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Crest of a Wave: The Distressed Investing Opportunity

Investors focused on special situations and distressed assets have been on the hunt for deals since COVID-19 struck without much to show for it, but that could be changing

Crest of a Wave: The Distressed Investing Opportunity

The joke is that distressed investors have called 13 of the last three recessions. So when certain fund managers start going around to investors saying, “This time it’s different,” naturally there’s a bit of skepticism.

Valuations and balance sheets have proven relatively resilient since the start of the most recent financial crisis. The pandemic led to a fresh round of distressed and special situations fundraising only for much of that capital to remain on the sidelines as stimulus programs helped businesses muddle through. But this time, maybe it really is different.

This section of the report originally appeared in Middle Market DealMaker’s Fall 2022 issue. Read the full story in the archive.

Illustrated by Jay Vollmar & Rob Dobi

Even though businesses generally tend to be better capitalized and better managed than they have been during previous bouts of uncertainty, the sheer number of challenges companies are facing today will make it tricky for even the richest businesses to come through unscathed. Inflation, supply chain issues and a tight labor market are all eating into margins and liquidity. Even if these factors begin to normalize, it may be short lived. Geopolitical concerns, including the war in Ukraine and increasing tensions with China, could lead to downstream impacts to supply chain with the potential to propel commodity prices upward by winter.

While economists debate whether the U.S. is technically in a recession, companies are facing a number of challenges that might not show up in GDP figures right away. That hasn’t gone unnoticed by investors seeking businesses on the rocks.

A number of veteran distressed and special situations funds have just closed or are currently in the market and scouting for opportunities. Firms including Avenue Capital Group and OakTree Capital Management are reportedly pitching new funds to investors. Victor Khosla’s SVPGlobal has set its sights on dislocation in the aviation market over the last year and half, by deploying more than $2.5 billion in aircraft-related investments as of July. At the beginning of August, deep-value shop Banner Ridge Investors closed an oversubscribed $639 million fund to chase distressed and special situations investments—its fourth fund close since June 2019.

Given where we are and the conversations we’re having, it’s beginning to look like it’s not a matter of ‘if ’ but a matter of when we start to see more widespread distress in companies.

Lawrence Perkins

SierraConstellation Partners

That activity suggests the skepticism about investment opportunities in distressed assets is wearing off.

“Given where we are and the conversations we’re having, it’s beginning to look like it’s not a matter of ‘if ’ but a matter of when we start to see more widespread distress in companies,” says Lawrence Perkins, founder and CEO of SierraConstellation Partners, a middle-market special situations firm. “We’ve been in an environment where the focus is on liquidity solutions—really special situations-type investing. But we’ve started to see that shift over the past three to four months. Companies are running into limits in terms of what added costs they can pass on to customers. Liquidity is tightening. There is just more pressure now.”

Bad Vibes

Economists have been quick to argue that, despite negative GDP figures this year, the robust labor market and low corporate default rate make it difficult to say definitively whether the U.S. is in a recession. However, consumer sentiment may tell us more. Consumers faced with rising fuel, food and housing costs have pulled back on discretionary spending. The prevailing vibe says recession, even if the data can’t concretely back it up.

Ann Miller, managing director and co-head of the special situations practice at advisory firm Stout, says that the pullback is putting pressure on consumer discretionary companies like retailers and travel and leisure businesses. Real estate has also been hit hard as buyers and sellers grow wary of rising rates. “There are many companies right now that are hit with supply chain issues, unprecedented container costs and rising commodity costs, during a period of slowing consumer demand,” she says. “That’s just a perfect storm. It can be a great company with a bad balance sheet, primarily due to things that are completely out of its control. It does not necessarily mean that the company needs to file for bankruptcy protection; it may just need to identify liquidity solutions, or perhaps an equity infusion, to get through this difficult period.”

Sectors that should be riding high are also showing some cracks. Bob Del Genio, senior managing director and co-leader of the corporate finance and restructuring segment for the New York metro region of FTI Consulting, says that parts of the energy sector are running into trouble even as demand has bounced back. “If you’re looking upstream at things like oil field services, the level of exploration and development in energy has been down for several years. So even though a lot of restructuring has already happened, many companies aren’t seeing the pickup they were expecting,” he explains. “Oil prices can go up, but that doesn’t mean there is profitability or new investment throughout the whole universe of energy companies. That’s one area that might surprise people given the broader discussion around energy costs.”

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He adds that there’s a similar story in healthcare, where segments like senior living that were very popular before the pandemic are under pressure now as firms struggle with staffing and a dip in consumer demand.

