Debt special: waiting for a downturn

Firms looking to invest in distressed debt have raised $39.3 billion so far in 2017, far exceeding the $18.2 billion raised last year, according to PEI data. The largest of these vehicles is Apollo’s $25 billion ninth fund, which will invest 20-25 percent of its capital in distressed debt, up significantly from the 1 percent allocated to the strategy in Fund VIII’s portfolio, a document from the State of Connecticut Retirement Plans and Trust Funds shows.

Apollo is not the only firm to have one eye on the potential for distress. Over the past 18 months, Cerberus, KKR and Bain Capital have raised $4 billion, $3.35 billion and $3.1 billion respectively, for vehicles with at least a partial focus on the sector.

With the current market expansion one of the longest on record, it seems inevitable the market will turn, but predicting when is no easy feat. “In Europe, the economy has picked up compared to six months ago,” one sanguine European investor in Apollo IX tells PEI. “Unemployment is down, the elections are behind us.”

Apollo’s model takes into account the unpredictability of market cycles. “We are not dependent on the recession, but the fact is that [if] a recession happens in the next four years, it will be something we can also take advantage of in Fund IX,” Leon Black, chief executive of Apollo, said in a Q2 earnings call. “But if it doesn’t happen, we’re confident from what we were able to do in Fund VIII that we can continue to do that in Fund IX.”

Likewise, Oaktree, which raised $9 billion for its Opportunities Fund Xb, is “cognisant that the opportunity set for such a large fund has yet to materialise”, chief executive Jay Wintrob said in July.

Distressed specialist Castlelake, which raised $2.4 billion for assets including European and US distressed real estate, non-performing loans and corporate distress the same month, has estimated there is currently $3.3 trillion of sub-performing and non-performing assets on financial institution balance sheets. “The question is how much of that comes to market every year,” Rory O’Neill, founder and chief executive, says. On average, the firm has deployed $2 billion annually in the past couple of years albeit through targeting niche deals of around $20 million.

LIVING LARGE

A lack of larger opportunities ahead of a possible downturn leaves LPs in a difficult position, according to Janet Brooks, managing director at placement agent Monument Group. “[Investors are] sitting there paying fees on it and if the UK doesn’t go into recession or Brexit has no effect, fees are going to eat away at your returns,” she says.

According to O’Neill, LP frustration may depend on whether the fund is charging fees on committed or invested capital.

“If the fund gets raised and doesn’t get invested [because] the downturn doesn’t happen, first of all people have committed capital and they have to factor that into their decision-making process in terms of other funds they can invest in,” he says.

“But if it doesn’t get drawn, you’d rather be in other types of investments where your capital is going to get committed. I think the investors understand the risk they’re taking, [but] if it doesn’t happen you’re probably frustrated, because you’ve got a pretty big fee base that gets amortised over a fairly small investment base and that can really degrade performance.”

Few people look forward to a recession, but for those paying fees on committed capital to distressed funds it will likely be bittersweet when it comes.