You’ve heard the word ‘dislocation’ often enough by now, but what does it really mean in a private debt context? Covid-19 was spreading fast by late March and it wasn’t long after that we began hearing from our market sources that dislocation funds were suddenly in fashion.
To explain what they are is not easy, however. A report by published in May by consultancy bfinance – Dislocation and Distress: Navigating New Opportunities – identified seven strategies that are all considered to be part of the dislocation trend.
One common denominator is that they all aim to take advantage of the investment environment created by the pandemic. Beyond that, it’s pretty much a case of anything goes. “It’s interesting how broad the definition is,” says Tavneet Bakshi, a London-based partner at placement agent and advisory firm FIRSTavenue. “The breadth of strategies is quite remarkable and the speed with which established managers are launching dislocation funds is equally remarkable.”
The need for speed is because the opportunity is perceived to be temporary and in relation to a specific set of circumstances. This was the motivation for KKR raising $4 billion in just eight weeks for a “flexible” public and private market investment strategy: $2.8 billion for its Dislocation Opportunities Fund and another $1.2 billion for separately managed accounts investing in the same types of deals. Despite the lightning-quick fundraising period, the firm managed to entice 20 institutional investors that were new to KKR and 40 that were new to its credit arm, KKR Credit. At around this time, Apollo Global Management was putting the finishing touches to a $1.75 billion dislocation fund that was raised in precisely the same eight-week period.
The snail gathers speed
Limited partners are suddenly faced with a wide range of new funds seeking commitments, which is very much at odds with how the year started. After all, Private Debt Investor data show that only around $20 billion was raised by private debt funds globally during the first quarter. In the record-breaking fundraising year of 2017, $253 billion was raised in total, thereby implying a quarterly average of more than $63 billion.
“GPs were expecting the end of the cycle and therefore from a fundraising perspective they are better prepared this time than before the global financial crisis”
“I’ve seen quite a few of these funds,” says Rohit Kapur, pensions investment research manager at UK energy and services company Centrica. “I started to add these to our pipeline tracker and quickly realised it was a large number and only getting bigger. It’s interesting because in this situation there will be attractive opportunities, and you want to be able to invest in those opportunities if you’ve got capital, but there isn’t a shortage of funds to choose from.”
However, he also notes that the development was not entirely unexpected. Some fund managers, particularly those with experience of special situations and distressed investing, had been briefing investors long before covid-19 hit the headlines that they expected a downturn of some kind and that it would be wise to set aside some capital in advance.
“GPs were expecting the end of the cycle and therefore from a fundraising perspective they are better prepared this time than before the global financial crisis,” acknowledges Kapur. “They wanted to have the ability to move quickly when the market turned, and they had the discussions with LPs that would enable that. We’ve seen funds with triggers where you commit the capital but it won’t be deployed until the opportunity is there.”
This certainly offers an explanation for the speed with which managers such as KKR and Apollo have been able to raise money, and it implies that LPs have been well prepped. But is there not still a danger that some investors – excited by the opportunity – might jump in before having done sufficiently comprehensive due diligence?
“It depends very much on the LP and the relationship with the GP,” says Kapur. “If it’s a sophisticated LP that has invested in commingled funds or even SMAs with that GP before, you’re in a better position to meet a shortened timeframe for the fundraise. But in the current environment, with social distancing, it makes it more difficult to build new relationships.
“For the same reason, there’s also a potential issue with governance at the LP level in terms of getting approval to commit the capital. Will the crisis make it more difficult to obtain investment committee approval for new commitments?”
Go with what you know
Investors might also be tempted to throw established norms out of the window as they spy an opportunity that might disappear as quickly as it arose. Trevor Castledine, a senior director at bfinance in London, says it is important to keep a cool head when assessing options.
“Some of the advice is the same as I would give at any stage in the cycle: understand what investment needs you have, whether you need liquidity or not, how long you’re willing to lock money up for, what’s in your existing portfolio, and what sort of return you’re looking to access,” he says. “Ultimately, you need to choose something that you understand, that fits with your current portfolio mix and will be additive in terms of diversification, style and returns.”
In other words, try to work out whether this is something complementary to what you already have. Will everyone plump for this kind of rational, cool-headed approach, however? Bakshi points to the phenomenon of “FOMO”, or fear of missing out. “I think some LPs do pride themselves on being more opportunistic and tactical,” she says. “Those that made money by being brave and bold during the GFC are thinking very hard about prioritising near-term dislocation.”
