In the aftermath of the 2007 financial crisis, many of my institutional clients asked: Why should we increase our investment exposure to distressed debt; the economy is weak so the risks are still unusually high? The answer simply stated: because it can be worth it. There are several ways to measure how bad times like 2007 were good times for investors.
The Eurekahedge Distressed Debt Hedge Fund Index is one of the best. In the decade since the crisis, the EDD Hedge Fund Index has returned 11.12% on an average annual basis. Remember, that’s before compounding. This represents a superior return compared to the 7.8% Eurekahedge 50 index or the 6.5% return for the broad-based Eurekahedge Fund Index.
Another measure of importance is volatility, usually expressed in the world of quants as Standard Deviation. Here is where the relative risk shows up. For the average hedge fund covered by Eurekahedge, the Standard Deviation measures 4.77%. However, for distressed funds it is 6.33%.
This greater volatility, however, has one very important redeeming quality. Over the past 19 years, there have been only two instances of negative returns: 2008 (when just about every financial asset fell more in value) and one small loss in 2015.
What Qualifies As Distressed
Veteran investors in distressed securities look first at the biggest markets: bonds and bank debt. What goes into making some of these securities distressed? There is no precise definition. For practical purposes, anytime a fixed-income instrument offers a yield to maturity of more than 1,000 basis points over the risk-free rate of return, chances are there is an investable distressed debt candidate.
One of the most conspicuous examples of late is Sears Holdings Corp. In the middle of last year, the company’s 6.625% debt was traded at less than 90 cents on the dollar. Since less than six months remained before maturity, the bonds offered an eye-popping yield of 39%.
Sears managed to meet its obligation whereas many distressed securities are typically in default, at least on interest payments. Bankruptcy may be near or already declared.
Distressed securities can even come from companies offering tangible assets to collateralize their debt. This can be a trap. If the value of the collateral decreases (think Sears Holdings real estate) the bond value will fall and possibly quite significantly. Websites like Standard & Poor’s, Moody’s or Fitch are good resources for distressed securities.
A Land Of Vultures
Hedge funds and Private Equity managers that invest in distressed debt are appropriately known as vulture funds. This uncomplimentary moniker is well chosen. The name is derived from the ability to act like scavengers and quickly take over large distressed debt positions from pension funds and other fiduciaries. The well-worn saying: one person’s garbage is another person’s treasure, pretty well sums up the vulture’s role.
In any given year, it is fairly common for these firms to purchase the bulk of new debt issues rated CCC to CCC-. With more than $20 billion in new issues, vulture investors have a full menu from which to choose their targets.
If successful, one of the hidden benefits that vulture funds bring is their influence on the actions of the debt issuer. Such actions include restructuring debt, narrowing the operational structure or even implementing a turnaround plan. As a last resort, institutional investors occasionally negotiate an exchange of distressed debt for new debt or even add fresh capital to facilitate a business restructuring.
The Role Of Private Equity And Distressed Debt Funds
According to data from the CAIA Association, over the past 20 years, distressed debt investing has become increasingly popular. There are around 170 U.S. based, and 20–30 Europe based managers who shepherd $120-$150 billion in distressed funds.
As the distressed debt market has increased in size — private equity firms and distressed debt hedge funds have evolved into key players; their roles often overlapping. Here are some of the reasons for this symbiotic relationship:
Private Equity and Distressed Debt Funds
- Prefers medium to long-term investments
- Less comfortable with buying distressed debt without certainty of attaining ‘blocking’ position
- Concerned about contentious restructuring situations
- Pays up for control
- Pays higher multiple for management
- Extensive usage of financial leverage with significant equity commitment
- Conducts extensive due diligence, often with access to management and nonpublic information
- Longer lead time
Distressed Hedge Funds
- They can excel at short to medium term trading of distressed debt securities
- Does not require control
- Does not pay a premium for management
- Requires little to no equity contribution
- Makes investment decisions based on publicly available information
- Quick turnaround
In Pursuit Of Performance
With the growth in investor appetite for distressed investment opportunities has come a widening variety of different strategies. It is important to keep in mind that many of these funds tend to have fairly broad mandates. They may trade in distressed and out of favor debts, including commercial and corporate loans and asset-backed securities, residential sub-performing or non-performing loans and securities, corporate and commercial loans, mezzanine loans and other investments in subordinate levels of the capital structure of issuers.
These loans and investments sometimes include related warrants, options and other securities with equity characteristics, publicly traded or privately negotiated equity securities (such as preferred stock, common stock, and warrants) of stressed and distressed firms.
Investing in distressed debt often becomes a major creditor of the underlying company through the purchase of low-priced bonds or other financial instruments. In many circumstances, they are able to exercise a certain level of control through the acquisition of significantly discounted securities (recapitalization) in order to enhance the value of the underlying company.
In turn, during and after such underlying company’s reorganization, these funds are in a position to realize attractive gains through sales of restructured debt obligations, newly-issued securities and/or sale of its currently-held securities. Traditional investors, who mainly seek to generate capital gains and investment returns through exposure to distressed debt investments, can join in a free ride with strategic investors undertaking distressed M&A.
The same attributes that attract hedge funds also attract individual investors to distressed debt. While an individual investor is unlikely to take an active role there are plenty of ways for a regular investor to follow the moves of institutional investors and achieve attractive returns.
With such a unique and complex asset class, becoming involved in distressed investing demands a contrarian headset. Timing is an important factor in creating the best distressed investment opportunities. The worse the economy, the greater financial stress. So bad times can be good times for buyers of distressed debt.