Ever since the onset of the financial crisis, there have been dire predictions of a deluge of defaults by firms pole-axed by the tough economic conditions. There were two sound reasons for such predictions. First, many firms were clearly going to face severe challenges as consumer spending shrank. Second, banks were going to have to clean up their balance sheets by getting rid of poorly-performing assets – so firms struggling to repay their loans for whatever reason might expect to have their life-support turned off. Then came the Eurozone crisis, which seemed likely to exacerbate the problem.
So far, however, the expected flood has failed to materialise – which looks, on the face of it, to be bad news for the big distressed funds that have been raised to pick up the pieces. Apollo Management raised a $3 billion distressed fund, Oaktree Capital Management raised $5 billion; Kohlberg Kravis Roberts, too, has billions of dry powder ready to invest in Europe. So when will this money be deployed? Is distressed still seen as the boom area it once was?
Everybody in the space agrees that things have not taken off as quickly as predicted. “All the operational turnaround funds have been slow to put capital to work over the past few years,” says Neil Harper, chief investment officer for the private equity fund of funds group at Morgan Stanley Alternative Investment Partners. “They all believe that the next few years are going to be better; but it is the case that they have to date generally been slow. The area is conceptually very interesting, and conditions are now I believe a little better than they were. But the set of opportunities has not been not quite as broad as people might have anticipated.”
Yet the potential for distressed remains massive. “Yes, if you look to historical averages, default rates in the U.S. are at historically low levels,” says David Matlin, founder and chief executive of MatlinPatterson, a New York-based firm that specialises in the distressed markets. “That said, the record issuance of high-yield bonds and levered loans over the past several years has grown the pie substantially. A two percent default rate today represents more than $50 billion of actionable debt in the U.S. And that is only the debt that is in default; the universe of ‘stressed’ companies, [which is] not captured in the default statistic, is exponentially higher. For investors focused on distressed opportunities, the sheer amount of investable product today is enormous. In many respects the distressed market is as large and diverse as it has ever been.”
So which segments of the distressed universe showing most signs of life? “The two areas that are still very active are [around] restructurings and/or refinancings,” says Mubashir Mukadam, who leads the European special situations business at KKR. “The third area that is active is portfolio sales. If we look at the market, there is still two to three trillion euros on banks’ balance sheets that need to be de-levered – and they are not doing this by single asset sales. So they are looking to de-lever by doing structured refinancings or portfolio sales.”
One of the reasons that distressed strategies have been trickier than anticipated is precisely because the opportunity was so widely predicted – which has meant that well-priced distressed assets have been hard to find, says Harper. “At the larger end, there are not only debt-for-control funds but debt trading funds, in the form of hedge funds, that compete too. So there are opportunities there; but pieces of paper are well-picked-over and therefore well-priced. European banks are holding a lot of paper they haven’t fully dealt with yet.” The turnaround space, he says, is also well-picked-over. The overall result, therefore, is a lack of bargains.