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The pros and cons of distressed debt for family offices

Family offices looking to protect their wealth in these uncertain economic times need to carefully consider where to invest.

One sector that looks well placed is distressed debt which seeks to make money in a downturn. But investors also need to be aware that distressed companies can take longer to turn around in distressing market conditions. 

There is no shortage of turnaround opportunities but family offices looking to back distressed debt managers need to take a longer-term outlook. Turning around the fortunes of stricken companies in a bear market will take longer. 

Also known as special situation funds, or “opportunistic credit”, these strategies pick up the loans and bonds of companies struggling with the debt on their balance sheets and on the brink of bankruptcy. 

A slew of high-profile managers have launched special situation funds to focus on opportunities. Bain Capital has raised $2 billion for its second Asia-Pacific fund, more than twice the size of its first. Oaktree Capital Management is hoping to raise up to $3 billion for its third special situations fund. JP Morgan Asset Management has closed its Lynstone Special Situations Fund II with $2.4 billion,

Meg McClellan, global head of private credit at J.P. Morgan AM says: “Distressed debt and opportunistic credit become particularly attractive towards the end of an economic expansion and the start of a contraction, which is where we are at now. The close of our Lynstone Special Situations Fund II is an example of the level of investor interest for these types of strategies at the moment.” 

When portfolios may be under stress: “An allocation to this part of the market can act as an accelerator on the way back up”.

Distressed debt managers seek out the most attractive opportunities in heavily discounted bonds, believing that the market has mispriced them and that underlying companies have the potential to recover. If a bond trading at 50 cents on the dollar recovers to 80 cents on the dollar, the manager has done its job and generated “alpha” for the strategy. 

Another aspect to distressed debt investing involves the purchase of portfolios of non-performing loans (NPLs) from banks. Italian banks, which hold a large amount of NPLs, have been a big focus among investors. Distressed debt players can also choose to acquire the debt of distressed companies by executing a private equity-like, “loan to own” strategy. The aim is to take control of a company by acquiring its debt and equitise it through restructuring.

Last year was a good one for distressed debt hedge funds. The Eurekahedge Distressed Debt Hedge Fund Index shows that, on average, the strategy returned 15.2%. This performance was largely attributable to the speed of post-Covid economic recovery.

2022 offers a far more complex market environment, as companies struggle to cope with rampant inflation and the US Federal Reserve’s commitment to raising interest rates. There is no shortage of turnaround opportunities but family offices looking to back distressed debt managers need to take a longer-term outlook. Turning around the fortunes of stricken companies in a bear market will take longer. 

On May 20th, there was approximately $146 billion of US corporate debt trading at distressed levels; that compares to $73 billion a year ago. 

According to a research note by family office adviser Verdad Capital, high-yield spreads crossed their 10-year median of 430 basis points on 9 May. Historically, every equity drawdown of 30% or more appears within six months of high-yield spreads crossing this median as falling equity markets hit struggling companies, leading to a vicious feedback loop. 

Marc de Kloe is the risk and compliance officer at Theta Capital Management, a leading Dutch hedge fund of funds manager. One of its fund vehicles is Theta Distressed Credit Opportunities Pool.

He confirms continued supply chain bottlenecks, exasperated by the war in Ukraine, rising interest rates as well as significantly higher inflation, and overall a tightening of financial conditions is leading to a significant increase in opportunities.

“This is highlighted by the fact that the US IG (Investment Grade) Index is down over 16% YTD with a record amount of IG debt trading below $90. This will trickle down the capital structure.

“The credit market is beginning its repricing of risk which will lead to significant opportunities in distressed debt. Some 43% of the European High Yield market trades below $90 versus 1% at the start of the year.  The opportunities are there,” says de Kloe.

The automobile sector looks particularly vulnerable as it bears the brunt of strained supply chains and higher wages and commodity prices. The auto collision repair company, Service King, is struggling to find workers and parts and cope with its debt load, for example, while the US energy complex is another sector throwing up distressed opportunities. 

Talen Energy Supply filed for Chapter 11 protection last month to reduce its $4.5 billion debt load. The company hopes to raise $1.65 billion in new equity from certain bondholders. 

Nicholas Brooks is head of economic and investment research at Intermediate Capital Group, a global private equity firm. In his view, investors need to be opportunistic: “We are going to see a moderation in economic growth, with some sectors seeing real distress, and some sectors actually flying through the period quite well”.

Energy-intensive sectors like heavy industry and chemicals are going to face a difficult time in his view, while consumer discretionary is clearly going to weaken over the next 12 to 24 following a rise in cost pressures. 

“I don’t think the consumer sector as a whole is in trouble. But I do think some pockets of consumer discretionary will be,” says Brooks. 

Certain sectors and companies are going to go through this period of slower growth and higher input costs without any major issues, and in some cases do very well, just like technology and healthcare did during the pandemic. But many will not. 

“The opportunity set spans a wide range of sectors and we are being highly selective and looking for places that are too difficult to assess or too unique for the larger debt funds. As markets become more volatile, traditional bank capital can get more nervous which is creating opportunities across the board,” says JP Morgan’s McClellan.

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