The multi-speed approach to beating the cycle

Rather than piling into distressed strategies based on a hunch about the cycle turning, LPs may be better off diversifying by type of manager.

Surely the credit cycle must come to an end soon, mustn’t it? In the private debt market, that’s a question, or some variant of it, that you’ll hear on a regular basis. LPs are perhaps asking it with the most urgency – especially those which have taken a leap of faith by recently committing capital to a distressed strategy or two. There is no shortage of such commitments: our fundraising data showed distressed was the most popular private debt strategy last year, accounting for $61 billion of capital raised.

Whether these LPs will prove to have got the timing right is one question; whether they are right to be trying to time the market at all is another. Earlier this week, SVPGlobal announced that it had closed its fourth special situations fund on $2.85 billion. In conversation with sister publication PDI, the firm’s founder, Victor Khosla, was keen to make the point that it had met or exceeded its target 15 percent internal rate of return through very different investing environments.

The performance stats back up Khosla’s assertion. According to SVP, it delivered a 16.3 percent IRR from its first special situations fund, which was invested in the wake of the global financial crisis. This was nothing exceptional – plenty of other distressed and special sits funds were achieving similar numbers at that time. What is exceptional is the 15.3 percent achieved by the second fund – and 15 percent for the third fund to date – during much less volatile periods (and, one would think, less conducive to this type of strategy).

What this suggests is that distressed investing need not be an ‘all or nothing’ strategy: i.e. either pile in at the right time and reap the rewards or arrive late to the party and suffer the consequences. Rather than obsessing over cycles, therefore, perhaps a more productive approach might be to carefully diligence the strategies of individual managers.

For insights into how to do this, it’s well worth visiting some research by Cambridge Associates in a report entitled Distressed Debt: A New Way to Categorise Managers, which was published in February this year. It divided distressed managers into three broad categories: sprinters, marathon runners and middle distance/milers.

To paraphrase (read the report itself for fuller explanations), sprinters are looking for a quick path to exit, often through re-financings, and their added value lies in their ability to extricate themselves rapidly from complex situations; marathon runners are (unsurprisingly) in it for the long run, seeking to convert debt to equity, taking control of borrowers and turning them around private equity-style; the milers have the ability to target either a quick exit or an extended process depending on the circumstances.

The report suggests that by investing with a selection of each type of manager, LPs can achieve diversification of strategy and opportunity across the credit cycle. Allocate to just one type and the turning of the cycle may indeed catch you out; allocate across all of them and a declining opportunity set for one manager can instead be a promising environment for another.

By focusing on strategy, it may be that questions about the turning of the cycle become a little less urgent.

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