The key to being a top sprinter is perfect reaction to the starting pistol: launch yourself into your first stride just a shade too soon or too late and you could be looking at either disqualification or last place. Your fate is sealed in that fleeting moment. For distressed debt investors, the means of achieving success is very similar.
Reflecting on the lessons of the global financial crisis, many investors and fund managers have told us that timing your investments in distress was crucial – in other areas of investment, it could make a return difference of a few percentage points. But for distressed managers deploying capital in the 2007-08 period, it was often the difference between a 20-plus percent return and losing all your capital.
When covid-19 began spreading swiftly around the world early last year, the point about timing was reinforced. As public and private markets alike experienced a sudden bout of volatility, some fund managers smelt opportunity and attempted to urgently corral investors into dislocation funds. Anecdotal reports suggest that some of these funds shot the lights out, but the timeframe for making serious profits was once again short. Leave it too late and the window for taking action had been slammed shut.
Some of the capital for dislocation funds may well have come from capital raised in 2019, a good year for distressed debt fundraising with 50 funds gathering $58.5 billion. This was around the time that talk of a possible market downturn was growing louder, even though no one could reasonably have predicted the turn of events of the following year. One of the criticisms of distressed debt from the limited partner side is that capital, once committed, can be left sitting idle for a long period of time – while still generating fees for the manager. The global pandemic may have saved some managers from uncomfortable conversations.
In today’s market environment, it might have been anticipated that the economic pressures brought about by the pandemic would have produced a bottleneck of distressed deals. Instead, given the liquidity that has been pumped into the system in the form of business support schemes, many potential issues for portfolio companies have been kicked into the long grass. This does not mean to say that these issues will not surface at some point once the support schemes have been wound down.
Capital continues to be raised for distressed strategies but in relatively modest amounts. Just $31.3 billion was raised in 2020, compared with a peak of $81.5 billion in 2017. However, interest certainly still flickers. While the three largest fundraises in the first quarter of this year were all senior debt funds, distressed debt funds accounted for four of the top 10, led by Cerberus Capital Management’s $2.8 billion Institutional Real Estate Partners V. They’ll be hoping they’ve got the timing right.
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