Distressed debt: What's in a name?

Everyone in private credit these days seems to be asking some variation of “what inning are we in?” But investors in distressed debt (often labelled “special situations” when referring to non-distressed but more complex transactions) really need to know when the downturn is coming before signing any cheques.

Eight years into a mature credit cycle would normally be the time to invest in distressed or special situations. But 2016 wasn’t normal. Largely unanticipated geopolitical events, particularly Brexit and the election of President Donald Trump, happened during a historically low interest rate environment. Accordingly, distressed and special situations investors and fund managers may have a harder time anticipating when the distressed cycle will arrive.

But two major debt fund managers say that the “special situations” umbrella, as opposed to just “distressed”, allows them more flexibility and a larger fundraising schedule to weather whatever 2017 has in store.

Ivan Zinn, founder and managing partner at Atalaya Capital Management, says the special situations moniker grants his firm significantly greater flexibility, especially during the market cycle years when the majority of private debt deals are not distressed.

“From an investor’s perspective, that ‘distressed’ label says it is a relevant strategy for only three out of 10 years,” Zinn says. “Because most people want to invest 10 out of 10 years, debt fund managers need to maintain a broader mandate for marketing purposes.”

Atalaya considers any opportunity with complicated circumstances or tight timeframes as special situations. Because of the unusual nature of a special situations investment, the firm is able to earn a higher, distressed-level return profile, even if the opportunity is a non-distressed or performing asset.

“So this gives us the ability to wait and not chase distressed or the flavour du jour on the distressed side,” Zinn says. The firm’s most recent special situations Fund VI closed on $800 million, above its $750 million target, according to PDI data.

Jamie Weinstein, global co-head of special situations at KKR, agrees that the elasticity of the “special situations” term itself allows its funds, which includes distressed debt as an integral part, to be active internationally throughout the entire market cycle.

“For us, the flexibility in the definition of ‘special situations’ allows us to be truly global,” Weinstein says. “There is always an interesting part of the cycle going on somewhere, in a country somewhere in the world, which opens more opportunities for us than a fund focused exclusively on US distressed debt.”

Weinstein says the distinction between special situation or distressed is particularly important for limited partners, as LPs need to know and understand where the fund managers are putting their money.

“The LPs can become frustrated when managers say ‘we’re distressed investors’, but then veer into other investments outside their core when the cycle changes,” he says.

Though definitions of the term vary across the credit sector, KKR defines its special situations activity in the following ways: rescue situations, or debt capital for a company to avoid insolvency; distressed-for-control options, where KKR buys the loans or bonds of a company with the intention to restructure the company’s balance sheet; secondary market trades of loans, bonds or post re-organisation equity; and other structured principal investments.

The New York-based firm’s latest special situations Fund II closed on $3.35 billion, above its $3 billion target, according to PDI data.

Both Zinn and Weinstein say that this flexibility and fundraising in non-downturn years will come in especially handy for special situations funds this year. That’s because neither believes that the private credit markets will falter and open up significant distressed opportunities in the near term.

In fact, KKR decreased its distressed and special situations allocation for this year, from 5 percent to 2 percent, according to a recent report.

Weinstein says the decrease was in large measure a response to the low interest rate environment created by the quantitative easing of central banks across the globe last year, which “makes it harder and harder to find the types of returns that we want”. Like many distressed debt funds, KKR seeks net returns to its investors in the mid-teens or more.

Energy rebound

He adds that the rebounding global energy market, which was a significant driver of the distressed debt market in 2016, may also limit distressed opportunities this year. Many of the formerly stressed energy companies have recovered as oil and other commodity prices stabilised.

“There are still some energy companies with wood to chop, but that giant wave of companies in distress from 2016 is gone,” he says.

Instead, KKR will focus on the volatile retail market for distressed opportunities this year. That sector is experiencing a secular down-shift, not a cyclical one, he thinks. “It is clear that we have now crossed the Rubicon and are well into the secular shift to online or multichannel, meaning a lot of these bricks and mortar retail businesses are going to go away.”

Retail companies typically have a more difficult time reorganising and end up liquidating more often than other businesses, which can more easily reorganise in bankruptcy, Weinstein says.

Zinn also cited retail as the best – or perhaps only – option for distressed investments this year: “We don’t really see much opportunity in distressed investments except for retail.”

However, an even larger unpredictability for the special situations market in 2017 will be the ripple effects of policy changes from President Trump’s administration and the Republican-controlled Congress.

Weinstein says the new administration’s potential changes to US tax policy (specifically the potential elimination of deductibility of corporate interest), border adjustability, or post-financial crisis regulations could create enormous stress in the entire private debt space this year, including special situations.

But Zinn is sceptical that any regulatory changes could bring the banks back into the mid-market, arguing that credit opportunities in that area post-2007 and 2008 are typically activities that banks never pursued or didn’t exist in the same format, such as lending to small businesses.

“So we don’t get worried about BofA making $20,000 loans to small businesses soon, even if there are significant regulatory changes this year,” says Zinn.

Both Zinn and Weinstein insist that what really matters for special situations activity in 2017 is patience, which they likely would not be able to afford if they limited their special situations funds to only distressed opportunities.

“There was a massive market run-up in 2016 in the high-yield market, with mid-teen returns and strong inflows into that market, and that’s not necessarily going to be the case this year,” says Weinstein. “It’s a time to be cautious.”