The highly cyclical nature of their market has always posed a problem for distressed debt fund managers – and now is precisely the point at which they are scratching their heads and wondering what to do, as they contemplate diminished opportunities.
They are asking themselves at least two questions: when is the market going to turn, and what, if anything, can they do in the meantime?
These interlinked questions are all the more pressing for many general partners because of the huge sums recently raised. As of 11 September, the year-to-date total came to $46.4 billion, according to PDI data – greater than in any of the entire calendar years since 2008.
Limited partners do not like to see their committed capital standing idle, but Jeff Davis, partner at Eaton Partners, the placement agent and advisory firm, based in Rowayton, Connecticut, says some investors that committed capital 18 months ago are still waiting for the money to be deployed.
Because of this huge mound of dry powder, the pressure on distressed debt investors to find suitable opportunities is immense. But at the same time, of course, LPs do not like to see their money invested irresponsibly.
Kevin Kuryla, global head of the private funds group at UBS in New York, sums up the problem: “A number of funds, frankly, raised money too soon and bet on a bounceback in energy prices too soon” – enticing investors into funds raised to exploit opportunities in the huge North American shale industry, which has shown acute distress since the oil price collapse of 2014. This has put GPs in an impossible position.
“Limited partners can be very fickle,” he says. “If the sponsor is not active enough, they’re concerned. If the sponsor seems to be investing too quickly, they’re concerned. It’s rarely just right.”
Distressed debt fund managers must remember fondly the glory days in the aftermath of the Lehman shock, when most sectors had a large number of distressed companies. LPs that committed to distressed at the time are almost as nostalgic. The difference for them, of course, is that they are free to seek opportunities elsewhere – more or less ignoring distressed – when pickings are slim.
“We invested in distressed debt securities shortly after the financial crisis, and they did very well,” says Jonathan Bell, chief investment officer at Stanhope Capital, the wealth manager in London. “However, now returns in distressed are lower and now we are looking more at other areas.”
Jeffrey Griffiths, principal in the London office of Campbell Lutyens, the placement agent and advisory firm, explains the current state of play in more detail. “The opportunity in distressed is now somewhat isolated to small pockets of the market where there may from time to time be some opportunities for returns in the low teens,” he says – largely in what he deems “special situations opportunities that are less scalable”.
Where are these pockets? Griffiths cites the offloaded non-performing loans of European banks. Fund managers active in this market include Kartesia and AnaCap, say analysts.
Griffiths also sees opportunities to buy the debt of smaller US leveraged loan and high yield borrowers that are not in default but struggling financially because of disappointing earnings growth. These opportunities exist, he says, because investment banks that used to provide liquidity in the secondary loan and high-yield bond markets for businesses of this size are now reluctant to do so.
Stephen Carre, head of advisory andproject management at the UBS private funds group in New York, describes another pocket. “Some sponsors bring a pretty heavy value orientation to their funds and are still able to find unique opportunities,” he says.
“These are not classical distressed or bankruptcy situations, but cases where the managers are willing to roll up their sleeves and do the work where others are not – almost to create companies.
“The managers who can improve or transform businesses can make strong gains.” This is an approach followed by fund managers such as Apollo and Centerbridge, according to people in the market.
Davis says that where a manager does find a niche opportunity, LPs are keen to commit capital. He cites Fundamental Advisors’ $993 million fundraising, which closed in May. Fundamental Partners III LP will target distressed US municipal assets, both debt and equity. Eaton Partners assisted with the fundraise.
There have also been some opportunities in energy, despite the failure of energy prices to return to their former highs. An example is IGas Energy, a UK shale gas group that restructured in March after being caught out by low prices: reducing debt from $122 million to $10 million by issuing new shares to its lenders, including the cornerstone investor, the private equity firm Kerogen Capital.
NEED FOR HASTE
But although the presence of a number of pockets suggests fund managers can still make decent returns, this is not the key issue for LPs. What they fear is not bad investment but non-investment. “There are managers that are doing well in distressed, but the capital is not being invested at great speed,” says Bell.
This puts LPs in a quandary: should those that have not already committed capital to distressed debt funds do so now, or wait for further signs of a turn in the credit cycle? Kuryla thinks many will still prefer to observe – for now.
“Some investors feel that there will be some opportunities in the coming years, but they’re saying, ‘We will wait until there are some obvious cracks before we place our bets.’”
But Davis thinks some LPs fear missing the boat, by failing to commit capital now, only to find a dearth of interesting fundraises in the future when they eventually decide to do so. “Investors want to get inline, because they know the line is already long,” he says.
A solution to this quandary might, in the end, lie with the GPs, if they can structure their funds to accommodate the cyclicality. Griffiths has seen the emergence of distressed debt fund managers that seek to raise a large amount of money but may only call a minority of the total funds in an environment with less distressed activity – perhaps only $3 billion out of $10 billion, for example.
An alternative model, says Griffiths, is a hybrid strategy where funds aim for lower returns in the low teens in credit bull markets by seeking special situations investments, while aiming for 20 percent from classic distressed debt in credit bear markets or recessions.
But one obstacle to this hybrid may come from the borrowers. Market observers say some borrowers that are not genuinely distressed do not like to deal with them, out of a fear that the fund managers may want to take over their business.
“We have seen distressed investors trying to do deals in our space a bit,” says Theo Dickens, managing partner of Prefequity, a London-based provider of debt and equity to fast-growing companies – the diametric opposite of distressed. “The companies are a bit nervous about who they get into bed with.”