Fund managers at the pure end of the distressed debt market are only happy when it rains, as the song goes – but at the moment, it is not raining.
Responding to this, many advisors are wary of pushing limited partners to increase their distressed debt allocations until there is clear evidence of a downturn.
However, advisors know that eventually the rain will come. Hence, there is a good deal of head-scratching about how to avoid being too late to take advantage of distressed debt opportunities, while not being too early either.
Sylvia Owens, global private credit strategist at Aksia, an alternatives advisory firm in New York, says: “We think that in the US in particular, distressed activity will remain pretty limited during 2020 in the absence of major macro events.”
She acknowledges, however, that the groundwork is being laid for a resurgence in distressed: “The potential distressed opportunity continues to grow as aggressive lending behaviours persist.” Nevertheless, “investing too early, at the wrong entry point, bears considerable downside risk”.
For most people, the unusual longevity of the US’s current economic cycle, slow growth in much of Europe and a loosening of covenant protections on both sides of the Atlantic do not present a sufficiently strong signal that either region is on the cusp of a distressed market. After all, default rates are low, and interest rates look unlikely to rise by much for the foreseeable future.
Advisers say they need a good deal more evidence of a downturn than they presently have before raising allocations, or advising clients to do so, for fear of being too early. “If we do see an opportunity emerge for distressed investments, of enough expected duration to give managers the time to deploy capital, we will lean into that – going overweight to a degree,” says Tim Atkinson, credit research analyst at Meketa Investment Group, an investment advisory firm in London.
When opportunities are strong, he suggests a reasonable maximum in distressed or stressed commitments (debt is ‘stressed’ when the borrower is in trouble but not in default) of up to half the private credit allocation. Yet Atkinson adds that such opportunities are “few and far between”. The last such opportunity came in 2008-09, when Meketa did go overweight. Currently, however, the evidence of a downturn occurring any time soon is not strong enough for the firm to recommend a material increase in distressed or stressed investments.
One solution to the fear of being too early is to choose funds with ‘contingent’ structures. This is where capital is committed by LPs for distressed opportunities, but capital will not be called, or fees paid, until a broad-based downturn materialises. Owens of Aksia is cautious about these contingent structures, though. “If you do not know when your capital is going to be called – and it may never be called – you face opportunity costs,” she says. “These structures aren’t always ideal, especially if you need to tie up capital in relatively low-risk, low-return liquid assets, so that you can access them when the distressed opportunity emerges.” In other words, “you’re waiting around”.
Another approach to the timing issue, for investors lacking confidence that they can predict when the market will turn, is to devote a broadly stable amount to distressed throughout most of the cycle. This would, however, require a change in the mindset of both advisors and limited partners. Aiyu Nicholson, partner at StepStone, the private markets investor and advisor in New York, talks of direct lending as “a more Steady Eddie asset class” with stable allocations. For distressed debt, by contrast, “we go up and down”, though with about 15-20 percent as an average allocation over the course of the market cycle.
Advisors usually like to recommend dialling up and dialling down distressed allocations much more than they do for direct lending. However, many also see the virtue of trying to have at least some money in distressed, even when the opportunities look limited.
One way of balancing the tension between stable allocations and the desire to dial up and down is to avoid an excessively strict devotion to pure distressed managers, in favour of those that can also invest in stressed debt and ‘special situations’. This term means different things to different people, but it broadly signifies complexities that merit higher returns than for plain-vanilla direct lending. Advisers say these managers can invest mainly in stressed or special situations when defaults are low, and switch to outright distressed when defaults are higher.
Christoph Gort, head of credit and private debt at Siglo Capital Advisors in Zürich, thinks the stressed/distressed combination is “very attractive” at the moment, partly because opportunities have been so poor for so long. “This skill hasn’t really been needed for the past few years, because there have been so few defaults that there hasn’t been that much to restructure,” he says.
As a result, some distressed managers disappeared, and many of the new private debt managers did not focus on retaining their capabilities in workouts and restructurings for distressed and stressed debt. Ultimately, “although there are plenty of private debt managers, there are not that many with really skilled and experienced distressed teams,” says Gort. This means that when opportunities do increase, the limited number of experienced distressed debt managers that are left, on both sides of the Atlantic, will face only limited competition.
Gort is convinced that opportunities will increase eventually because of the way the market has developed. “The skill set needed to work out and restructure troubled credit is greatly underestimated,” he says. “It requires a lot of experience, pain, effort and know-how to secure high recovery rates, and we think a lot of the direct lending managers do not have the necessary skills and resources.”
Ugly face of distressed
The people required are the experienced lawyers and analysts who can deal with the conflicts the debtholder has with management, other creditors, local courts and the equity sponsor – and, in some unlucky cases, all four. It sounds like a recipe for stress, particularly for the inexperienced. As Gort puts it: “It’s not a nice job to do. It’s ugly.”
Gort also warns against waiting until the downturn arrives in earnest before asking limited partners to put money into distressed debt. “When a big crisis emerges, we will definitely increase our recommended allocations to distressed,” he says. “But we counsel clients against having nothing in distressed before this point, because when the real crisis starts, you will not find many limited partners willing to increase their allocation significantly – it takes a lot of guts.”
He recalls his experience of 2008: “It would have been a great time for institutional investors to buy distressed debt, but some of them refused to invest at all.” His solution: build a 10 or 15 percent allocation now, as a proportion of total private debt, grow familiar with the managers and strategies, and wait. “When a bigger crisis starts, and you start to see massive discounts on credit, you probably want to top up your allocation to 20 or 30 percent.”
This approach of waiting for deep discounts – the ultimate proof of a credit downturn, to satisfy even the most doubting Thomases – chimes with Atkinson of Meketa’s experience during the credit crunch. “The environment was not particularly clear,” he says. “But we were at least comfortable that we could get our money back, just because of the low prices that we were buying assets at.”