The conventional wisdom is that this is not a good time to be invested in distressed debt given historically low levels of default rates, ample liquidity in the capital markets and a robust mergers and acquisitions environment. Yet distressed funds were one of the top returning asset classes in 2006, returning 15.8% in 2006 as measured by the Eurekahedge Global Distressed Debt Index. Through this series of questions and answers, we assess the various strategies employed by distressed managers, the current market environment for distressed investing and where the opportunities will be in the next cycle.
What are some of the Issues Facing Investors in Distressed Funds?
One of the issues for investors in this space is that distressed funds employ a wide range of strategies and invest in a wide range of assets. It is imperative that investors clearly understand what strategies the distressed managers they are invested with (or are considering) are employing. Distressed funds run the gamut from small funds of US$20 million or less to the very large multi-billion dollar funds. Strategies can range from direct lending activities – often taking the form of rescue financings which are typically individually-placed financings – to funds focused primarily on secondary market purchases. Managers can be control oriented – taking more of a private equity approach – and investing in debt securities they believe will be the fulcrum security to control the equity (the loan to own model). (The fulcrum security being the point in the capital structure where the enterprise value no longer fully covers the claim.) Other funds may be non-control or passive investors. Strategies can be actively traded or more fundamental value-driven where the managers are looking for longer-term appreciation and a longer-term holding period.
The assets involved in distressed strategies run the gamut down the capital structure from senior secured leveraged loans to unsecured bonds (private or public) to equity. Capital structure arbitrage and use of CDS (credit default swaps) is also an important part of distressed strategies as are more niche opportunities like trade claims. Some funds will invest across the capital structure, picking their spot in bank debt to bonds depending on the situation and the perceived risk/reward of the various positions. Other funds will target the senior part of the capital structure focusing on senior secured bank debt or bonds. Yet others will focus more on the deeply discounted plays.
Finally, the size of the fund often drives the opportunity set. Small funds have the ability to invest in the smaller, off the run issues in the US$5-10 million position size that are less widely followed and where the market may still be less efficient and less momentum driven. Large control situations, increasingly involving rights offerings need to be done by the larger funds, as does direct lending where you need a much deeper infrastructure.
Opportunities and plays can include operational issues and turnarounds, M&A and event-driven or more litigation-oriented plays. With so many different approaches to distressed investing, investors can choose managers with styles and strategies that differ sufficiently and their correlation to one another is low, thereby diversifying their exposure within the asset class.
What is the Environment for Distressed Investing?
The tremendous amount of liquidity in the markets coupled with historically low default rates has created an environment of high valuations and competition for product. People talk about whether the liquidity has created a “new paradigm” in the markets in which we will never see a return of cycles and a significant increase in the default rates. While the emergence of hedge funds as the major source of liquidity and major buyer of distressed debt has forever changed the complexion of the business and the way deals get done, we do not accept the “new paradigm” theory.
There has been a tremendous explosion in the issuance of both high yield bonds and leveraged loans over the last three years, with issuance in both categories reaching record highs in 2006. The amount of leveraged loans issued in 2006 exceeded US$500 billion.
Growth of the Leveraged Loan Market: 1989 - 2006
Of note is that the tremendous demand has driven a severe deterioration in credit quality. In the leveraged loan market, metrics such as leverage, collateral coverage and covenant packages have all been stretched to historic extremes. Moody’s has cautioned that in leveraged finance what is happening with those structural elements is a more important factor than what is happening in the economy. In the high yield market, issuance in the lower quality credit ratings (rated Split B, CCC or below) has also ballooned over the last three years. In 2006, lower quality issuance exceeded US$30 billion compared with US$18.5 billion in 2005. More significantly, US$79.5 billion of lower quality paper has been issued since the start of 2004, compared with US$56.5 billion during the three years ending in 1998, the last period viewed as taking on increased risk in the credit markets. Use of proceeds has also shifted from over 75% of new issuance being used for refinancings to 40% being used for refinancings in 2006. Acquisition-related financings grew to almost 50% in 2006 with shareholder dividend deals also increasing dramatically.
Refinancings Declining while Acquisition Financings Increasing
With the increased aggressiveness of the new issue structures came the re-emergence of toggle notes (essentially the ability to pay interest in kind rather than in cash). Of note is the historically higher default rate associated with these notes, exceeding 20% during the last default cycle.
We believe this credit environment will create an extremely compelling distressed cycle. While the amount of liquidity is depressing default rates by giving troubled companies access to “rescue financing” that defers defaults, companies with over-levered balance sheets will eventually need to restructure and correct their financing. That may take the form of in-court or out-of-court transactions – either way it creates opportunities for distressed investors. Significantly, the tremendous increase in the high yield and leveraged loan market – with over US$1 trillion of high yield debt outstanding, up from approximately US$600 billion in 2000, going into the last default cycle – has created a much larger pool of potential distressed products. It will not take a significant move in the default rate to create significant products for distressed investors. Finally, we note that the increases in the default rate have preceded recessions in the last two cycles – consistent with Moody’s statement about the importance of structural elements.
What will be some of the Differences in this Default Cycle from Previous Cycles?
As indicated previously, the role of hedge funds in the distressed market and the significant increase in their role in this market, even since the last default cycle, has changed the nature of the business. As the driving force in restructurings has shifted from insurance companies to mutual funds to hedge funds over the last ten years, the process has gotten more dynamic and litigious. Strategies and tactics have become more aggressive. A fascinating development is the attempts by private equity firms to restrict the buyers of their financings and to limit who their paper can be traded to in the secondary market – effectively “blackballing” certain hedge funds from their deals. Whether those efforts will be successful or enforceable in a bankruptcy is yet to be determined, but underscores the clash that will be seen when the large private equity deals and firms inevitably face off against the distressed community.
Cash versus Deferred Default Rates: 1980 - 2006
The leveraged loan market and the second and third lien deals will be where we see the major battles of the next cycle. Due to the much higher leverage levels through the secured debt, we will see valuation fights develop between the various levels of secured debt. It may well be that fulcrum securities will now be in the senior parts of the capital structure, as opposed to the face offs we saw in previous cycles between the secured creditors and unsecured creditors or the unsecured creditors and the equity. (Of course, the current robust financing and M&A environments have seen the emergence of more equity committees and the increased use of rights offering to preserve equity.) We expect recovery rates in the unsecured paper and subordinated paper to drop dramatically again driven by the dramatic increase in leverage through the senior parts of the capital structure.
Investors need to carefully read the Inter-Creditor Agreements and understand the rights and remedies specifically afforded in each deal. In the early vintage second and third lien deals there was much less standardisation of language and provisions. The leverage afforded first lien versus second lien creditors can shift dramatically from deal to deal depending on the language. Finally, we note that many of the provisions of those deals have not yet been tested in bankruptcy court. Many of the buyers of the leveraged loans and second lien paper are CLOs and CDOs that may not have the ability, desire or expertise to hold that paper as defaults rise. Those structures will be the sellers in this cycle – much like the commercial banks in the last cycle – that will create the significant opportunity for distressed funds.
This article first appeared in the April 2007 issue of the MFA Reporter.
Katalin E Kutasi is the portfolio manager and director of distressed & high income investing at Kellner DiLeo & Co, which she joined in 2005. Kutasi, a principal of the firm, brings more than 26 years of distressed and industry experience to Kellner DiLeo, a multi-strategy hedge fund group. Throughout her career, Kutasi has been influential in the restructuring of numerous private and public investments, including senior debt, mezzanine investments and equity. She has taken lead positions on numerous bond holder committees, negotiating both in-court and out-of-court transactions across a wide span of industries in the US and abroad.