After an extended period in the wilderness, distressed debt funds – bereft of opportunities because of ultra-low interest rates and economic buoyancy – are back in the spotlight with large players coming to the market.

  • Distressed debt funds are back in the spotlight
  • Timing is crucial and very difficult in a time of a pandemic
  • Nimbleness and flexibility are ingredients for managers to be successful

Although powder is being kept dry, they are poised to take advantage of coronavirus-related prospects when they begin to appear on the horizon.

Private debt funds, overall, raised $55.5bn (€65bn) in the first six months of 2020, according to data from Preqin – about $1.1bn more than they garnered in the same period last year. 

Direct lending accounted for the bulk of the capital but there was a flurry of activity in the distressed sector in the second quarter. The tally in the April to June period was $9.7bn, comprising about 90% of the $10.8bn collected for the first six months. 

The standout fundraisings included Bain Capital Credit’s $3.2bn Distressed & Special Situations 2019, Ares’s $3.5bn Special Opportunities and KKR’s $2.8bn Dislocation Opportunities funds. They will all be dwarfed, though, if Oaktree Capital, acquired last year by Brookfield Asset Management, hits its $15bn target for Oaktree Opportunities Fund XI.

Timing, of course, is everything. If capital is deployed too early, valuations may not be as attractive as they could be later on; move too late and the opportunity may have vanished. Moreover, as competition intensifies, the lower the potential for yield. 

“One of the biggest questions if distressed funds buy positions too early is whether they have the cash to support companies if the recovery takes longer or if there is a double-dip recession,” says Floris Hovingh, partner at Deloitte. “They need to be willing to own the business and lead the restructuring in the worst-case scenario.”

A significant wave of defaults is expected as governments begin to unwind their furlough schemes and global central banks slowly curtail their unprecedented emergency fiscal and monetary measures. “At the moment, we are in the calm before the storm,” says Nick Warmingham, managing director, private investments, at Cambridge Associates. “There are so many companies that are being supported by government initiatives and schemes that I think we will not see any significant uptick in activity until the end of the year. The weaker companies are likely having discussions, but this will increase significantly in Q3 and Q4 when covenants will be tested.” 

Trevor Castledine, senior director of consultancy firm bfinance, also says the shape of the recovery is hard to forecast. He predicts distressed opportunities arising from the economic impact of COVID-19 will play out over a long period – at least 12 to 24 months. “Our view is that the companies which have been limping along will meet a cliff edge when they try and get refinancing from an existing or new fund,” he adds.

Sectors and opportunities
Managers have their own slant on opportunities. Justin Jewell, senior portfolio manager at BlueBay Asset Management, says the emphasis should be on best-in-class companies operating in sectors that are currently struggling, such as gaming and aircraft-servicing industries. These sectors have significant players but face huge challenges. 

“Where you’re not leading with a company that was already in a tailspin decline before the pandemic, and if you’ve got patient capital where you are able to be the buyer who can give lasting support, you can get a good result,” he says.

Bryan High, co-portfolio manager of Barings’ Global Special Situations strategy, on the other hand, splits the field into three main categories – market dislocation, rescue financings, and the default cycle. He notes that sectors such as travel, retail and energy have been well publicised and are the early headline grabbers for corporate credit defaults. “However, any company that entered the pandemic with a highly leveraged balance sheet is going to struggle to ramp back up to prior trading levels as we return to a normal operating environment,” he says.

Meanwhile, Tom Maughan, managing director at Bain Capital Credit is shunning “structurally challenged” sectors such as retail, very cyclical ones like energy, subsidised industries including solar, as well as those with limited barriers to entry or lacking in unique features. 

He says Bain “tends to rely on passive recovery and restructuring initiatives to generate value, targeting distressed borrowers or stressed investors to find such opportunities, but the space already has significant competition for underlying positions and may present ESG [environmental, social and governance] concerns.”

ESG challenges
ESG has risen to the fore in the wider asset management community, but has been slow to gain traction in private equity or distressed investing. One of the problems with restructuring models is that they typically include layoffs, severance pay, selling unprofitable groups, and other measures designed to make a company more efficient. 

“That is changing, mainly due to pressure from investors especially in Europe,” says Ainun Ayub, Brown Brothers Harriman’s alternative fund servicing product head for Europe and Asia. “They want managers to be mindful of what they are doing. However, it is not always straightforward and the decisions are more nuanced rather than blanket top-down approaches.”

Warmingham echoes these sentiments. “There is no shying away from the fact that in workouts, jobs will get lost and difficult decisions have to be made when restructuring a company,” he says. “This may not suit every investor and some may not be interested in distressed debt as a result. You have to go in with your eyes open. Take the Virgin [Atlantic] restructuring, where private capital played a part; some people did lose their job but, in the end, the company has been saved.”

“At the moment we are in the calm before the storm”

Nick Warmingham

The airline’s $1.2bn rescue package included 3,500 job cuts, but the remaining 6,500 staff were said to be secure. 

While firms are trying to make progress on ESG, they are adopting more flexible structures and fee models. In general, fees payable on investment are still typical in debt funds and not on a commitment-of-capital basis as in private equity. However, it depends on the client and the type of fund.

High of Barings says its flagship Special Situations funds, for instance, are structured as unlevered private closed-end vehicles, reflecting the relatively illiquid nature of the asset class. Its base management fees are paid on the net asset value of the fund, and it only receives compensation based on the assets sourced and their performance and not on the amount of committed capital received.

Barings also aligns a portion of its fees with the performance of the fund, whereby once a preferred return has been achieved, the general partner begins to share in the upside of the fund’s performance.

As for the frameworks, Maughan notes that for Bain Capital Credit the focus is on senior secured loan structures, some committed undrawn facilities, as well as secured stretched senior loans. He says the next most common arrangement is unitranche loans where Bain provides first-dollar risk – avoiding splitting unitranches into first out/last out – followed by some second-lien loans. Bain is also able to provide more junior-debt structures as well as some equity co-investment alongside strong partners.

While these configurations will continue to evolve, the most successful distressed investors will be those that are able to adapt to quickly-evolving conditions and to pivot swiftly from opportunistic, market-driven investments to short-term rescue financings to full-blown restructuring opportunities, according to Rafael Cerezo, co-head of restructuring and debt solutions at M&G Investments.     

Briefing: Timing is everything in distress