Investing in distress

Despite a huge volume of debt trading at distressed prices, distressed debt investors remain sceptical about the opportunities available. “There are no good distressed debt opportunities. There are a lot of distressed sellers,” said Ian Cash, a managing director at Alchemy Special Opportunities.

Restructuring experts suggest trading in secondary credit markets is too indiscriminate to represent real value, undervaluing the best performing credits but overvaluing truly stressed names.

“Distressed investing is not really happening yet, largely because there is more value to be had in buying performing senior debt,” said Matthew Prest, a managing director at Close Brothers.

So investors are buying debt backing less stressed credits in expectation of continued coupon yield and capital appreciation, leaving little incentive to target trickier underperforming credits.

In fact, says Simon Davies of the Blackstone Group, the abundance of sub par debt actually complicates the issue. “Many distressed debt investors are fundamentals driven, but the situation is complicated at the moment by market technicals – the lack of liquidity and oversupply of assets – which means it isn’t always clear where the real opportunities exist,” he said.

Another factor stopping distressed investors piling into the market is that they themselves are under some of the same pressures the rest of the market is facing – notably having to keep cash on hand ahead of the year-end in order to meet possible redemptions. That limits their appetite and ability to invest.

Fingers off the trigger

One more reason for investors hanging back is the lack of defaults. Their absence means a lack of real control events of the kind activist investors need in order to drive deals as distressed debt investors have traditionally used their unleveraged funds to buy discounted debt in order to drive financial restructurings.

Despite a plethora of underperforming LBOs the default rate has stayed remarkably low, limiting the control creditors can exert.

Recent vintage deals have loose covenants, equity cures and extraordinarily wide headroom, all of which allows them to underperform plan without triggering restructuring events, leaving creditors sidelined for far longer than was traditionally the case.

Many deals will see covenants tested in January and March 2009, but investors have already seen a number of waivers and requests for additional covenant headroom being waved through by banks, many of which seem desperate not to see a default.

Banks feel they are not in a position to write off debt – preferring instead to support zombie credits than to have to announce write-offs that could potentially drive down their own equity. That could allow space for companies to ride out the downturn. It could equally be no more than a value-sapping delay on an inevitable restructuring. Either way it strengthens the hand of equity owners at the expense of the debt.

“Banks are very unwilling to recognise losses. But the problem with that attitude is it that debt holders are better off biting the bullet early if they want to retain value,” said Prest.

As a result, while Prest is convinced that the rate of defaults will pick up soon, he does not think it will surge as dramatically as some are expecting. “There won’t be an immediate tidal wave of defaults but I can see rates rising to 10% in the next one to two years,” he said.

It’s complicated

Even with a good read on the market and appetite to invest, investors who do jump in face a whole new set of issues.

When LBOs do start to crumble they will be of a size and nature without real precedent. And while syndication has been done across borders in recent years, especially in Western Europe, restructurings will necessarily be on a country by country basis and multinational work-outs are likely to be complex and slow-moving.

Documentation will be tested as creditors and sponsors scramble to determine when and where restructurings happen.

There will also be issues around the way investors hold distressed assets. If loans are held through total return swaps, for instance, it is not clear the investor can be sure of exercising voting rights. In fact, unless an investor can ensure they are the legal creditor they may not be sure of any claim against defaulted companies.

The fragility of the banking sector is a new issue that investors will have to weigh. The collapse of Lehman Brothers and a number of Icelandic banks has put counterparty risk into focus and highlighted the need to ensure agency role obligations are met – especially where debt has been sold down and there is little if any incentive for a bank to get stuck into driving consensus. There are as yet no clear systems in place for counteracting such risks.

While such concerns are technical, so are restructurings, and with liquidity scarce even for investment grade credits the lack of financing available to recapitalise stressed credits means restructurings are likely to be more rather than less formal.

Despite the difficulties, investors are eyeing opportunities, and 2009 will see buyers taking positions in capital structures as potential gains outweigh risks.

Davies says one theme is starting to emerge: “A focus on heavier industrials, which have relatively large fixed cost bases but are asset heavy. That contrasts with retailers, where once you start to peel the onion you realise there are often no real assets.”

That suggests that investors may well stand aside as the weakest credits go under, a situation already seen in the US with the liquidation of Linens ‘n Things.

As the economy underperforms, listed companies too could be in investors’ sights. Sources suggest that while corporate borrowers did leverage up in recent years, especially to fund acquisitions, they did not benefit from the loosening of covenants that sponsors pushed for in 2006 and 2007. Therefore, unlike sponsor-backed deals, which can underperform out of the spotlight, the flow of information from listed entities makes them vulnerable.

With work-outs of better quality corporates on the agenda in the future that also limits the appeal of some of the weaker, more highly leveraged credits currently trading at what on the face of it look like compelling levels.