Published on November 17, 2020

Investing in Distressed Debt

Over the past 20 years, investing in distressed debt has become an increasingly popular investment strategy. As distressed debt markets have grown, private equity firms and hedge funds continue to be key players in the industry. This topic is of renewed interest for many sophisticated investors, given that 2020 U.S. high-yield bond issuance as of September topped 2012 as the busiest year ever at $330 billion. This record growth may provide a potentially large ocean of stressed and distressed debt to swim in over the next few years.

Distressed Debt Investing - Trading Strategies

Distressed strategies can be divided into two categories: Non-control/trading-oriented strategies or control-oriented strategies.

Non-control / trading-oriented distressed debt investing – Trading-oriented strategies are typically the domain of hedge funds. These funds aim to generate returns by purchasing distressed debt at discounts to par value and then selling at a profit as the securities appreciate due to sector or company-specific developments. This approach hinges on the investor’s ability to identify companies that are currently in financial distress but look likely to recover in the near future. The opportunity set is usually best during a weak economy, as it leads to increased corporate default rates, and thus creates opportunities to cheaply acquire distressed debt in companies that have viable business models, products, or tangible book values—with a view to sell the bonds when prices recover and appreciate. Non-control distressed debt investors do not get actively involved in corporate restructuring, which allows them to freely adjust their positioning as prices appreciate.

Control-oriented distressed debt investing - Control-oriented investors acquire distressed debt with the goal of actively driving strong recoveries by participating in the bankruptcy process. Control investors often sit on creditor committees, and their claims may be converted to equity interests or new debt claims through financial restructurings or reorganizations. In other words, these funds buy specific bonds with the intent of taking control of a company. Control-oriented distressed debt investing is largely practiced by private equity funds and hedge funds that aim to generate returns by accumulating large, distressed debt positions that allow them to acquire a position of control in bankruptcy proceedings. Once the investor has gained control through the bankruptcy process, they can make active financial, operational, and managerial interventions to improve the company’s performance.

The Case for Distressed Debt Outperformance

Institutional investors often focus on allocating to distressed debt strategies during times of economic and financial stress. Bond prices can sell off dramatically as investors cut exposure due to perceived increases in default risks when economic conditions start to tighten. This is especially true of investment-grade fixed income mutual funds and other publicly registered investment vehicles that have strict covenants prohibiting the funds from owning bonds that are no longer rated investment grade. This can provide attractive opportunities for distressed debt managers in bonds perceived to be trading beneath the companies’ immediate or long-term future values.

Crisis-Era Distressed Debt Returns

With many high-profile distressed debt funds raising record levels of capital this year, Preqin has evaluated how previous vintages performed during economic crashes.

According to Preqin, those distressed debt funds launched as the dot-com bubble burst through 2000 and 2001 had the strongest returns and low standard deviation, and those raised during the Global Financial Crisis (GFC) show a similar profile.

Distressed Debt: Net IRR and Standard Deviation by Vintage Year

Invesing in Distressed Debt: Net IRR and Standard Deviation Graph

Source: Preqin Pro

*Wazee Street Opportunities Fund was removed from the 2012 benchmark due to its low outlier AUM and high IRR figure distorting performance metrics.

Will 2020 Prove a Strong Vintage?

While past performance is not necessarily indicative of future results, distressed debt funds typically perform well during certain economic conditions. This includes periods when monetary conditions have been dramatically eased and when high-yield debt issuance is high. At present, global interest rates are near all-time lows, following a steep drop in March in response to the COVID-19 pandemic. Corporate debt issuance is also at an all-time high – U.S. high-yield issuance has already met 2019’s issuance number by August of this year.

“If the worst of the Covid crisis has played out, then 2020 vintages have a favorable economic playing field to generate higher returns in the distressed debt space,” wrote Julian Falcioni, Senior Research Associate at Preqin. “And if financial market conditions worsen further, subsequent vintages could stand to benefit.”

Fundraising in this environment: Managers are seeking to capitalize on the current market conditions

There are 521 private debt funds in the market targeting $295 billion in commitments as of the third quarter of 2020, according to Preqin. This is a 54% increase compared to January 2020. The number of funds in the market also grew by 19% over the same period, from 436 to 521. For context, the total junk bond market back in April 2020 was predicted to be $1.2 trillion in the US alone.

Distressed debt funds accounted for 13% of the funds in market and 25% of capital targeted, the data firm reported.

Additionally, a majority (60%) of private debt investors tracked on Preqin Pro are seeking to commit to at least one distressed debt fund in the next 12 months.

For some of the industry’s biggest players such as Apollo Global Management, Blackstone, Oaktree and Elliott Management, the last decade has been largely frustrating for their distressed debt businesses, thanks in part to rock-bottom interest rates and a resilient global economy. This led some investors to prefer obtaining distressed debt exposure via more opportunistic credit hedge funds that can produce returns via short-term trading and in rescue lending activities when an abundance of distressed debt is not available.

However, the economic disruption unleashed by the coronavirus crisis is stirring hopes that the debt funds — and their investors — could be set for their richest pickings since the financial crisis, although executives stress they will not be on the same scale as a decade ago.

“It’s a moment in time where the opportunity set is so rich,” said Victor Khosla, head of Strategic Value Partners, a distressed debt investment group based in Greenwich, Connecticut. “But it is a once-a-decade opportunity, not a once-a-generation opportunity.”

So far this year, hedge funds specializing in distressed debt investing have had little to trumpet, returning an average of 0.8%, according to Eurekahedge, a data provider. But the strategy tends to struggle in the midst of a crisis — when prices for riskier corporate debt can be volatile — and fares better as an economic recovery builds. Distressed debt hedge funds, for example, notched up gains of 36% and 23% in 2009 and 2010, respectively.

Many opportunistic credit investors view the Covid-19 related economic crisis as a once-in-a-decade credit investment opportunity, which is why there has been a scramble to launch new distressed debt and special situations funds. Almost $29bn has been raised by 31 funds this year, according to Preqin. But a further 140 funds are currently tapping investors and targeting another $100bn. If even half meet their targets, then 2020 will be as notable a period for fundraising as 2008, the previous banner year.

Investment groups scramble to raise new funds to take advantage of the Covid-19-induced economic system

Investing in Distressed Debt: Size of Funds Raised or Aimed to be Raised Graph

View the institutional funds on our platform that are positioning themselves to take advantage of distressed debt opportunities.

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