Waiting, watching

Distressed investors have seen some historic opportunities for profits come and go in the rollercoaster markets of the past few years. Now, all eyes are on Europe

The private equity distressed investment market looks a lot different today than it did two years ago. 

That was made particularly plain in February when Oaktree Capital Management, considered a distressed investment bellwether, chose to distribute to LPs $3 billion in profits from its $10.9 billion distressed debt fund rather than reinvest the proceeds in a changed economic climate. The same fund was also expected to eventually release up to $1 billion in unspent capital. 

The “OCM Opportunities Fund VIIb”, which began investing in May 2008, deployed the bulk of its capital in the period between the Lehman Brothers bankruptcy and the end of 2008. Market conditions and thus the firm’s returns expectations had also changed along with the cycle. Fund VIIb had been aiming for gross returns of 25-30 percent or more, but good distressed investment opportunities in today’s climate are more likely to produce gross returns of 13 to 15 percent, market sources say.

“We wouldn’t want to take the money from VIIb and reinvest in those conditions,” firm chairman Howard Marks told Private Equity International in February. Prior to the distribution, Fund VIIb was generating a 1.53x return, as of 31 December, according to performance information from the Oregon Public Employees’ Retirement System.

Some of the reason for the changed environment had to do with the various government bailouts and stimulus packages over the past two years that have helped restore confidence and revive credit markets, but suppressed the supply of distressed investment opportunities.

The opportunities firms like Oaktree chased in 2008 related largely to large-cap distressed debt deals, a market segment that has “gone quiet, but will come back”, one source notes.

In every kind of market, there are always opportunities for operationally focused turnarounds of struggling companies, but those investments are challenging today because asset prices have risen, especially in the US, according to market sources.

“Today, there are still some distressed trading opportunities, but you are seeing more attention in the longer term opportunities of distressed investing,” says Pat Daugherty, head of private equity, distressed and special situations at distressed investment firm Highland Capital Management. “I wouldn’t say distressed debt trading is out, but it isn’t like shooting fish in a barrel. It’s more of a stressed trading market than distressed,” he says.

European focus

A number of fund managers have turned their attention to Europe, where financial institutions have finally started shedding assets and continuing sovereign debt issues have raised fears of contagion that could push the region into recession.

Greece has been teetering on the edge of defaulting on its debt despite its austerity measures and the bailout packages already agreed by other eurozone countries. In June, Standard & Poor’s stuck Greece with the lowest sovereign debt rating in the world, indicating that the country was likely to default on its obligations. And Greece was only one of several countries under pressure: Italy, Spain, Portugal and Ireland have also struggled to meet their obligations, and any one of these countries defaulting could serve as a “trigger” event to a wider financial crisis in Europe.

“Greece could be the catalyst for new distressed or turnaround opportunities,” says John Chase, a partner with placement agent Atlantic-Pacific Capital. “When there is a large scale destruction of capital, such as we would anticipate in the event of a Greek default, capital becomes precious system-wide. This essentially is a liquidity crisis, which forces bond holders to confront the true value of their positions, just as it forces inept managements to confront bloated operations.”

A Greek default would only accelerate the opportunities that are already rife in the region.

The nationalisation of European financial institutions after the market crash in 2008 has already led to a massive sell-off of troubled assets at cheap prices.

“There are not enough buyers to take in all those assets,” says Nat Zilkha, co-head of Kohlberg Kravis Roberts’ special situations group. “We’re deploying capital at attractive rates of return.”

KKR has focused on opportunities in European companies shouldered with leveraged buyout debt from the frothy years of 2005 through 2007. When debt on such companies became distressed in 2008 and 2009, European banks were generally reluctant to take a loss and push through comprehensive restructurings that happened in the US.

“In many cases, companies were left with unsustainable debt loads and this debt will need to be restructured again. We are now seeing banks more willing to sell in advance of this second round of restructuring,” Zilkha says.

Other firms including Oaktree and Avenue Capital are similarly focused on overleveraged companies or rescue lending in Europe and are busy raising European funds.

“[Distressed] managers do seem to be getting their troops in place for when that opportunity arrives in scale,” says one LP advisor about Europe.

Investor appetites

Committing to distressed or turnaround funds this year would be a way to prepare for opportunities that emerge in the future, though LPs are viewing the strategy with caution.

“LPs share the view that the opportunities may not be as easy today versus the dislocated markets of 2008 and early 2009, especially for distressed trading. However, that is the case across the entire investment universe,” Highland’s Daugherty says.

Committing to distressed and turnaround funds is not overly attractive today because prices are high, according to Lamar Villere, head of private equity at the Tennessee Consolidated Retirement System a public pension fund that plans to grow its exposure to distressed funds.

“It’s going to be a lot more difficult for the market to generate good returns,” Villere says. “If I made a distressed commitment today, it would be more of an insurance policy for future market events, rather than a bet on what is going on right now. It’s about having the money so that if there’s a shock of some sort, we’ve got some exposure to managers in that strategy.”

Generally, fundraising for both distressed investment and turnaround funds died down in 2010. Some LPs took losses in their distressed portfolios because they committed capital to funds that put money into the strategies too early, in late 2007 and the first half of 2008, according to Kelly DePonte, a partner with placement firm Probitas Partners.

LPs were then told to expect strong distressed opportunities in 2009, which never materialised as the markets rose and companies tapped the high-yield market to refinance their debt, pushing back maturities and avoiding defaults.

By last year, LPs had cooled on distressed. “I think there are a lot of LPs who won’t be rushing to the table,” DePonte says.