Distressed Debt Opportunities

Good article on distressed debt opportunities in Financial News. I have pasted the article below...

Distressed debt funds queue for opportunities

Phil Craig

12 Jul 2010

Jumping in near the top of the market goes against almost every rule in the book. But distressed debt managers are expecting investors to do just that. They are preparing for substantial inflows even though hints of another recession suggest asset prices could be set to fall.

Weak economic data, such as the US non-farm payroll data released this month, which showed a 125,000 decline in jobs in June, the largest fall since October, suggests a “double-dip” recession is growing more likely, say investors and companies. A survey published last week by accountancy firm Deloitte found that chief financial officers at 125 UK companies believe there is a 38% chance of a double-dip recession.

Distressed debt funds made 30% last year, according to data provider HedgeFund.net, and rose a further 7% in the first half of this year. Managers of distressed debt funds already took hundreds of millions of dollars into their strategies in 2010.

An economic downturn would cause the prices of distressed assets to fall, implying losses for distressed debt funds. Losses can be substantial. In 2008, this class of fund lost 27%, according to HedgeFund.net. Investors might be expected to pull money away from the funds and avoid the sector until they feel sure that any recession has passed its lowest point.

But fears of an economic downturn are making managers more optimistic, not less. Distressed debt funds typically have extended lock-in periods, minimising risks of substantial short-term withdrawals. Moreover, they believe that slowing growth will spur investors to place even more money in the asset class, as more distressed opportunities come to the fore.

Iain Burnett, head of distressed debt at BlueBay Asset Management, which manages $1.6bn (€1.3bn) of such assets, said: “Over the last 12 months, maybe $2bn or $3bn have flowed into distressed debt as a whole, but I would expect a much higher figure over the next year. It will be a combination of investors understanding that we are in a stage of the cycle where there will be very good returns, and that the outlook is not so good for other asset classes.

“The opportunity is defined largely by the leverage pumped in during 2007. There are hundreds of billions of potentially distressed situations out there. This is the distressed debt opportunity of a lifetime.”

Paul Taylor, head of restructuring at M&G Investments, said: “Our view is that there will be an abundance of opportunities in the coming years, and we are putting the work in now.”

He highlighted four reasons for expecting an oversupply of distressed debt: a persistently weak economic backdrop; limited credit available for refinancing; “sticking plaster” refinancings enacted in 2008 that need to be restructured; and a wave of approaching maturities over the next few years. He said real estate debt provided particularly good opportunities, as few debt investors specialise in the area.

Investors have been placing money with distressed debt managers in recent months.

BlueBay launched its second distressed debt fund, focused on Europe, last December. Alchemy Partners has taken commitments of more than £280m (€335m) for its latest distressed debt fund focused on Europe and is targeting £500m, and OakTree Capital Management is preparing to raise its third fund focused on Europe this year, according to sources familiar with the two companies. Other managers that have closed European distressed debt funds this year include Intermediate Capital Group and Apollo, according to data provider Preqin.

Why not delay an investment until any second economic dip has begun? Andrew Kirton, global head of investment consulting at Mercer, highlighted distressed debt as a good opportunity for investors in early 2009 and said Mercer’s view had not changed. He said: “There’s a danger of catching the falling knife. Clearly, there is risk involved. But if you are building a diversified portfolio of distressed debt, you will be able to withstand a certain default rate. I remember back in the early 1990s when some managers were buying property debt at 40 cents in the dollar. It took five years, but they made a lot of money for investors.”

Damien Miller, global head of special situations at distressed debt specialist Alcentra, said: “It is possible that less sophisticated investors will retrench due to fear, as many did during 2009. The more sophisticated investors will increase allocations to distressed funds on the back of the inevitable increase in the size of the opportunity that a double dip brings. We have already started to see this.”

Miller said a pull-back in flows should, on balance, be a net positive for the overall return opportunity in the asset class. He said: “Any interruption to supply and demand for an asset class will serve to create assets or investment opportunities which are mispriced – there is no better example of this than leveraged loans during 2009. We like to pursue actively investments in assets which we believe are mispriced because we think we are able to value them better than other market participants.”

Ken Kinsey-Quick, head of multi-manager alternative investments at London boutique Thames River, which runs a fund of funds investing in distressed assets, said: “I think most investors are committed to this space. If anything, we have seen people thinking about adding assets.”

There is a fly in the ointment. A weakening economic backdrop could lead banks, which still hold substantial loans on their balance sheets, to avoid selling them, according to BlueBay’s Burnett. He said: “One of the key drivers for distressed debt is that we need banks to start selling their problem corporate loans.

“They haven’t done it yet on any significant scale, and we would like to see the banks making big profits, which would give them cover to sell bad loans at a loss. But a double dip would be bad for banks’ earnings, meaning they might put off selling bad loans.”

However, a senior executive at a rival asset manager, who declined to be named, said other factors could offset such worries: “It is possible that a bigger driver for banks’ behaviour will be a liquidity crisis. If the European Central Bank stops providing short-term liquidity, the banks will have to shed their assets to avoid the refinancing risk.”