PrivateEquityOnline, 31 March, 2003
Value impairment is looming large. While most financial market participants are finding the current climate increasingly tough to bear, some contrarians are rubbing their hands at the prospect of taking advantage of the current turmoil in their own special ways.
Late-stage buyout investors for instance are convinced that the coming years will provide enough opportunities to invest in corporate divestitures and public-to-private transactions that the by now notorious overhang of uninvested capital will become a non-issue. Another group enthusiastic about the current market are distressed debt investors, who in the words of one such US based specialist are looking at a “simply extraordinary investment opportunity” right now.
This opportunity is said to be truly global too. In Europe, Ahold and Vivendi are among the highly leveraged credits whose debt is trading at levels that make it very attractive to specialist buyers. In Asia, where it is still not clear just how feasible control-securing equity investments in privately owned businesses really are, buyers of distressed senior debt have ever since the Asian crisis been able to take advantage of a steady supply of non-performing bank loans.
But, given the explosive growth of the leveraged debt markets in the US over the past decade, it is here that distressed houses are most animated by the prospect of the coming years. Practitioners estimate that the amount of high yield and leveraged bank debt issued in the US has increased fivefold since 1990 and currently exceeds two trillion dollars. Even at average default rates of around five per cent per annum - right now this figure is closer to ten per cent - this means that some $100bn of new product is emerging in the distressed space every year.
What seems particularly exciting is the fact that much of the debt that is currently in the market was issued in the late 1990s and will be coming due some time during the next five years. Given the current state of the credit markets, refinancing much of this debt with new debt will be tough. Instead debt-for-equity swaps are expected to play a significant role in corporate restructurings.
Different strategies are being deployed to exploit this. Hedge funds and distressed debt traders tend to concentrate on buying a company’s debt significantly below par and turning a profit over a relatively short period of time once the balance sheet has been improved and the discount on the debt begins to shrink.
Others, such as alternative securities and private equity manager Oak Hill Advisors in New York, take a more long-term view. Oak Hill has a history of buying distressed debt in order to take control and apply private equity investment techniques once, post-restructuring, a company’s debt has been converted into equity at low prices. As debt-turned-equity investor, Oak Hill then begins to work with the business hoping to generate a higher return than what a pure debt play, where the upside is essentially capped at par, would have generated.
This kind of approach is more time-consuming and requires a huge amount of know-how, but even the seemingly more straightforward concept of buying debt at 30 cents on the dollar and selling it for 70 should not be tried at home without plenty of understanding of the process. Expertise and experience are vital ingredients to successful distressed investing. They are also a significant barrier to entry, and even though plenty of new participants have already entered the distressed space (and more are expected to follow), the incumbents believe they’re sufficiently ahead of the game to fend off these pretenders.
Much more capital is likely to enter this field as well. Granted, distressed is regarded as a highly cyclical business - a high point reached in the early 1990s was followed by a long drought - and investors may want to step up their exposure to the sector slowly. Neither is it obvious to all investors that distressed is indeed the place to be right now. As one sceptic puts it: “[Distressed funds] said that two years ago, but if you made your move then, you would have ended up catching falling knives.” The way the proponents counter this is to point to some of the structural arguments cited above as well as the sheer magnitude of the numbers. Flavour of the month? No, they say: distressed is too big for that. And it's here to stay.
Meanwhile private equity houses will be busy going after those late-stage buyouts. However, some will be keeping an eye on distressed debt opportunities as well - an Oak Hill-style hybrid approach can produce impressive results.