There is an obvious tension, though, between FOMO and the attention that needs to be paid to existing portfolios. Some GPs may be going through the covid-19 crisis with their existing exposures in reasonably decent shape, and can thus afford to devote time and resources to assessing new types of commitment. Others, perhaps exposed to underlying assets in badly hit sectors such as retail and hospitality, will almost certainly not have that luxury. Might some be tempted to jump on the bandwagon nonetheless – perhaps even gambling that they can compensate for hits taken by current investments by placing bets on dislocation funds with their promises of returns in the mid-teens or even higher?
That would certainly be a risky game to play, especially if, as Bakshi believes, the best opportunities are difficult to identify. “The GFC was quite specific in terms of sectoral pain, so I think the opportunity set was a bit more obvious,” she says. “The challenge right now is that there is so much uncertainty in the market with stress and distress sector-wide and impacting all forms of business – large and small, across industries, in multiple regions – which makes it far more challenging to understand and pinpoint where the right opportunity is if you’re going to play the dislocation theme.”
Because of the broad nature of dislocation, as outlined by Bakshi, Kapur says it is important to avoid being too narrowly focused when it comes to mandates. “We’re very keen to explore this theme, but in a measured way,” he says. “Distressed debt covers a wide range of strategies. At one end there are performing credits in scenarios where the capital need can’t be filled by banks, public markets or traditional direct lenders, and special situation strategies can fill the gap. In more liquid markets there are also stressed opportunities where you have credits that are still performing but the price has fallen significantly as the market perceives an increased risk of default.
“And then there’s distressed, where the company is not performing and is very likely to default. We’ve historically liked mandates that have the ability to tilt to where the most attractive risk-adjusted returns are at any given time.”
Simplicity is bliss
In terms of attracting LPs to their dislocation funds, many GPs are trying to keep things as simple as possible. The wide choice of strategy is confusing enough, so why muddy the waters even further with fund structuring innovations? Instead, managers are keen to present investors with propositions that typically do not deviate from what they are used to – in the hope that they will then be able to commit quickly.
“We’re seeing very compressed fundraising periods,” says Jessica O’Mary, leader of the credit funds team at law firm Ropes & Gray in New York. “Sometimes it’s a ‘one and done’ closing, and even funds that technically have the ability to fundraise for a traditional 12-month period are, in reality, looking to have much quicker and chunkier closes and not take advantage of that full fundraising period.”
O’Mary adds that it is not just fund structuring that is drawing investors in quickly but also familiar fee and carry rates: “Originally, when we first started talking to clients about developing these products, we thought that maybe we would end up with fee structures that were a little different from the regular structures – maybe a higher carry and lower management fee, or something like that. The reality is that I have not seen that coming to fruition.”
However, she concedes that she has seen some instances of “premium carry”, where significant outperformance of a hurdle rate would allow managers to participate in a higher-than-normal carry.
“It’s very important to understand exactly how the performance fee is being structured and its sensitivity to under- and over-performance”
Another source in the market tells us they have seen one dislocation fund coming to market with a zero management fee, thus putting the emphasis entirely on performance. It is a good piece of marketing, the source suggests, because it is guaranteed to get attention.
Castledine says he is seeing innovation in terms of lock-up periods, which is entirely consistent with the potentially short-term nature of the opportunity: “Some funds, especially on the financing solutions side, are saying we’ll have a one-year investment period, harvest it over the next four or five years at most, and if the opportunity set is still there they’ll just launch a follow-up, also with a one-year investment period. That might suit some investors that aren’t so comfortable with long-term lock-ups.”
He also thinks there are some interesting developments around the performance fee, which he is concerned may cause confusion. “The question is: are all of these performance fees structured equally? And the answer to that is not easy. Some have a catch-up and some don’t. Hurdles are different and percentages are also different.”
He advises caution when it comes to funds projecting performance deduced from the previous crisis. “A lot of the target returns are based on historical numbers that were achieved in the GFC, and we really don’t know that those are capable of being replicated,” he says. “For that reason, it’s very important to understand exactly how the performance fee is being structured and its sensitivity to under- and over-performance.”
But it is clear from the fundraising by KKR and others that many investors are managing to make themselves comfortable with the new generation of dislocation vehicles, even if they are being asked to make decisions faster than would be the case in more normal market circumstances. With KKR’s vehicle worth around a fifth of global private debt fundraising in the first quarter, is the asset class set to ride through covid-19 in much better shape than anyone had dared hope?
Tavneet Bakshi says she is hopeful, but that LPs are having to spend a lot of time assessing current exposures and may be lacking confidence when it comes to making new commitments. She does not predict a rapid return to business as usual, though the continuing attractiveness of private debt means it will be well placed when sentiment changes for the better.
