The gargantuan opportunity distressed investors anticipated in March 2020, as COVID-19 was shutting down much of the planet, never quite materialized — at least not to the degree expected. Still, distressed investors were busy buying bankrupt companies, high-grade and high-yield bonds and other discounted assets, and they continue finding new investments. What are they looking at now, and what do they see coming?
Distinct cycles
Before the pandemic drove down asset prices, it had been a decade since investors had a true distressed market to work within. Given the cyclical history of distressed, that seemed too long.
Prior to the 1990 recession, distressed investing was the territory of small, highly specialized funds and individuals who played in occasional distressed or bankrupt situations as they came along. Then the nearly concurrent failure of Drexel Burnham Lambert and the 1990 recession kicked the support out from under the high-yield market, and the first distressed cycle was underway. The 1994 government bond market decline precipitated the second. The 1998 duo of the Russia Crisis and Long Term Capital Management's implosion created the third cycle. That bled into the recession and what might be called the corporate governance crisis between 2000 and 2002, generating the fourth. The Financial Crisis precipitated the fifth.
Since then, the distressed world has been waiting. There have been plenty of one-off opportunities, and the mid-decade commodities price collapse beckoned those inclined to play in that narrow sector, but nothing like the full-fledged cycles of the past.
The next cycle finally seemed to arrive near the end of 2020's first quarter. Equities plummeted below support levels and high yield option-adjusted spreads rocketed more than 1,000 basis points above Treasurys, the generally accepted demarcation for distressed. Via U.S. monetary and fiscal policies, a safety net was quickly bolted into place for consumers and the economy. Aggressive new Quantitative Easing steps, multiple stimulus payments and Paycheck Protection Program loans, among other measures, excited market bulls, and perhaps as soon as two months after the meltdown began, the easy money had been made. Equity markets have since climbed to new records, while high-yield spreads hover near all-time tights.
Distressed investors are still making money. The HFRI distressed/restructuring index was up 12.5% through the first five months of 2021. But the environment is not as target-rich as they had expected.
Recent distress ratios highlight this clearly. S&P Global Ratings reported that the U.S. distress ratio — the proportion of speculative-grade issues with an OAS above 1,000 bps — fell to 2.6% in May, its lowest since October 2007. In April, the S&P/LSTA Leveraged Loan Index distress ratio fell to 2.04%, its lowest point since 2015 (in May it ticked back up slightly, to 2.10%).
Oaktree co-chairman Howard Marks, a sharp-eyed market observer for decades, was reported by Bloomberg News to have recently said, "In the short term, I worry about not having great things to buy," adding that investors cannot safely make high returns in a low-return world.
Everything except real estate?
LCD conversations with buy-side and sell-side credit market participants reveal portfolio managers pursuing a number of investing strategies. In general, the targeted assets are not what might be considered "traditional" distressed situations. That is, they are mostly not the beaten-down securities of troubled companies, bought in hopes of being ridden back up as the company restructures.
Instead, the opportunity set today is more nuanced.
Dan Zwirn, chief executive officer of Arena Investors LP, says he is seeing other market players buying what he believes are overpriced leveraged loans and bonds in the high 90s, looking for them to rise above par in anticipation of refinancings at lower coupons.
Zwirn says investors have also directed their high beams to the universe of special purpose acquisition companies. He notes that the popular equities have two features that make them interesting to investors.
More Deep Dives: Amid recovery, limitations, distressed SPACs eye acquisitions
First, they have a built-in put, exercisable by shareholders who are not happy with the announced but as-yet-unclosed merger. Second, they generally must merge with an operating company within two years of their own IPO.
Zwirn believes that loudly ticking clocks may cause some SPACs to overpay in their desire to get a deal — any deal — done on time. That overpayment could create a longer-term distressed opportunity as the company struggles to meet expensive financial obligations. Notably, he points out that it might also create a near-term profit opportunity from the boost in the value of warrants that typically accompany SPAC shares at the time of a deal's announcement.
Josh Friedman, co-chief executive officer of Canyon Partners, is also focused on the SPAC space, and for the same reason. The urgency to put money to work, especially when debt is needed to complete the purchase, fosters an environment where "there will be mistakes," he warned in a recent Bloomberg television interview.
Odeon Capital Managing Director Richard Fels believes cash is not the place to be in this current environment. Fels identified investments driven by the intersection of current political and social dynamics as places distressed investors are investigating for their portfolios. Two examples he cited are private prisons and government-sponsored enterprise conservatorships — namely, Freddie Mac and Fannie Mae.