Even if the U.S. avoids a deep recession—at least from the perspective of economists—and some factors like inflation or supply chain issues begin to settle, that might not be enough to avoid a distressed cycle.

“I think we’re at the point where if you’re a company that’s on the edge, and one or two factors come down, it’s not enough to move the needle—there are too many needles,” says SierraConstellation’s Perkins. “If you fix your supply chain issue but you’re still having your margins eaten away by inflation, labor, transportation—sure that’s one less thing, but it doesn’t fix everything else. And if you look out over the next handful of months, the data suggests maybe the supply chain issue will come back because no one can handicap what’s going to happen with Ukraine or China or any number of issues that could make it difficult to import.”

That math, he says, could keep liquidity tight. If companies have difficulty accessing capital, it becomes harder to avoid restructuring or some other type of turnaround effort.

Value Preservation

There are a lot more financing options, whether those are bridge arrangements, rescue financing or other workouts that are happening outside of court.

Bob Del Genio

FTI Consulting

For fund managers and investors looking at the opportunity set among businesses in distress, there are a number of ways to get involved. Much of the money raised during the pandemic is still sitting on the sidelines, and many of those funds are designed to be liquidity providers—either through loan-to-own arrangements or simply as a financing provider.

“Veteran teams are always going to find ways to invest and make a return, but there are more opportunities now for everyone,” says Stout’s Miller. “We’re seeing increased activity in both the primary and secondary markets. Agile investors trade and play the spreads in high yield, they can buy the fulcrum security, provide rescue financing, or if there is a bankruptcy filing, they can fund a DIP [debtor-in-possession] or purchase claims. There are many more entrants into distressed, who have added more liquidity into the market in the form of alternative financing.”

Miller notes that it will be important for investors to understand where fund managers are finding their opportunities. The market for special situations and distressed assets has matured over the years, and much more of the activity is happening out of court through improvement plans or other solutions. “I think when people think of this space they think bankruptcies, but that can destroy value and the costs can get out of control really quickly,” she says. “It’s always an option, but we really try to avoid going there if we can identify other value-maximizing solutions. Distressed investing encompasses much more than just bankruptcies.”

FTI’s Del Genio agrees. “There are a lot more financing options, whether those are bridge arrangements, rescue financing or other workouts that are happening outside of court,” he says. “Parties generally want to try to do that because then you can move into and out of a process faster and you have a concrete plan that you can tell to the market, to customers, to vendors, versus just going to court and trying to figure it out.”

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Successful fund managers in this environment are going to be those that can evaluate companies but also take a view on the entire capital structure and determine which financing tool makes the most sense. Miller adds it’s likely to be a more challenging environment for funds that aren’t dedicated to special situations or distressed. If they just have the option to look for opportunities as part of a broader mandate, they’re unlikely to generate the same types of returns. “There is a preference for working with teams that know the options and can get a deal done,” she says. “If you’re hunting for a one-off deal without the track record, it’s going to be harder to accomplish that when there is already a lot of uncertainty in the market.”

This shift could also lead to new opportunities in the high-yield market. The selloff in high yield bonds has been deep, and investors have been hesitant to return, given recent volatility. But both KKR and OakTree have published research notes in recent weeks highlighting attractive entry points reminiscent of what happened in the first half of 2020. In that instance, investors sold in response to the pandemic, only for the market to rebound significantly. KKR’s August note echoes some of the trends already discussed here: There are many good companies dealing with suddenly tight liquidity or other circumstances that are out of their control. While those factors may lead to some distress, default risk remains low, in part because of the preference for work-outs. As a result, high-yield spreads are widening and fund managers that are willing to invest could be well positioned to reap higher returns for taking on the risk.

“The average 1-year forward return for loans at the 500-599bps [basis points] spread range is 8.1%,” the note says. “And the 1-year forward return for high yield is 7.8%.” When spreads are over 600 basis points, forward returns can reach 7% for high yield and 10.7% for leveraged loans, the note says.

SierraConstellation’s Perkins says that, taken together, these factors set up the potential for a distressed cycle that may have legs. “Everyone expects people like me to say, ‘This time it’s different,’” he says. “Is there another rabbit that someone can pull out of a hat and we get more stimulus that slows all of this down? I suppose it’s possible. But I’m not sure there’s an appetite for that. I think it’s too early to say what the opportunity set ends up looking like, but we’re seeing more deal activity than we have been and there’s a lot more uncertainty.”

Bailey McCann is a business writer and author based in New York.