The upside of distress

Private equity portfolio design and construction must be done with discipline, diligence and prudence, while taking into consideration the riskiness of all the sub-asset classes that will be a part of that portfolio.

When deciding on strategic and tactical allocation, it is important for the portfolio manager to consider how a portfolio will be affected by factors such as inflation, the availability of credit and/or the potential level of government intervention in various sectors in various jurisdictions. These conditions, coupled with the manager’s unique investment philosophy, can greatly influence critical portfolio construction decisions.

Conversely, in troubled times, these detailed analyses provide the portfolio manager with the data necessary to remain patient with some of the sub-asset classes through stretches of underperformance. This allows the portfolio manager to avoid the pitfalls of changing tactics at exactly the wrong time, or selling the position on the secondary market unnecessarily.

There are considerable difficulties in forecasting how specific portfolios are affected when exposed to sudden changes in macroeconomic factors. A successful track record across market cycles is really the key to understanding and supporting a manager’s decisions in turbulent times. This approach is akin to a behavioural model that aims to limit the risk of the whole portfolio, as concepts such as regular asset allocation and diversification are not adequate in this environment.

Distressed debt investments, perhaps comprising 5 to 15 percent of a total private equity portfolio, can offer a countercyclical element to the portfolio. Strategies where private equity investors take control of a company are most dependent on highly specialised investment expertise and provide the opportunity to create real value in the portfolio (although timing the exposure within the economic cycle is critical).

And as well as providing good risk-adjusted returns, the use of debt-related strategies has additional benefits – such as smoothing volatility, mitigating the J-curve and providing early liquidity. These factors can be beneficial to a number of investors, such as funds of funds, insurance companies, pension funds, endowments and family offices.

Investors are likely to have debt components in other areas of their overall investment portfolio depending on their asset mix. Some portfolio managers place these debt components in their fixed income portfolio, others within special situations and the rest in their absolute return strategies. The point here is to make sure that one not only analyses the effects of holding these assets within the private equity portfolio, but also understands the place these strategies have within the entire portfolio.

DIFFERENT WAYS TO DEAL WITH DISTRESS

Technically, distressed debt is defined as debt securities that trade at 1,000 basis points above the risk-free rate. (That distinction is meant to differentiate debt that is simply mispriced in the current market from the debt of companies having significant difficulties.)

The availability of distressed debt and restructuring opportunities is cyclical, as illustrated using historical bond default rates in Figure 1. Though a company can run into difficulties at any point in a market cycle, when credit is easy lending standards become lax and it is easier for a company to finance its way out of a problem. As the economy deteriorates, lenders become conservative and liquidity begins to dry up, leading to increasing defaults and bankruptcies.

Private equity fund managers use a variety of strategies to generate value in the distressed debt sector.

•  Short-term trading tends to be done by a manager who specialises in buying debt securities of individual companies that are traded on various exchanges with a known market value. These managers are often allied with larger hedge fund or fixed income managers, and most often operate with a desk of analysts seated with other trading specialists.  At times, they also generate income from current coupons as they focus on companies in distress though not on the brink of bankruptcy.

•  Financial reorganisations typically involve buying debt positions in individual companies with stable operational cash flow but with too much debt on their books, resulting in debt servicing problems. Companies will typically work with creditors to renegotiate their debt obligations either in rate or maturity, and this will often entail debt forgiveness in exchange for concessions that often include equity positions in the firm. Such strategies can be affected outside the bankruptcy process, but very heavy debt loads or complex creditor structures often require a full chapter 11 procedure (in the US) and can result in the transfer of ownership to debt-holders of the fulcrum security in bankruptcy. Fund managers who seek to gain control in these situations are in effect looking to buy a company cheaply once its debt burden is adjusted. Other managers seek to gain influence in this process in order to maximise the value of the debt positions that they hold, rather than trying to use debt to take control.

•  Operational turnarounds are more complex than a financial restructuring and involve reorganisation or reconfiguration of company management as well as a change in ownership. Fund managers active in this sector need to have operational skills, either internally or through established relationships with turnaround specialists, as once control of these companies is gained they need to be actively managed. These investments are longer in nature due to their complexity and involve a significant amount of risk – but with the potential for significant rewards.

•  Asset-backed securities strategies focus on pools of smaller loans often made to individuals (as opposed to companies). These pools, often of mortgages, credit cards or student loans (though sometimes of corporate debt) typically emerge from the need of banks or financial institutions to rebalance their books, or to generate revenue via syndication or otherwise. Specialists that buy these securities at deep discounts need to understand the portfolio dynamics in detail and strategically work the portfolios, in order to resell them at a profit later (or to simply hold them to maturity if the life of the portfolio is short).

•  Debtor-in-possession (DIP) financing takes place at the top of the capital structure and provides the cash necessary for the company to operate during the chapter 11 restructuring process. During this market cycle with much reduced liquidity, a few funds have been launched that focus on providing DIP financing, due to its high spreads and preference in the capital structure.

•  Liquidation involves companies that are no longer viable. Since a firm in liquidation has no going-concern value whatsoever, recoveries in liquidation are usually quite small. Though there are distressed consultants that specialise in liquidation, this presents more of a risk to a fund manager than an investment opportunity.

SPOT THE VALUE-ADDERS

With an investment horizon of over 10 years, the private equity portfolio manager is not only faced with the challenge of building a portfolio that will stand the test of time but also the challenges of robustness, diversification, and manager selection – all the while keeping in mind that private equity is often part of a larger pool of assets. In this case, it is important for the portfolio manager to have a clear understanding of the role private equity plays in the firm’s overall asset base. This is the key to determining which sub-asset classes to target.

The lifetime of a distressed debt for control fund is roughly the length of an entire distressed cycle from trough to trough; thus a portfolio would always have some degree of exposure to the sector. However, the portfolio manager should try to anticipate the cycle and be proactive in over-allocating to the sector at the proper time, in order to provide the opportunity to generate outsized returns. A portfolio manager should always remember that manager selection is a key determinant for obtaining long-term superior portfolio performance: while a rising tide in a given sector will help all managers involved, real alpha will be generated by fund managers that are truly adding value to their portfolios.  

Réal Desrochers is the head of private equity at CalPERS (California Public Employees’ Retirement System), the largest public pension fund in the US. He was previously chief investment officer of Sanabil, the Saudi Arabian Investment Company, and director of alternative investments at CalSTRS (California State Teachers’ Retirement System).

This is an abridged extract from The Definitive Guide to Distressed Debt and Turnaround Investing (2nd ed.), published by PEI Media in 2010.