Roll on the bad times

When Private Debt Investor asked limited partners about their capital allocation plans for distressed debt investments in the next 12 months, we got some surprising responses.

A full 70 percent of respondents said they planned to stay the course and commit the same amount of money to the strategy. Another 23 percent told PDI they planned to up their contribution, while just 7 percent expected to reduce their exposure to distressed debt.

With the exception of some tumult at the beginning of the year, markets have been relatively benign. But LPs appear to sense we are closer to the end of the credit cycle than the beginning, as witnessed by fundraising activity. Recent PDI data analysis showed a third of credit funds in the market had a distressed investing strategy.

Perhaps New Jersey Division of Investment director Christopher McDonough summed it up well when recommending a $150 million commitment to Benefit Street Partners’ distressed fund that is in the market seeking $500 million.

“Factors such as deteriorating underwriting standards, increased volatility and suppressed liquidity potentially create a unique investing platform,” McDonough wrote in a letter to the State Investment Council. “Leverage levels remain elevated, a trend that is typical for a market that is in the later stages of the credit cycle.”

A market source echoed these sentiments to PDI, citing not only leverage levels, but also the deterioration of loan documentation, among other “significant excesses”.

LPs see this opportunity, the source said, but are being judicious with their capital, possibly explaining why the vast majority want to keep their allocations the same. The source said investors do not want to miss the opportunity but also don’t want fund managers to make distressed investments in a “frothy” market that would leave them with less capital and a finite resource available for the true distressed cycle.

A second market source told PDI that, when speaking to investors about distressed debt, they are making the case for a “quite large” opportunity. PDI’s LP survey responses seem to indicate there are many who would agree with that assessment.

A large chunk of money dedicated to distressed debt has been raised and committed to vehicles of varying sizes – ranging from sub-$1 billion all the way to Oaktree’s Opportunities X and Opportunities Xb funds that together that have pulled in over $11 billion.

Fund size can determine how well the manager can react to the credit cycle. Those with smaller funds may fare better in shorter-term market dislocations because they have a smaller capital base that needs to be deployed. Distressed shops that can write large cheques might perform better through a complete credit cycle when they can plow capital into companies that are one missed interest payment away from filing bankruptcy protection.

It’s feasible over the next 12 months, though, that the LPs polled will change their minds. If we really are – as conventional market wisdom has it – in the seventh inning of the credit cycle, then we are closer to choppy waters than not. But activist central banks remain the big question mark, one source said, noting that whenever worrying signs pop up in international markets these entities often pursue interventionist policies.

Bottom line: some distressed specialists find themselves in a situation many would love to be in – large amounts of capital sitting around and LPs seemingly keen to keep the distressed investing tap running. All they need now is a bit of distress to really put the smile on their faces. 

P.S: Yes, it’s awards season! Or almost. We are currently at the information-gathering stage and looking for tips and insights into the star performers of 2016. To keep us up to date with what your firm has achieved over the year so far, please visit the link here. Many thanks.