Covid-19 was spreading fast by late March and it wasn’t long after that we began hearing from our market sources that dislocation funds were suddenly in fashion.
Explaining what they are is not easy, however. A May report published by consultancy bfinance, Dislocation and Distress: Navigating New Opportunities, flagged seven strategies that are considered to be part of the dislocation trend.
One common denominator is they all aim to take advantage of the investment environment created by the pandemic. Beyond that, it’s pretty much a case of anything goes. “It’s interesting how broad the definition is,” says Tavneet Bakshi, a London-based partner at placement agent and advisory firm FIRSTavenue. “The breadth of strategies is quite remarkable and the speed with which established managers are launching dislocation funds is equally remarkable.”
The need for speed is because the opportunity is perceived to be temporary and in relation to a specific set of circumstances. This was the motivation for KKR raising $4 billion in just eight weeks for a “flexible” public and private market investment strategy: $2.8 billion for its Dislocation Opportunities Fund and another $1.2 billion for separately managed accounts investing in the same types of deals. Despite the lightning-quick fundraising period, the firm managed to entice 20 institutional investors that were new to KKR and 40 that were new to its credit arm, KKR Credit. At around this time, Apollo Global Management was putting the finishing touches to a $1.75 billion dislocation fund that was raised in precisely the same eight-week period.
The snail gathers speed
Limited partners are suddenly faced with a wide range of new funds seeking commitments, which is very much at odds with how the year started. Sister title Private Debt Investor data show only around $63 billion was raised by private debt funds globally during the first half. In the record-breaking fundraising year of 2017, $127 billion was raised in H1.
“I started to add these to our pipeline tracker and quickly realised it was a large number and only getting bigger,” says Rohit Kapur, pensions investment research manager at UK energy and services company Centrica. “In this situation there will be attractive opportunities, and you want to be able to invest in those opportunities if you’ve got capital, but there isn’t a shortage of funds to choose from.”
Some fund managers, particularly those with experience of special situations and distressed investing, had been briefing investors long before covid-19 hit the headlines that they expected a downturn of some kind and that it would be wise to set aside some capital.
“GPs were expecting the end of the cycle and therefore from a fundraising perspective they are better prepared this time than before the global financial crisis,” Kapur says. “They wanted to have the ability to move quickly when the market turned, and they had the discussions with LPs that would enable that. We’ve seen funds with triggers where you commit the capital but it won’t be deployed until the opportunity is there.”
This implies LPs have been well prepped. But is there not still a danger some investors – excited by the opportunity – might jump in before having done sufficiently comprehensive due diligence? It depends, says Kapur.
“If it’s a sophisticated LP that has invested in commingled funds or even SMAs with that GP before, you’re in a better position to meet a shortened timeframe for the fundraise. But in the current environment, with social distancing, it makes it more difficult to build new relationships,” he says.
“For the same reason, there’s also a potential issue with governance at the LP level in terms of getting approval to commit the capital. Will the crisis make it more difficult to obtain investment committee approval for new commitments?”
Go with what you know
The key, says Trevor Castledine, a senior director at bfinance in London, is to keep a cool head when assessing options.
“Some of the advice is the same as I would give at any stage in the cycle: understand what investment needs you have, whether you need liquidity or not, how long you’re willing to lock money up for, what’s in your existing portfolio, and what sort of return you’re looking to access,” he says. “Ultimately, you need to choose something that you understand, that fits with your current portfolio mix and will be additive in terms of diversification, style and returns.”
In other words, try to work out if this is complementary to what you already have. However, Bakshi points to the phenomenon of “FOMO”, or fear of missing out. “I think some LPs do pride themselves on being more opportunistic and tactical,” she says. “Those that made money by being brave and bold during the GFC are thinking very hard about prioritising near-term dislocation.”
“GPs were expecting the end of the cycle and therefore from a fundraising perspective they are better prepared this time than before the global financial crisis”
Rohit Kapur, Centrica
There is an obvious tension, though, between FOMO and the attention that needs to be paid to existing portfolios. Some GPs may be going through the covid-19 crisis with their existing exposures in reasonably decent shape, and can therefore afford to devote time and resources to assessing new types of commitment. Others, perhaps exposed to underlying assets in badly hit sectors such as retail and hospitality, will almost certainly not have that luxury. Might some be tempted to jump on the bandwagon nonetheless – perhaps even gambling that they can compensate for hits taken by current investments by placing bets on dislocation funds, with their promises of returns in the mid-teens or even higher?
That would certainly be a risky game to play, especially if, as Bakshi believes, the best opportunities are difficult to identify. “The GFC was quite specific in terms of sectoral pain, so I think the opportunity set was a bit more obvious,” she says. “The challenge right now is that there is so much uncertainty in the market with stress and distress sector-wide and impacting all forms of business – large and small, across industries, in multiple regions – which makes it far more challenging to understand and pinpoint where the right opportunity is if you’re going to play the dislocation theme.”
Because of the broad nature of dislocation, Kapur says it is important to avoid being too narrowly focused when it comes to mandates. “We’re very keen to explore this theme, but in a measured way,” he says.
