Insider appraisal

Is investing in distressed debt a good thing? That’s a trick question, writes Oaktree Capital Management chairman Howard Marks.

Like all other assets classes and investment strategies, buying distressed debt is a great idea when it can be done at prices that are below intrinsic value, whereas at other times it can produce lacklustre results. Like everything else in the world of investing, success with distressed debt is a matter of opportunity and execution.

Over the 21 years of my involvement with distressed debt, there have been three periods when it was possible to access highly outstanding returns through bargain-basement purchases.

There is no silver bullet in investing – not even distressed debt.

The year 1990 witnessed a recession, a credit crunch, the Gulf War, the meltdown of many of the prominent leveraged buyouts of the 1980s and the government’s war on junk bonds. The accumulation of these events had tangible effects on creditworthiness (for example, the default rate on high yield bonds reached 10 percent) and on debt-holders’ psyches. Investors are usually happy to hold unbesmirched assets marked at high prices, but they can become entirely unwilling to deal with them when flaws become evident and their prices are brought low. This is the process that generates opportunities for bargains – in distressed debt as elsewhere. And this is what happened in 1990.

Likewise, in 2002 we also saw a recession and credit crunch, this time along with the invasion of Afghanistan, the collapse of the telecom industry and the disclosure of corporate scandals beginning with Enron and eventually affecting several other companies.

Howard
Marks

And again we witnessed the corrosive effects of fundamental deterioration and psychological undermining. The default rate on high yield bonds once again soared to nearly 13 percent, and downgrades turned holders of the debt of many former high grade companies – now “fallen angels” – into highly motivated sellers.

Whereas we had to wait 12 years between our first and second corporate debt crises in 1990 and 2002, it only took six years for the third crisis to materialise: the financial meltdown of 2008. The contributors to cyclical highs listed above were once again elements in the meltdown: overly generous capital markets, a lack of discernment and discipline, too much confidence and too little caution. Providers of capital competed intensively, lowering their credit standards in the process. In this go-round, however, opaque financial innovations made a major contribution to the general crisis, and overpriced, over-levered buyouts were a key specific factor in the rise of distressed debt opportunities.

Once again, unsustainable highs led eventually to collapse. This time around it started with foreclosures on sub-prime mortgages, progressed to jeopardise financial institutions and reduced the value of corporations, rendering many buyouts upside-down, leaving the face value of their debt in excess of the market value of the underlying assets. The confluence of these factors depressed debt prices as usual, and unjustified highs were replaced by irrational lows.

With the collapse of debt prices and arrival of forced sellers, purchases of distressed debt made in 2002 produced ultra-high rates of return over compressed holding periods. The purchases made in late 2008 appear likely to produce even greater dollar profits, albeit earned over longer time periods.

So is it all wine and roses? No, because these helpful influences are not everlasting (remember, the things that are good for most investors, and most citizens, are bad for those looking for bargains in distressed debt). In 1995–1997 and 2004–2007, the economy was strong, business was good and capital markets were wide open and willing to solve overextended companies’ financial problems. Investors and creditors were fat and happy. There were no depressing influences and no forced sellers. As a result, there were few chances to buy distressed debt capable of producing the returns investors long for.

There is no silver bullet in investing – not even distressed debt. The profit opportunity is cyclical, rising and falling as described above. Potential distressed debt supply is created through the unwise extension of credit and turned into actual supply when conditions deteriorate. But at other times, usually after a round of losses has punished investors and lenders and left them chastened, discipline in credit standards reasserts itself and the supply of potential distressed debt contracts. So distressed debt investing can be highly profitable at some times, but certainly not all.

And even when conditions are good for distressed debt investing, performance still cannot be accomplished without deft execution. Compared to buying mainstream stocks and bonds, distressed debt investing is certainly a “skill position”. Judgements have to be made about the survivability, prospects and value of an enterprise in crisis, and about the legal and realpolitik restructuring process that will reset an overly indebted company’s balance sheet and usually turn many creditors into owners.

As with other forms of so-called alternative investing, the range of returns among distressed debt investors at a given time is probably much wider than it is among participants in the more efficient mainstream stock and bond markets. Personal investing skill based on aptitude and experience – “alpha” – is the essential ingredient. Inefficient markets may make mispriced securities available, but they do not hold up a sign pointing the way to the best bargains. Distressed debt investing occasionally provides investment opportunities with great potential, but the outcome will always be dependent on skilful execution.

This is an excerpt from PEI Media's recently released book, The Definitive Guide to Distressed Debt and Turnaround Investing, Second Edition. For more information, visit http://www.peimedia.com/distressed2