“We’re in the seventh year of a six-year cycle,” is a tongue-in-cheek view you often hear expressed by private debt professionals. The point being made is that it normally takes around six years for a benign credit environment to start turning bad (or vice versa). Taking historical precedent as the cue, it should be about time for distressed investors to be rubbing their hands together in anticipation of the opportunity ahead.
So why does this chart show both the volume of fundraising for distressed debt, and the number of funds in the market, continuing to fall? If the bad times look as if they’re about to roll, shouldn’t we be seeing a fundraising uptick by now?
The answer appears to be that the normal rules no longer apply. The ‘lower for longer’ interest rate environment looks as if it’s here to stay for a while yet, and this is helping to sustain a global corporate default rate of around 2.0 percent (compared with a 35-year annual average of 4.1 percent, according to S&P).
In Europe, where a big distressed opportunity had been forecast as the banks struggled with toxic balance sheets and growing regulatory demands, better rather than worse times appear to lie ahead. “The eurozone is very slowly recovering,” notes Faisal Ramzan, a London-based partner in the corporate department at law firm Proskauer and a member of the firm’s private credit, finance and distressed debt groups.
“Many expected it to tip the other way, but there are green shoots of recovery. People have been waiting for depressed asset values, but it hasn’t really happened yet to the extent predicted or hoped.”
With the UK having thus far proved resilient to a post-EU referendum downturn (though a softening economy may present opportunity in time), attention has focused mainly on the southern European markets of Italy and Spain. But with Spanish banks having done a lot of balance sheet cleansing already, some observers think only Italy – of the major European economies – continues to have a big problem with asset quality.
However, as one fund manager who wished to remain anonymous observed: “Even [in Italy], there is usually a big disconnect between what investors want to pay [or the perceived market value] and the book value, or price at which the asset is provisioned. It’s very difficult for the banks to sell in a satisfactory way, without taking a hit to their P&L.”
Moreover, market observers point out, there is considerable political pressure on Italian banks to carry on supporting businesses rather than sell off their positions to what are – unflatteringly – perceived as Anglo-Saxon vulture funds.
False dawns may be nothing new when it comes to expectations of a surge of distressed dealflow. Justin Mallis, a principal in the London office of placement agent First Avenue, only has to think back to 2013 and 2014 when “there was significant data pointing to a downturn – lots of triple C issuance, PIK/toggle issuance, covenants going down. Everyone thought defaults would increase significantly, but it only happened in certain sectors, not across the board”.
However, Mallis also notes that US high-yield bond defaults have been increasing (reaching their highest level for six years in the middle of last year), and covenant-lite issuance has been rising dramatically. Those are one or two signs, perhaps, of dark clouds on the horizon. But not enough, it seems, to convince fund investors that distressed is the way to go.
WHAT'S APOLLO UP TO?
The private equity giant appears to be lining up a significant counterintuitive move
With $23.5 billion targeted for its Investment Fund IX, any change of strategic direction for New York-based fund manager Apollo Global Management is bound to get tongues wagging – especially when it involves embracing distressed debt at a time when others are struggling to see the opportunity.
According to a recommendation document prepared by StepStone Group for the State of Connecticut Retirement Plans and Trust Funds obtained by sister title Private Equity International, Apollo is expecting to invest around 20-25 percent (as much as $6 billion) in distressed debt opportunities, up from a mere 1 percent allocated to the strategy in the 2013-vintage Fund VIII.
The strategic shift appears to be at the expense of buyouts, which made up 67 percent of Fund VIII but are expected to account for around 40-50 percent of Fund IX.
Hinting that it anticipates market turbulence ahead, the report noted: “During expansionary markets, Apollo tends to invest exclusively in opportunistic buyouts and corporate carve-outs, as is the case for Fund VIII.
“During recessionary markets, when most private equity investors typically pull back on investment activity, Apollo has remained active, executing on investments in opportunities that seek to capitalise on market dislocation mostly through distressed investments.”
While clearly indicating confidence in the potential of distressed, the 20-25 percent allocation is nonetheless more modest than the bet Apollo took following the global financial crisis when the 2008-vintage Fund VII invested 41 percent of its total capital in distressed debt between 2008 and 2013.
While Apollo declined to comment on developments, executives at the firm are known to have expressed considerable interest in the Italian NPL opportunity.
“I don’t know exactly what remit their latest fund has but clearly they are smart people and they see an opportunity,” says a placement agent we approached who was something of a sceptic about the distressed space in general.
Other sceptics are not hard to find. But with Apollo apparently set to blaze a trail, some will perhaps be re-evaluating their previous assumptions.