“Distressed debt covers a wide range of strategies. At one end there are performing credits in scenarios where the capital need can’t be filled by banks, public markets or traditional direct lenders, and special situation strategies can fill the gap. In more liquid markets there are also stressed opportunities where you have credits that are still performing but the price has fallen significantly as the market perceives an increased risk of default.
“And then there’s distressed, where the company is not performing and is very likely to default. We’ve historically liked mandates that have the ability to tilt to where the most attractive risk-adjusted returns are at any given time.”
Simplicity is bliss
In terms of attracting LPs to their dislocation funds, many GPs are trying to keep things as simple as possible to avoid muddying the waters with fund structuring innovations – in the hope investors will then be able to commit quickly.
Jessica O’Mary, leader of the credit funds team at law firm Ropes & Gray in New York, says it is not just fund structuring drawing investors in quickly but also familiar fee and carry rates: “Originally, when we first started talking to clients about developing these products, we thought that maybe we would end up with fee structures that were a little different from the regular structures – maybe a higher carry and lower management fee, or something like that. The reality is that I have not seen that coming to fruition.”
However, she has seen some instances of “premium carry”, where significant outperformance of a hurdle rate would allow managers to participate in a higher-than-normal carry.
Another source in the market tells us they have seen one dislocation fund coming to market with a zero management fee, thus putting the emphasis entirely on performance. It is a good piece of marketing, the source suggests, because it is guaranteed to get attention.
Castledine says he is seeing innovation in terms of lock-up periods, which is entirely consistent with the potentially short-term nature of the opportunity: “Some funds, especially on the financing solutions side, are saying we’ll have a one-year investment period, harvest it over the next four or five years at most, and if the opportunity set is still there they’ll just launch a follow-up, also with a one-year investment period. That might suit some investors that aren’t so comfortable with long-term lock-ups.”
He also thinks there are some interesting developments around the performance fee, which he is concerned may cause confusion. “The question is: are all of these performance fees structured equally? And the answer to that is not easy. Some have a catch-up and some don’t. Hurdles are different and percentages are also different.”
He advises caution when it comes to funds projecting performance deduced from the previous crisis. “A lot of the target returns are based on historical numbers that were achieved in the GFC, and we really don’t know that those are capable of being replicated,” he says. “For that reason, it’s very important to understand exactly how the performance fee is being structured and its sensitivity to under- and over-performance.”
But it is clear from the recent fundraisings that many investors are managing to make themselves comfortable with the new generation of dislocation vehicles, even if they are being asked to make decisions faster than would be the case in more normal market circumstances. Is private debt set to ride through covid-19 in much better shape than anyone had dared hope?
Bakshi says she is hopeful, but LPs are having to spend a lot of time assessing current exposures and may be lacking confidence when it comes to making new commitments. She does not predict a rapid return to business as usual, though the continuing attractiveness of private debt means it will be well placed when sentiment changes for the better.
“I wouldn’t be too surprised to see a congestion of activity coming into the end of the year and perhaps into Q1 of next year,” says Bakshi. Moreover, she thinks the appetite will once again be across the private debt spectrum rather than focused only on opportunities arising from covid-19: “We know we’re going to be heading into a low-yield environment and investors will need to have solutions not just through high-octane opportunities with private equity-like returns but also more vanilla opportunities that make sense in the medium to longer term.”
The dislocation funds do not have their eyes on that farther-off horizon, however. They are operating very much in the present. They need capital right now, and many investors are responding to the call.
Seven flavours of dislocation
The new funds come in many different varieties, but are all targeting opportunities arising from volatile market conditions. Of the funds that bfinance analysed in April and May, the consultancy found seven distinct sub-strategies:
1 Dislocated entry – private credit: Funds trying to gain entry into private credit investments at low prices, relying on passive recovery or, more likely, restructuring initiatives to generate value. These strategies target distressed borrowers and stressed investors under pressure to sell.
2 Dislocated entry – real assets: Funds focused on acquiring real assets (such as property, infrastructure, development land, aircraft or ships) or the debt secured on those assets at a discount to ‘true’ value. These assets will be stressed or have problems in financing structures, and positions will be acquired from sellers no longer wanting to hold them.
3 Dislocated entry – public markets: Funds targeting the purchase of normally liquid credit instruments at a significant discount, equating to a higher expected yield. Investment choices range across investment-grade credit, high-yield bonds, broadly syndicated bank loans and collateralised loan obligation tranches.
4 Evergreen opportunities: Open-end funds focusing on a broad opportunity set across stressed and distressed investing, restructurings, rescue lending and non-performing loans.
5 Financing solutions: Funds aiming to facilitate the survival of ‘struggling-yet-viable’ companies by providing bespoke financing solutions. Target companies are typically mid-market and cannot access their traditional financing sources.
6 Fund financing and secondaries: Funds that buy stakes in funds or portfolios of investments from funds and hold them to realisation at maturity; and fund financing for GPs required to provide liquidity to investors or support portfolio companies in need of capital.
7 Multi-strategy: Funds targeting some combination of the above six strategies to provide a single point of entry into a diversified portfolio, thereby taking advantage of distress or dislocation.