Higher leverage levels have expanded the number of opportunities in the distressed space. Some $440 billion of US high-yield debt was issued in 2021, according to the Securities Industry and Financial Markets Association, the highest amount on record. The first quarter of 2021 alone saw $149.8 billion of high-yield issuance as the covid-19 vaccines rollout gathered pace.
Earlier this year, the Financial Times wrote of concerns voiced by top US regulators – including the Federal Reserve Board, Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency – of potential risks in the leverage loan market. The Shared National Credit Review report also warned of loans with “weak structures”, including high leverage, aggressive repayment schedules and terms that allow borrowers to increase debt.
All this could lead to further opportunities for distressed investors.
“We’re seeing a robust global investment pipeline by historical standards,” says Robert O’Leary, global co-portfolio manager and head of North America for Oaktree’s Global Opportunities strategy. “Additionally, the seeds have been sown for the next expanded opportunity in traditional distressed debt, thanks to the ballooning supply of lower-rated global corporate debt.”
The idiosyncratic nature of many of the issues facing companies means there is a wide range of opportunities for distressed debt investors, particularly for those able to invest across multiple geographical areas. While US distressed strategies raised $8.5 billion of funds in 2021, more than any other region, multi-regional strategies were most popular, raising $29.9 billion in 2021.
“In the US, we continue to focus mostly on opportunities related to the industries that were hardest hit by covid-19. These include energy, real estate, travel and leisure, and aviation,” says O’Leary. “Many companies in these industries have unsustainable debt loads and are looking for structured solutions through which to right-size their balance sheets.
“We’ve noticed various attractive real estate and insurance-related opportunities in Europe, and we expect the broader pipeline in the region will grow over the balance of this year as Europe faces economic headwinds related to Russia’s invasion of Ukraine.
“In Asia, the crackdown on the shadow banking industry and the resulting largely real estate-related credit crunch continues to be a source of excellent opportunities, mainly with large real estate developers in China and non-bank financial companies in India.”
‘A second uncharted crisis’
For many investors, the war in Ukraine will remain a key source of concern, with little certainty over the ultimate outcome. Investors in European markets are likely to be significantly affected by the war, given their proximity to the fighting and the region’s reliance on Russian energy resources.
Sabrina Fox, chief executive of the European Leveraged Finance Association, whose members include distressed debt investors, says the Ukraine crisis could have long-term repercussions.
“There is a real focus on events unfolding right in front of us and an understanding that that’s going to play into how quickly a recession comes, how long it lasts, and how bad it is,” Fox says. “Our members have been very much focused on Russian sanctions. Our financial system is incredibly global, so even if you’ve got a business that may not operate in Russia or Ukraine, they may have supply chains that do.
“That means you’re digging really deep into these situations and into these investments for a very specific purpose: to determine what your level of risk is.”
Meanwhile, Maxime Laurent-Bellue, head of tactical strategies at Paris-based alternative asset manager Tikehau Capital, says that this “second uncharted crisis” has much less predictable consequences than the covid pandemic.
“Europe, which is much closer to the war taking place in Ukraine and more dependent on various energy supplies coming from Russia, might suffer the most,” he says. “We think the situation calls for cautiousness. It’s very hard to have any view on how this will impact companies and businesses simply because it will depend on how long the crisis goes on for.”
A wave of new opportunities
Unlike previous cycles, the alternative lending space has raised a considerable amount of capital to help support companies in distress.
David Conrod, founder and CEO of FocusPoint Private Capital Group, believes demand for distressed debt should remain solid as investors look for more diversified sources of return. “We believe that post-covid is ripe for an agile distressed investor. With headline inflation in the US and across the globe at their highest levels in decades, we believe covid-19 coupled with supply-chain shocks and inflationary pressures will provide an opportunity for investors willing to come in as a ‘white knight’ and provide stability to companies during uncertain times.”
He adds that companies that were already too highly levered pre-covid have been encouraged to take on addditional debt to cover losses and benefit from free government stimulus, creating opportunities for investors.
“These companies benefited greatly from payment deferrals and covenant waivers which saved them from default scenarios,” Conrod says.
“In effect, these actions were essentially kicking the can down the road, and it is becoming evident that the burden of servicing these higher debt levels under increasing capital costs and margin pressures will force companies to renegotiate waivers or be forced into restructurings. These workouts provide distressed managers unique entry points.”
An alignment of risk factors
For some distressed debt investors, there may be similarities with previous cycles. But Tikehau’s Laurent-Bellue says investors should be mindful of drawing too many parallels.
“Over the last two years, there has been a lot of support from both central banks and governments globally,” he says. “However, now we have already seen central banks starting to tighten the conditions of their support, particularly in the US. When it comes to government intervention, there is uncertainty around the sustainability of the ‘whatever-it-takes’ approach.”
As distressed debt managers continue to adjust to post-covid life, however, there are many issues affecting the market. From rising inflation around the world – as the fiscal stimulus and loose monetary policy of the pandemic begin to filter through to the economy – and the interest rate hikes needed to slow it down, to the conflict in Ukraine and the global sanctions on Russia aimed at stopping it – there are clear challenges facing global markets.
“There is currently an alignment of risk factors in the market, which has rarely been seen,” says Tikehau’s Laurent-Bellue. “If you add up the inflation pressures, the supply-chain issues, the high leverage and valuations that might have to adjust at some point, and now the huge geopolitical instability that can accelerate all of the previous risks – it turns into a very uncertain environment with growing potential funding gaps, creating opportunities for flexible capital providers.”
Indeed, not all companies that need funding are in distress, says Brendan Galloway, head of European opportunistic credit at asset manager BlackRock, who believes many companies are facing more idiosyncratic challenges.
“I wouldn’t say we’re in a distressed cycle right now, and nor have we been,” says Galloway. “Some of the themes recently have been commodity-oriented shocks to businesses; covid-related; businesses impacted by supply-chain difficulties; companies that are overly reliant on capital markets; and, lastly, normal non-cyclical stress due to mismanagement.”
A good fundraising year
Last year was good for fundraising. PDI data shows distressed debt funds raised $44.5 billion in 2021 compared with $36.7 billion in 2020.
This included several oversubscribed funds, including the $16 billion Oaktree Opportunities Fund XI, the $8.2 billion Lone Star Fund XI and Blackstone’s $7.1 billion GSO Capital Solutions III.
“Following the first lockdown, liquid markets did sell off,” says Andrew Amos, fund manager and head of restructuring and debt solutions at UK asset manager M&G. “There were some opportunities to buy the debt of good companies at distressed levels, but most investors invested with caution, given the unprecedented nature of the pandemic.
“Liquid markets then rallied within a few months, as government support programmes and central bank market intervention reassured investors. Lender and investor support also helped the rally. The combination of liquidity injections and forbearance on covenant defaults was also impactful.”
The pandemic also provoked a lasting change in lender and investor behaviour in credit markets.
“Before the pandemic, companies with significant balance-sheet problems would likely have had to file for Chapter 11 bankruptcy, and an investor’s approach would likely have been to buy the company’s traded debt. But things are different today,” explains O’Leary.
“Management teams and sponsors have found that, in the current environment, they can avoid bankruptcy, sidestep the ballooning legal costs of a formal restructuring, and maintain full control of their companies by tapping capital markets. This is one of several reasons why default rates have remained low, even though supply chain issues, soaring input costs and labour shortages are disrupting the global economy.
“We no longer view default rates as the best indicator of the magnitude of the distressed debt investing universe, given the attractiveness and breadth of opportunities in the private market.”