State of distress: Special report on distressed debt
As a tsunami of distressed debt prepares to hit the market, Kathryn Gaw asks how private credit managers can take advantage of these new opportunities…
Distressed debt will soon be the hot topic of the alternative credit space. The volume of distressed debt on the market is expected to swell this year, as high interest rates put more borrowers into difficulty.
An estimated 40 per cent of the direct lending market is maturing in 2024-25, according to Bank of America Global research, which will lay bare any financial distress among borrowers.
Furthermore, many Covid-era loans are among those set to reach maturity, and are expected to be a particular source of distressed debt.
By some estimates, $790bn (£616bn) of corporate debt will mature in 2024 and more than $1trn will mature in 2025. These loans date back to a time when interest rates were on the floor, and governments encouraged business owners to use this cheap credit to survive the uncertainty of the pandemic. But since then, the lending environment has changed beyond recognition. In the UK, the base rate has risen from an all-time low of 0.1 per cent, to 5.25 per cent at the time of writing. Financing has also become harder to come by, especially for small- and medium-sized enterprises (SMEs).
Banks have reduced their lending activities, meaning that there is a mismatch between borrower demand for loans and the supply of cash. This has limited the refinancing options for business borrowers. Furthermore, any business that is able to successfully refinance a Covid loan will face much higher repayments. Amid an ongoing cost of living crisis and UK recession, these higher interest rates could convert formerly creditworthy borrowers into a distressed position.
Read more: Credit ratings for SME CLOs forecast to remain stable despite rising insolvencies
Recent research from Evelyn Partners found that in 2023, the number of company insolvencies in the UK reached a 30-year high. Mark Ford, a partner in restructuring and recovery services at Evelyn Partners, said that this is “a stark reminder that, while in terms of interest rates and prices the general feeling might be that the worst is over, the trading environment for businesses in the UK remains pretty onerous.”
This suggests that the uptick in distressed debt is only just beginning. Private credit managers have already noted these opportunities, but they seem to be exercising caution in their allocation plans, at least initially. Several managers told Alternative Credit Investor that they are watching the segment with interest, and are keen to peruse the incoming cohort of Covid loans with a view to exploiting any capital structure mispricing between the debt and equity of a company.
In expectation of this upcoming tsunami of distressed debt opportunities, many asset managers have already begun building out their distressed debt teams.
Read more: UK insolvencies continue rising with thousands at risk of going bust
“We have observed that large private credit firms are increasingly taking more of a role in distressed debt markets,” confirms Luke Chan, a partner at HighVista Strategies, a Boston-based private investment firm that manages $10bn on behalf of sophisticated investors globally.
“Specifically, as their assets under management have grown, some of them have launched opportunistic credit strategies which are able to invest in distressed debt assets.”
Earlier this year, hedge fund Savin Investment Partners launched a new credit opportunities fund to capitalise on upcoming opportunities in distressed debt. The fund runs a relative value strategy that focuses on the relationship between equity, option volatility and credit spread, by buying bonds and hedging default risk with longer-dated stock options covering maturity.
In October, special situations investment manager Ironshield announced the first close of its European distressed debt fund targeting €300m (£256m). Around the same time, it was announced that two former Deutsche Bank colleagues – Michael Sutton and Alex Mahler – had teamed up again at Mahler’s Alinor Capital Management to launch a distressed debt hedge fund, with assets under management of approximately $500m. The fund will focus on debt tied to troubled corporations.
These new fund launches hint at the underlying investor demand. Although it is risky, distressed debt has the potential to deliver double-digit returns, making it a useful diversification tool in larger portfolios.
“Investors typically increase allocations to distressed debt when there is ample economic turmoil or an economic downturn is expected,” says Chan.
“We believe that investors are increasingly grouping distressed debt within a broader ‘opportunistic credit’ allocation which includes classical distress as well as special situations, thematic stress and other idiosyncratic opportunities.
“This broader bucket can allow investors to benefit from numerous types of opportunities as opposed to being dedicated to distressed debt and risking that the opportunity set does not materialize in any given vintage.”
But novice investors in distressed debt must also be aware of the risk of investing in these types of assets. While there will be plenty of profitable opportunities for savvy fund managers, there will also be a lot of bad debt reaching the market soon.
A recent Fitch Ratings report on the European leveraged loan market predicted that loan defaults will continue to rise “due to the challenges that highly leveraged issuers in cyclical sectors face as growth slows and 2025 and 2026 maturities approach.”
“We expect defaults to be led by issuers undertaking A&E transactions that trigger our distressed debt exchange criteria, and issuers that will re-default after defaulting in 2022 or 2023,” Fitch added.
The ideal prospect for a distressed debt investor is an overleveraged company which has a good prospect of being saved if it restructures. It is therefore vital that distressed debt fund managers are choosing to fill their portfolios with creditworthy businesses which can be converted into profitable investments.
Read more: Moody’s: Private credit returns could fall this year
“It is really a question of risk versus return,” says Adam Caines, banking and finance partner at Macfarlanes.
“Whilst we have seen more established funds competing for the good credits, that is not to say that weaker credits – though not necessarily distressed – are not being funded. But the dynamics are different and sponsor power is very much eroded in favour of credit fund lenders driving the deal.
“In terms of the lenders writing these deals, it often fits either into a special opportunities strategy of a larger manager or with a more specialised manager who focusses on special situations.”
Timing is also an important factor for distressed debt managers. A major risk for investors is that they deploy their distressed debt capital when the economy is not stressed.
“If the economy then goes into a downturn, the investments could take a leg down and possibly impair investor capital,” explains Chan.
“This should be intuitive as stressed assets prior to a downturn are already on shaky footing and the addition of cyclical headwinds could tip them over the edge.”
Read more: Private debt AUM passed $1.6trn last year amid “explosive” growth
Unfortunately, UK distressed debt seems to meet this criteria, making it one of the least attractive markets for private credit managers seeking distressed opportunities.
In February 2024 it was confirmed that the UK economy had entered into a recession, but even before this fund managers were cooling on the UK private credit market, citing the higher risk of default. In January, KKR said that it is much more cautious on UK consumer risk than any other markets. This suggests that the UK distressed debt market could be less appealing than European or North American distressed debt, at least among private credit managers.
”We see hedge funds being involved in deals in this space, alongside their core activist investor and/or debt trading strategies,” says Jat Bains, head of insolvency at Macfarlanes.
“Only in respect of certain distressed credits may there be an overlapping appetite,” counters Macfarlanes’ Caines.
“More mainstream credit funds may well shy away from pure distressed opportunities where the risk is very high, however compensated, but there is a class of opportunistic credit fund that will compete with hedge funds.”
The full spectrum of distressed debt opportunities will reveal itself slowly over the next few years, and private credit managers will have to be able to spot the best deals quickly in order to deliver the market-beating returns that their investors crave.
This is not a market for the faint hearted, and unexpected economic volatility can upend even the most meticulously managed portfolios. The challenge for private credit fund managers will be to identify the best investments within the distressed space, at the best possible time, and to quickly offload under-performing cohorts. Investors should approach this market with educated caution, and an eye for an unmissable opportunity.
