So-called ‘vulture’ funds had hoped for a better crisis – highly levered corporates, private equity-backed businesses and struggling banks surely should have provided a huge amount of dealflow for distressed debt funds. The reality that followed the correction of 2007-09 left distressed specialists almost at a loss as to what to do with the capital they had raised.
Now, question marks hang over whether this year such firms will benefit from a greater amount of deleveraging or lose out as the improving macro-economic environment helps businesses avoid crippling problems.
Rating agency Moody’s, in a report on default rates published in March, expected the global speculative-grade default rate to stay low for the remainder of the year, ending up at 2.1% in December, thanks to “improving economic conditions, continued accommodative money policy, and healthy corporate fundamentals”. Such a rate would compare with 2013’s year-end rate of 2.9% and be well below the 4.7% historical average. For Europe, it predicts that the rate will drop to 1.6%, while in the US it expects a rise to 2.3% by the end of 2014.
Distressed specialists broadly agree with the predictions, with some doubtful that interest rates will rise significantly in the near future. “Interest rates are so extremely low that it will definitely take time for any company with a reasonable business to default,” says David Bullock, managing partner at Brookfield Asset Management.
“It is not necessarily true that interest rate rises will lead to more distressed deals in Europe,” says Stuart Mathieson, a managing director at Babson Capital. “If anything, Europe is still working through its problems. With low growth expected, we are going to see low rates for longer.”
A rising-rate environment would be something of a double-edged sword, as Neil Harper, CIO of Morgan Stanley AIP’s private equity team, observes. “Borrowers with floating-rate debt, in general, feel a little more squeezed, and the impact on cash flow is more intense,” he says. “However, in general, we see rising interest rates when the general economy is recovering and growth is resurfacing.”
A lot of attention was paid to the so-called ‘wall of refinancing’ that seemed to be on its way during 2008-10 but, in the event, a lot of maturities were simply pushed further out, particularly on larger LBOs. Today, credit issuance is unusually buoyant and credit terms reminiscent of 2006-07 are making a comeback.
“Spreads are wider than they were, so credit is more expensive, but availability in Europe and America is nonetheless remarkable,” says Harper. “There will be some issues but if credit markets continue as they are, refinancing will not be as challenging.”
Even so, not everyone takes a gloomy view of forthcoming opportunities. Phillip Schaeffer, senior portfolio manager of Scott’s Cove Management, a US long/short credit-focused investment manager, says that while rising rates will signal a healthier economy, it will still be interesting to see whether that really does improve profitability enough to off-set higher rates and a more competitive refinancing market.
“The trade-off will likely be positive for some companies and negative for others, which will provide interesting investment opportunities, both long and short,” he suggests.
According to Standard & Poor’s, $4.1trn (€3trn) of European financial and non-financial corporate debt rated by the agency is expected to mature between this year and 2018 – about 46% of the $8.9trn of maturing debt globally. Out of the $4.1trn, $866m is due to mature this year, $909bn in 2015, $863bn in 2016, $754bn in 2017, and $678bn in 2018.
In a report published in January by BlueBay Asset Management, the firm said it expected an uptick in distressed deal activity this year, partly as banks get into more of a position to recognise losses in corporate loans, and their lack of resources to manage problem assets.
“Whilst it has been a long time coming, we think the quantum of distressed assets should dramatically increase, going forward,” the firm suggested. “In the first eight months of 2013 alone, €46bn of assets were transacted, with a further €12bn in the pipeline.”
Distressed funds have been eager to put capital to work, with the biggest volume of the past decade raised in 2007 and 2008 – almost entirely by US-based funds – ahead of what was expected to become a booming distressed opportunity. According to data provider Preqin, firms globally raised $27.5bn across 23 funds in 2007, and $30.2bn across 24 funds in 2008. The combined fundraising in these two years accounts for 37% of distressed debt fund capital raised between 2004 and the end of last year.
