including non-performing residential and commercial loan pools,” Marks told investors during a call in February.

James Roome, co-head of Bingham McCutchen’s financial restructuring group, observes: “We have noticed increased competition amongst distressed funds and insitutional lenders trying to source and invest in opportunities which might previously have been outside their comfort zone.”

With most of the low-hanging fruit in northern Europe long since plucked, distressed funds looking at corporates have been forced to consider riskier markets on the continent. The substantial uptick in activity in Spain and Italy, for example, is clear evidence of this.

KKR Asset Management (KKRAM) has managed to deploy capital in both markets, for instance, investing €100 million in Italian vending machine business Gruppo Argento as part of a rescue financing in January, having backed Spanish construction company Uralita with a sizeable €320 million funding package last year.

Other firms are looking even further afield. Oaktree signed a memorandum of understanding with China Cinda Asset Management late last year to jointly invest in distressed Chinese assets. Each party is understood to have committed up to $500 million to the venture.

Larger firms have come to dominate the market, both in terms of fundraising and deals, thanks to their infrastructure, firepower and track record. A leading distressed debt investor at a mid-sized firm revealed to PDI recently that his firm had recently been in a two-horse race with Lone Star, but had been outbid “by a very substantial margin” because the US group could afford to do so and could stomach a potentially reduced return as a result.

“The larger distressed debt investors – the likes of Apollo for example – are successful because they understand the entire capital structure for individual businesses,” believes Andrew Wingfield, a partner at King & Wood Mallesons SJ Berwin. “They also have the level of experience and resource to understand each individual situation really well.”

Large funds funnel commitments

Bigger firms have also been highly effective at garnering commitments from investors.

KKRAM raised $2 billion for its first special situations fund in the fourth quarter of 2013, for example, while GSO Capital Partners raised a cool $5 billion for its rescue lending fund.

More recently, Pacific Investment Management closed its Bank Recapitalization and Value Opportunities Fund II (Bravo II) on $5.5 billion last month. 20 percent of that fund has been earmarked for special situations and distressed debt investing in the real estate sector. Castlelake, formerly TPG Credit, raised $1.4 billion for its third  flagship fund, which will invest in European non- performing loans, US distressed opportunities and dislocated industries.

There’s likely to be plenty more where that came from too. Dallas-based Lone Star Funds is targeting $7 billion for Fund IX, according to documents filed with the US Securities and Exchange Commission in February.

Despite these large fundraises, overall fundraising for distressed funds fell by 16 percent last year, according to a Bain & Company report. The group attributed the decrease to the general improvement in the global economic outlook, with fundraising for distressed fund correlated with corporate default rates.

Investors would be wise to take note of distressed funds’ outperformance relative to other strategies, however – Bain found such funds generated an average 18 percent return in 2013, the best one-year IRR among the strategies tracked in the study, according to Cambridge Associates data cited by Bain. Castlelake’s second fund, for example, had generated a 22.8 percent IRR as of 31 March last year, according to CalSTRS.

The consensus then is that while the market hasn’t lived up to expectations yet, it could yet do so. In the meantime, the bravest and savviest investors have made, and will continue to make, outsize returns.