In the US, figures on corporate insolvencies show how devastating the impact of the coronavirus has been. According to legal services group Epiq Global, the number of US companies filing for Chapter 11 bankruptcy during the first six months of 2020 stood at 3,604, a 26 percent rise on the same period in 2019.

Although these figures are astonishing, industry experts say thousands of other companies are teetering on the brink. Many are being kept afloat by accommodative monetary policy and government support packages.

“The Fed has been extremely accommodative,” explains Aaron Peck, managing director and co-head, opportunistic credit at Monroe Capital. “There is a section of companies that, in a more traditional market, might have had to file for bankruptcy, but in this market are being bailed out by the bond market or other financing sources as a result of the accommodative stance.”

Peck explains that “a second set of companies” are still operating in challenged sectors and have not yet filed for bankruptcy but may do so in the future.

3,604
Number of US companies filing
for bankruptcy in H1

26%
Rise in Chapter 11 filings in H1

20%
Proportion of Florida SBA’s
dry powder earmarked for
distressed strategies

Another factor that may be helping companies survive is the upcoming US election, scheduled for 3 November. Industry experts say that with the vote looming, the current administration is keen to maintain as much support for businesses as possible.“Some are being delayed because of all the stimulus,” he says. “When you have these dislocations, the whole market is impacted.”

“The government will continue to ensure the economy is supported and consumers and small businesses are protected,” says Matthew Potter, a partner at Pollen Street Capital. “After the election we expect to see the [full] impact of the shutdowns.”

Unlike during previous downturns, Peck’s expectation is for a greater number of pre-packaged bankruptcies this time around, as the plentiful liquidity has given companies time to negotiate terms.

Waiting to pounce

Institutional investors have been quick to recognise the opportunity set. The Florida State Board of Administration – which manages the $165 billion Florida Retirement System Pension Plan – noted it in a meeting on 30 June as the pandemic swept across the US.

“We think this is probably the best distressed opportunity perhaps ever,” Trent Webster, the pension’s senior investment officer for strategic investments, told the investment advisory board. “By some estimates, the distressed opportunity is twice that of the global financial crisis, which is utterly astonishing, considering that was the closest we came to another Great Depression in our lifetime.”

The trustees were told that 20 percent of the Florida SBA’s dry powder had been earmarked for distressed strategies at the time of the meeting, and that money was ready to be deployed “once markets and economies begin to recover”.

The pension’s bullish stance on distressed debt followed similar enthusiasm from the $227 billion California State Teachers Retirement System and the $215 billion New York State Common Retirement Fund.

“New allocations offer the opportunity for more niche strategies”
Matthew Potter
Pollen Street Capital

Pollen Street Capital’s Potter acknowledges the increased interest in allocations to “distressed buckets”, and says investors are conducting much stronger due diligence on fund managers than ever before as understanding of private credit markets has grown.

“New allocations offer the opportunity for more niche strategies as these buckets develop,” he says. “However, the asset class has matured over the last 10 years and more and more managers are entering the space. There is, therefore, significant scrutiny on current and ‘stressed’ performance projections.”

Proceeding with caution

Some market commentators have warned that investors should look closely at their own economic forecasts and investment timelines before making commitments to distressed or opportunistic private credit.

Trevor Castledine, senior director of private markets at consultancy bfinance, says that generating outsized returns from economic disruption is far from straightforward. “The range of managers and strategies that seek to exploit the alleged opportunities is, in a word, bewildering,” he says.

Castledine says investors must understand what role any allocation to this asset class will play and ask themselves how long the economic recovery is likely to take. He also stresses that they must understand their appetite for “mini cycles” of distress along the way to achieving their returns and questions whether there is any urgency in making allocation
decisions.

“Even if we believe the market disruption will not be short-lived, should we nonetheless be concerned about the best managers’ capacity being filled very rapidly?” he asks. “How much capital is chasing each opportunity set, and should we be paying more attention to some of the less-widely marketed strategies?”

Peck thinks so. He believes there is too much money competing for the same opportunities in the traditional distressed market.

“There are limited opportunities in the distressed market today,” he says. “There is so much money competing for those opportunities. You have to have a very specific view of a quick economic recovery to make most trades in distressed right now.”

Peck believes investors should instead look at the opportunities on the “periphery” of the distressed market. Monroe’s opportunistic credit strategy is predominantly asset-heavy. The firm also invests in the stressed and secondaries markets by buying up discounted loans.

“It is going to be hard for LPs to find an opportunity that they can feel certain about in the distressed market,” he says. “There will be some fund managers that perform well, but the places to look for alpha are the areas which are not the traditional distressed debt for control strategies.

“In opportunistic credit, we are looking for deals that are impacted by the pandemic in terms of their availability and yield potential, but the underlying investment thesis has
less direct impact from the pandemic and the resulting economic recession.”