Fundraising in more recent years remains well above the amounts raised pre-crisis. According to Preqin, firms raised $15.7bn globally across 17 funds last year, compared with $22.1bn over 18 funds in 2012 and $14.6bn for 21 funds in 2011. In 2006, firms raised $8.3bn across 12 funds, compared with $6.5bn for 12 funds in 2005 and $6.5bn for 16 funds in 2004.
This year, two funds have raised more than $2bn between them – a $1.4bn fund raised by US alternatives firm Castlelake – formerly known as TPG Credit, and a £600m vehicle raised by UK firm Alchemy in March.
Funds which finished raising last year include an $845m fund by private equity house EQT Partners and a $770m fund by distressed specialist Bayside Capital.
“Those [funds] which had significant pots of capital to invest have found it quite tough to put money to work,” says Babson Capital’s Mathieson. “This cycle started with speculation that European banks were set to be big sellers of corporate distressed debt. The reality is that while a few banks have been more strategic in their selling most have, until now, held onto the corporate loans. We have seen a steady flow of distressed but not enough for the capital raised.”
In Europe, a disconnect between buyer and vendor price expectations also helped hold back deal activity, according to Bullock. “Over the past few years, however, valuations have increased combined with gradual portfolio markdowns by the banks to levels that now make more sense for buyers and sellers,” he says. “The ECB and regulators in the periphery are starting to force banks to mark the assets more realistically and also to raise cash. So more supply is now being forced out of those banks. Part of the trick to sourcing is to know which ones are in that position.”
Harper at Morgan Stanley sees a significant number of investment opportunities arising from ‘stress’ or dislocation in Europe, on the credit and equity sides of corporate balance sheets, particularly in sectors such as financial services, as well as asset classes such as consumer debt.
“However, it is not clear that many traditional distressed managers that have raised large pools of capital targeting a distressed opportunity set currently have the appropriate mix of capabilities to address this successfully,” he says.
Distressed debt has remained largely a US-dominated sector, with much of the capital held by distressed funds coming from US-based investors, a trend that is expected to continue. However, fund managers hope regulation in Europe will improve, making it easier to execute distressed deals in the region. Currently, firms require much local expertise to navigate bankruptcy rules that vary widely from country to country.
“It is hard to adopt a pan-European strategy,” says Harper. “You need people experienced in individual markets in Europe. Some are easier to navigate, with characteristics similar to the US and others are more of a challenge. You have seen debt-for-control deals, which were unheard of in certain countries, carried out in the last few years. It is gradually becoming easier to navigate many European countries in distressed debt and debt for control.”
As Harper suggests, rules in southern Europe are improving. Spain, for instance, has been reforming its bankruptcy laws to bring them closer to the US Chapter 11 model, according to trade body the Loan Market Association.
“We are seeing regulation change with time, largely favourably,” says Amit Staub, portfolio manager at credit investor ECM. “They are not perfect, they are not at the level international investors would be used to from a US court process, which has a huge amount of case law behind it. But one thing that has not improved dramatically is investor expertise – the number of people who are proficient in understanding different regimes and legal protections and how you would approach restructuring.”
But while much of the capital in the distressed market comes from the US, Yannick Naud, a portfolio manager at Sturgeon Capital, highlights that a significant proportion of the talent in Europe is native to the region. “Historically speaking the specialised vulture funds have come from the States and it is where they have very good knowledge,” he says. “Having said that, those funds have had European teams with staff in Europe for quite some time. The capital [is American] but the decision making is in Europe by European people.”
In short, there are some big decisions for would-be investors in distressed debt to make before allocating capital. Has the disappointing supply of opportunities just been a delay, or has this cycle been completely smoothed out? Is a long/short approach necessary to capture the more idiosyncratic nature of the risks in this cycle? And which managers can prove the right skills to attack the opportunity when it finally does arrive – particularly across the difficult terrain of Europe.