Investment

There’s a tidal wave of distressed debt, but family offices are wondering about returns

Record sums are being raised by distressed debt funds keen to take advantage of an unprecedented $7.5 trillion credit opportunity as Oaktree Capital Management, co-founded by Howard Marks, closes in on raising an unprecedented $15 billion for its eleventh fund.

After raising $30 billion in the first half of the year, managers are seeking a further $100 billion from family offices and institutions to restructure debt taken on by companies desperate to access cheap loans over the last decade, culminating in the Federal Reserve’s Covid-19 monetary easing.

 Family offices have been spoiled for choice in choosing between managers. But consultants say returns will take longer than normal to achieve. They need to be patient or make investments directly in companies needing to address solvency problems, which the Fed can do nothing about. Family offices also need to discriminate when seeking income from debt as spreads gap out. 

Mightn’t we see a rise in defaults and bankruptcies and a softening of investor psychology and thus asset prices?

The discovery of a potential Covid-19 vaccine, backed by German family office Athos Service, has, of course, provided markets with a relief rally.  But the Fed is set to keep interest rates low to ease the pressure caused by debt, disruption and disease. The solvency of many companies has declined, providing distressed debt managers with opportunities to pursue workouts. 

Distressed debt manager Jason Mudrick says: “The big difference in this opportunity is the sheer size of it.”  If you tot up US junk bonds totalling $2 trillion, leveraged loans of $1.8 trillion lent to poor credit prospects and a further $3.6 trillion credit-rated BBB, just ahead of junk, you end up with distressed, or potentially distressed, credit totalling $7.5 trillion, against $5 trillion in 2019. 

Bill Ackman of hedge fund Pershing Square has taken out insurance against corporate distress saying that the market has become over-optimistic following news of the vaccine, after making $2.6 billion from a similar exercise early in the pandemic.

A slew of household names like J. Crew, Hertz, WeWork and PetSmart have been struggling with restructurings, or worse. Bloomberg has recorded 219 bankruptcy filings in 2020, the highest since 2009. 

Lenders have an extra reason to worry because loans often involve cov-lite terms which only offer them limited protection. Family offices need to brace themselves for potential write-downs in holdings of private credit which they have bought over the last few years to cover a loss of income from cash and bonds. 

Private equity firms tend to be good at profiting from situations like these at their portfolio companies.

Family offices sometimes take the view that a good distressed debt manager offers a good way to diversify during a downturn when interest rates are set to stay low. Complex restructurings can offer returns of 20% to 30% from the application of patient money.

According to a consultant: “Interest shot up immediately after investors started to understand the impact of Covid-19.”  But he warned of a big-time lag between raising money, finding opportunities and waiting for events to play out.  

Another consultant said the distress faced by companies is so extreme that the authorities will need to keep interest rates low for far longer than you would normally expect: “Investors need hybrid funds which can benefit from a challenging status quo until distress suddenly arrives.”  

He warned of zombie capitalism, where cheap money allows companies to stay afloat for years, defying attempts by distressed debt managers to get on board. Analysts point out that it is important for distressed managers to stay close to lenders, to help terminate zombies, where necessary. 

According to advisers, large families could consider directly investing in companies and SPACs that need capital rather than choosing to rely on relatively illiquid funds. A survey by data provider Fintrx has confirmed the growing popularity of direct investment, although families would find it more mentally challenging to invest in distress than venture capital. 

Most would agree managing distress is a job for professionals who know the right tranche of debt to buy at the right time. They also have skills in negotiation – and access to smart lawyers.

Sixty distress funds were seeking to raise $72 billion in the first half of this year, according to data provider Preqin. Around $30 billion was raised, say investors. Current funds are targeting $100 billion, lifting the potential haul for 2020 to $80 billion, or more. Private equity firms are in a position to put a further $68 billion to work in distress.

In his latest memo, Oaktree Capital Markets chief executive Marks said: “This year, lifelines have been thrown to industries that over-borrowed, over-expanded and/or spent too much of their cash on stock buybacks. It was decided they wouldn’t be permitted to go bankrupt.” 

This implies moral hazard is still causing problems, which are getting worse. Distressed managers expecting an uptick in performance in 2020 ended up being swamped by zombies. 

According to Eurekhedge, distressed debt managers only returned 4.3% in 2019 or less than half the average of 9.55% achieved over the long term. So far this year average returns have been minus 1%.

But Marks asks what we might see if financial support ebbs and business slows down: “Mightn’t we see a rise in defaults and bankruptcies and a softening of investor psychology and thus asset prices?” 

At some point, the odds will surely move in favour of distressed debt managers. The classic period for them to make double-digit returns is a year after a crisis. This time we may need to wait longer. But managers need to raise cash now to take advantage of the next cycle. 

According to its 60% owner Brookfield Asset Management, Oaktree raised $12 billion for its fund by August, adding it should achieve its $15 billion target. Marketers say Oaktree, which already manages $19.4 billion in the strategy, offers experience investing across cycles and sees an unprecedented opportunity to invest in Asia. PwC has estimated that distressed debts in China currently total $1.5 trillion.

On 9 November, Nasdaq confirmed that Cerberus Capital planned to raise $3 billion. In October, Goldman Sachs said it had raised its West Street Strategic Solutions fund to $14 billion with a view to investing on an opportunistic basis. 

According to Bloomberg, the fund is involved in a $1.2 billion debt deal at American Airlines whose distressed debt totals a staggering $11.1 billion – more than any other US corporation. 

Investment banks and private equity firms are both adept at purchasing debt or equity before restructurings, with a view to beefing up their involvement.

Bond manager Pimco raised $3 billion earlier this year. Highbridge raised $2.5 billion. Bain Capital has garnered $3.2 billion. 

Distressed real estate funds have been popular. Kayne Anderson raised $1.3 billion in just two weeks in April.  Angelo Gordon unveiled a $1.5 billion fund in June, following a collapse in oil and gas prices. 

Victor Khosla’s Strategic Value Partners has raised $1.6 billion for a hybrid fund to take advantage of restructuring opportunities directly caused by the pandemic. 

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One response to “There’s a tidal wave of distressed debt, but family offices are wondering about returns

  1. Excellent insight and data!

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