“I wouldn’t be too surprised to see a congestion of activity coming into the end of the year and perhaps into Q1 of next year,” says Bakshi. Moreover, she thinks the appetite will once again be across the private debt spectrum rather than focused only on opportunities arising from covid-19: “We know we’re going to be heading into a low-yield environment and investors will need to have solutions not just through high-octane opportunities with private equity-like returns but also more vanilla opportunities that make sense in the medium to longer term.”
The dislocation funds do not have their eyes on that farther-off horizon, however. They are operating very much in the present. They need capital right now, and many investors are responding to the call.
Seven flavours of dislocation
The new funds come in many different varieties, but are all targeting opportunities arising from volatile market conditions. Of the funds that bfinance analysed in April and May, the consultancy found seven distinct sub-strategies:
Dislocated entry – private credit Funds trying to gain entry into private credit investments at low prices, relying on passive recovery or, more likely, restructuring initiatives to generate value. These strategies target distressed borrowers and stressed investors under pressure to sell.
Dislocated entry – real assets Funds focused on acquiring real assets (such as property, infrastructure, development land, aircraft or ships) or the debt secured on those assets at a discount to ‘true’ value. These assets will be stressed or have problems in financing structures, and positions will be acquired from sellers no longer wanting to hold them.
Dislocated entry – public markets Funds targeting the purchase of normally liquid credit instruments at a significant discount, equating to a higher expected yield. Investment choices range across investment-grade credit, high-yield bonds, broadly syndicated bank loans and CLO tranches.
Evergreen opportunities Open-end funds focusing on a broad opportunity set across stressed and distressed investing, restructurings, rescue lending and non-performing loans.
Financing solutions Funds aiming to facilitate the survival of ‘struggling-yet-viable’ companies by providing bespoke financing solutions. Target companies are typically mid-market and cannot access their traditional financing sources.
Fund financing and secondaries Funds that buy stakes in funds or portfolios of investments from funds and hold them to realisation at maturity; and fund financing for GPs required to provide liquidity to investors or support portfolio companies in need of capital.
Multi-strategy Funds targeting some combination of the above six strategies to provide a single point of entry into a diversified portfolio, thereby taking advantage of distress or dislocation.
After the first wave, watch out for emerging markets
Dislocation strategies sprung up first in developed countries but may spread elsewhere in time.
The big fund managers such as KKR and Apollo, which have been quick to raise capital for dislocation, have their sights set on developed economies. According to Tavneet Bakshi of FIRSTavenue, these markets rather than their emerging counterparts are likely to stay in the spotlight for a while yet.
“Emerging markets debt seems too bold a choice right now,” she says. “Few are interested in emerging markets while developed markets are showing signs of offering fairly decent returns. You don’t need to venture too far out.”
However, she believes the impact of covid-19 will offer “a more sustained dislocation opportunity” in the future and that FIRSTavenue “is tracking a number of emerging markets players that might prove interesting to support further down the line”.
What Bakshi and others believe is that the latest crisis has underlined the over-reliance on banks in emerging markets and the lack of a ‘lender of last resort’. Private debt should be well placed to step into the funding gap.
‘If there’s a bit of stress, it’s great for us’
Pemberton is among those that have had a fruitful time on the fundraising trail, with a strategy that appears to have gathered speed in the current crisis
In its report on the rise of dislocation funds, bfinance identified two types of vehicle: those set up specifically to take advantage of opportunities created by the new environment; and those established strategies which, because of the changed circumstances, suddenly found themselves in a more optimal position.
Pemberton’s Strategic Credit Opportunities Fund II – which posted a first close on €800 million in May – could be considered an example of the latter, with its focus on mid-market first-lien lending. Robin Challis, a portfolio manager at the London-based fund manager, says that “spreads have been pushed out and value has increased.”
There are two main types of opportunity for the fund: good companies requiring access to capital in order to make acquisitions, often as part of a private equity-backed roll-up strategy; and taking exposures from banks that have incomplete syndication processes.
Ben Gulliver, also a portfolio manager at Pemberton, elaborates on the second example: “There are situations where a bank has underwritten a deal, the pricing has turned out to be incorrect, and it’s left with the residual risk. Banks are prepared to exit these positions at a discount in order to remove high levels of single-name exposure in periods of potential volatility. That’s where we come in as a long-term partner that can work with the bank and the borrower to get this done.”
Although fundraising was subdued in the first quarter, Pemberton was among a healthy number of GPs that found appetite to be reasonably strong in the second. Gulliver says there is a “bifurcation between those LPs which want to be opportunistic and those which want to be defensive. The more sophisticated LPs don’t want to miss out. They know that you can make better returns when things are uncertain”.