How Distressed Investors Are Getting Ready for Business Failures
Art by A. Richard Allen
Distressed investors have been out of favor over the past decade. Funds that invest in troubled companies raised just $19 billion last year, compared with their Great Recession high of $45 billion in 2008, according to financial data research firm Preqin.
But that is quickly changing, as business ranging from restaurants and hotels to energy companies and retail chains struggle to recover from the impacts of COVID-19.
Private equity (PE) funds are responding to their need for fresh capital. KKR, for example, recently announced a new $4 billion fund to focus on distressed investments created by today’s turbulent market. Ares Management just closed a $3.5 billion fund focused on “stressed/distressed” investments. And Oaktree Capital is targeting $15 billion for its latest distressed fund, news reports say.
All of which begs the question: Is this the opportunity of a lifetime for asset allocators and limited partners (LPs)?
It’s been a long wait for Trevor Williams, a managing director at Penn Mutual Asset Management who is responsible for the company’s alternative assets portfolio. His firm has had a toe in distressed investing for several years, to be ready for the bull market to subside and for stratospheric PE valuations to return to earth. (To be sure, Penn Mutual invests in many things other than just distressed companies.)
But an economic slide “did not really come to fruition over the past few years,” he said. Instead, he indicated, many distress managers took “investment detours” into deep-value buyouts, where a company is undervalued but not necessarily in financial jeopardy.
For the past 12 months, even before the coronavirus arrived, Williams said he preferred to avoid such detours. He remained a staunch believer that the economy was poised for a downturn, and he would wait for it.
Now that tough times are here, more businesses are in trouble and a wave of bankruptcies is on the horizon. And more distressed funds are coming to market to take advantage of that. While saying he is open to talking to anyone, Williams cautioned that it pays to be picky about the funds he invests in. As he put it, he is not “backing up the truck on opportunities like this.”
Rather, he is partial to the tried and true distressed players in the market. “We are less likely to back a manager that is new in the space and doesn’t have the track record or one that cobbled together a new team to execute on the strategy,” he said. “We prefer to see teams that have been in place for a fund cycle or two.”
Distressed investors, he noted, have a unique skill set, compared with other PE investors. For instance, good distressed players must have great credit analysis expertise, combined with a good understanding of how the workout process and bankruptcy laws operate. Plus, they need the right dealmakers and lawyers on staff. Their skills, he said, have not been in high demand since the end of the Great Recession, but they are desperately needed now.
“Every day, when you read the news, there is a new company that is filing for bankruptcy,” he said. They are looking for capital, often in vain. A lot of them are in energy and retail. Energy prices are still very low, which hinders profitability. And the rise of Amazon and its ilk has devastated the retail sector. Retailers searching for funding, he said, are in a difficult position “given the change in dynamics between online and bricks and mortar.”
For him, the real opportunity may reside in less obvious businesses that are struggling, such as dental practices and veterinary offices that had to shut down during the height of the pandemic. These businesses now have to reboot their operations, and many will seek financing to do so.
In the end, the prospect of outsized returns makes the quest worthwhile, he said. One problem is that “valuations are exceedingly high,” Williams observed. Investors like him want “strong risk-adjusted returns.”
An obstacle to this form of investing is that the market is not yet awash in distressed companies. Yes, the pandemic has accelerated the retail apocalypse. But other types of businesses that could offer a more attractive value proposition have not yet materialized as distressed types.
The reason for this? The federal government’s stimulus program and the Federal Reserve’s asset buying campaign, which injected massive liquidity into the system.
That is a big difference between this recession and the one a dozen years ago. Ordinarily, “a bunch of good businesses get into trouble early on,” because they could not refinance, said Steve Moyer, an adjunct professor at the University of Southern California (USC) Marshall School of Business. Previously, he was a portfolio manager with PIMCO, where he oversaw its distressed credit fund.
The extra liquidity from Washington certainly breathes life into struggling businesses. But the Fed can’t do that forever. Meanwhile, the risk is that easy money has sustained “a group of zombie companies that will survive but can’t ever grow,” Moyer said. “Some critics say we should have just let them fail, but that’s a matter of debate.”
While the distressed companies have gotten a pass recently, the number of them that need private capital is starting to grow, said Tim Meyer, co-founder of PE firm Angeles Equity Partners, which focuses on underperforming companies in autos, aerospace, and defense. He first noticed a pickup in shaky companies in the second quarter.
Outside of hospitality and energy, the woes weren’t immediately obvious, he said. “They are just starting to report their quarterly earnings and covenants to their lenders” as of mid-August, Meyer said, adding that his firm had gotten in earlier.
How long will things be bad, meaning good for distressed investors? At a minimum, Meyer estimated, the next six quarters.
A lot of distressed situations will appear in the third quarter, he predicted, “That will be just the beginning.” To be ready, he said, a firm like his requires “abundant dry powder”—meaning, ready cash— to “move quickly when you need to.”
Indeed, for a firm that has the right mindset and resources lined up, Meyer said he believes this could be the chance of a lifetime. A lot of the PE universe’s frothy multiples will drop, making deals cheaper, he said.
For distressed investors, their patience is paying off. “We’ve been waiting for this moment for a long time,” Meyer said. As he was raising money for his company’s debut fund, when the economy was doing well, investors asked him when the booming economic cycle would turn. His reply: “We don’t know. We just know we are a year closer.” But that time is certainly here now.
Related Stories:
Sam Zell: Nice Distressed Real Estate Bargains Are Ahead