What is Distressed Debt?

Distressed debt investing is defined as the purchase of equity or debt securities, bank debt, Credit Default Swaps, trade claims or options of companies under financial distress. Commonly carried out by Private Equity firms, Hedge Funds and Family Offices, distressed investing allows firms to purchase this low-quality debt at often highly discounted rates. If the once-distressed company emerges from bankruptcy as a viable firm, the fund can sell the company’s bonds for a considerably higher price. A decade of record-level economic expansion and low interest rates had caused a decline in fundraising in recent years, but the current environment, fostered by the pandemic, has induced worldwide corporate distress and the collapse of oil prices. This has brought opportunistic distressed strategies back into the limelight. The renewed interest in the distressed space has been reflected in recent fund raises. In Q2 2020, Special situations vehicles1 raised $12.2 billion, four times larger than what they raised in Q1, and Distressed Debt funds have raised $9.7 billion, nine times larger than what they raised in Q1 [1].

The Coronavirus pandemic has pushed the economy into a recession, with businesses closing in an attempt to stop the spread of the virus. Millions of people are out of work. Lockdowns have restricted travel and no one is staying in hotels. This has triggered waves of corporate stress and credit rating downgrades, as multiple countries come to deal with the effect of a prolonged quarantine, with a particular strain being placed on the retail, healthcare, education and real estate sectors. This unique situation provides the perfect landscape for event driven funds, such as distressed debt and special situations funds, to thrive in.

The Distressed Debt “Mega-Funds”

Two of the largest players in the distressed space are Oaktree Capital Management, a California-based alternative asset manager and GSO Capital Solutions, Blackstone Group LP’s credit arm. Dubbed the “Mega-Funds” of the distressed space, both firms have been aggressively expanding in the asset class following the pandemic. In April, Oaktree announced that they intended to raise the largest distressed fund of all time (Oaktree Opportunities Fund XI), with a target size of $15bn, of which $12Bn has already been raised [2]. Equally, GSO have launched GSO Capital Opportunities Fund IV, which will be used to invest in distressed and mezzanine debt2 in North American and Western European Businesses [3]. In its first purchase, GSO Capital Partners agreed to acquire KP1, a building materials provider, from private equity firm DH Private Equity Partners. Paulo Eapen, Managing Director of GSO Europe explains “KP1 is a robust and high-quality company, which has demonstrated its ability to generate growth over economic cycles, including in the current context [4]. The Oaktree Opportunities Fund XI has been just as active, completing the acquisition of a 6.75% stake in Watermark Lodging Trust, a real estate investment trust, for $200m. “This transaction provides us with additional operational and financial flexibility as we navigate the current economic environment, strengthens our balance sheet and creates a pool of capital with which we can opportunistically pursue growth, “ said Michael Medzigian, chairman and CEO of Watermark [5].

Where Are the Investment Opportunities?

This pandemic has presented two key areas of opportunity. Firstly, we see opportunities of forced liquidation3. Margin calls4, fire sales5, or fund redemptions6 causing stable or quality assets to trade at a significant discount compared to fair value. Here, Distressed Hedge Funds will buy the debt at a discount, with the intention to sell it once the price rises. Alternatively, if they believed the asset’s price was going to fall further, they could purchase a credit default swap in order to bet against the debt. Secondly, as traditional capital sources dry up, borrowers start to face temporary cash shortfalls, requiring liquidity injections or recapitalisations7. In this situation, Special Situations funds will attempt to profit from the potential rise or recovery in the valuation of a stock, affected by the special situations. These funds tend to ignore the fundamentals at play and try to predict how the one time event will affect the stock or other asset. Distressed private equity firms use a much wider range of strategies. They will usually get involved in situations where more heavy lifting is needed as balance sheets are strongly impaired and require rebuilding through more active ownership, workouts8, and potentially bankruptcy [6].

Conclusion

Ultimately, the success of the distressed deal is reliant on three things: Timing, Structure and Understanding. Timing is crucial, since a premature investment may miss out on the lowest (cheapest) valuations, whilst if the investment is made too late, the opportunity may disappear altogether. Those looking to get involved into the distressed market may be too late if there is a V-shaped recovery, considering how many of the largest funds have been closing deals as early as April. As distressed transactions involve uncertainty, it is critical to plan for contingencies when you structure them. Companies need to ensure the amount and structure of their financing is consistent with the findings of the due diligence and turnaround plan. It is key to consider if there is enough liquidity to change operations and to see if debt repayments can be manageable based on anticipated cash flow. Often, special situations and distressed funds will try to exploit a one-time event, such as a pandemic, to predict how a stock or asset will move, ignoring the rationale that investors ordinarily use to select investments. However, an understanding of the investment fundamentals and business flaws allows the investor to improve their likelihood of recognising and avoiding investments that will fail to achieve their intended yield.

The coronavirus pandemic has mutated into a global health and financial crisis that has provided investors with a once-in-a-decade opportunity. Only time will tell, but if investors take the key aforementioned considerations into account when deploying capital, they could see the most lucrative distressed debt returns since the global financial crisis.

Glossary

  1. A special situation is an unusual event that compels investors to buy a stock or other asset in the belief that its price will rise
  2. Mezzanine debt is the middle layer of capital that falls between secured senior debt and equity. This type of capital is usually not secured by assets, and is lent strictly based on a company’s ability to repay the debt from free cash flow.
  3. A forced liquidation entails the involuntary sale of assets or securities to create liquidity in the event of an uncontrollable or unforeseen situation
  4. A margin call is when money must be added to a margin account after a trading loss in order to meet minimum capital requirements
  5. A fire sale consists of selling goods or assets at heavily discounted prices.
  6. A Fund Redemptions describes the repayment of any money market fixed-income security at or before the asset’s maturity date.
  7. Recapitalisation is the process of restructuring a company’s debt and equity mixture, often to stabilise a company’s capital structure
  8. A workout agreement is a mutual agreement between a lender and borrower to renegotiate terms on a loan that is in default
You’ve successfully subscribed to Finance Focused
Welcome back! You’ve successfully signed in.
Great! You’ve successfully signed up.
Your link has expired
Success! Check your email for magic link to sign-in.