Private prisons are falling out of favor, exacerbating their earnings and capital structure struggles. As for the GSEs, Fels said their preferred securities continue to be held by distressed investors who believe that these situations have occupied uncertain waters long enough, especially after last week's Supreme Court ruling. Holders now have diminished prospects, but still have legal avenues to pursue.
A third category noted by Fels are companies both benefiting from and running afoul of environmental, social and governance considerations, offering both long and short plays. Private prisons are in this group, as are tobacco companies and arms manufacturers.
Finally, though President Biden's infrastructure plans remain unresolved, Fels says there are multiple corporations that would benefit if some form of infrastructure legislation is eventually passed.
Mark Levin, co-founder and managing member of research shop Asterisk Advisors, sees distressed investors looking for "reopening plays" — companies that are benefiting from the elimination of lockdowns and capacity restrictions, such as movie theaters, restaurants, and travel industry companies, but whose securities have not risen to reflect their improving fortunes.
Within the latter sector, Levin sees investors active in the unsecured and secured paper issued by airlines and lessors. Levin also sees investors searching for paper that might soon be called away — cash may be building and operations improving for companies that have not yet announced refinancings. Hence the opportunity.
Along with callable paper, Levin points to companies whose bonds are trading at fair prices today, but whose future prospects are underappreciated. The capital gains generated when the bond goes from, say, 5% yield-to-maturity to 4.5% or 4.0%, added to the coupon — and perhaps levered as well — can produce returns well above market.
One investor, who has spent much of his career in the smaller and private end of distressed, notes opportunities in that space in both the U.S. and Europe. He says that larger firms cannot play many small situations that require as much time to analyze and nurture as larger investments, yet are too insignificant to move the needle.
But small firms with the expertise to be involved and patient capital to hold for a few years, if necessary, are finding places to put money to work. Among investments available in these smaller situations, the investor cited preferred stock, incremental liquidity facilities, super-senior financings, and debtor-in-possession, or DIP, loans for companies entering bankruptcy.
Finally, Asterisk's Levin mentioned that investors he speaks to are looking for equities — other than meme stocks — that might appreciate with improving fundamentals. Not everything is rising on rumor and Reddit, Levin believes. He noted oil and gas equities as potentially attractive.
One sector notable for its lack of interest: real estate. It was almost never raised in conversation without prompting. Asking why elicited a range of answers, from there is not enough of it to trade, to it has not gotten cheap enough.
Arena's Zwirn wondered if perhaps some of today's real estate investors are hoping Zoom's impact disappears and office cash flows return to pre-pandemic levels. Zwirn also pointed out that foreclosure moratoria, court backlogs and relaxed bank lending standards have curtailed the availability of distressed real estate.
What next?
Not every distressed fund is still investing in this market. Stan Manoukian, of Independent Credit Research LLC, believes some investors feel they have made their money for the year in energy and in names such as Hertz Global Holdings Inc., Frontier Communications Parent Inc. and GTT Communications Inc., and have moved to the sidelines.
The small-situation distressed investor noted that many middle-market companies raised liquidity facilities during the pandemic that enabled them to survive the year. But that extra debt often now leaves these businesses more heavily leveraged than they were pre-pandemic. This investor hypothesizes that even if their earnings return to 2019 levels, it might not be enough to support their new balance sheets, creating new opportunities for distressed investors. That would be especially so if interest rates tick up.
One reason rates might rise is in reaction to inflation. The specter of inflation looms large over markets, making some players uncomfortable being too long. No one disputes that it is here — witness the May report from the Bureau of Labor Statistics, which recorded a seasonally adjusted 0.6% rise in prices and a 5.0% gain (before seasonable adjustment) for the prior 12 months. But inflation's severity, duration and ultimately its impact is open to debate. Many observers, most notably the Federal Reserve, believe it will be short-lived. (For a discussion of inflation's potential impact on the high yield market, see Deep Dive: Leveraged loan, high yield investors weigh push/pull of inflation.)
But that is a guess, and guesses can be wrong. Arena CEO Zwirn, for one, believes the Fed will have to react sooner rather than later to the inflation threat given the likelihood of overspending by the federal government, pushing the fed funds rate higher and/or curtailing QE, moves he believes are likely to bring markets back to earth. In his view, if the Fed does not act forcefully in the near-term, it risks a repeat of the '70s, with its inflation and stagnant economy. With the tightening of credit and a decline in liquidity, opportunities for traditional distressed investments will not be far behind.
Independent Research's Manoukian foresees a day soon when demand for investments will no longer continue to be "artificially backed by the government," and what he characterizes as the "Russian roulette" being played by the most aggressive investor class will lead to valuation declines. Coupled with a weakening of the post-COVID consumer demand spike, he sees a true distressed cycle coming.
If he's right, the next question will be: How long will this one last?