Distressed Debt Investing – An Overview from Gramercy
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“Buy to the sound of cannons and sell to the sound of trumpets” – Nathan Mayer Rothschild (1777-1836), 1810
“Buy when there’s blood in the streets, even if the blood is your own.”
– Nathan Mayer Rothschild, 1st Baron Rothschild (1840-1915), 1873
Distressed debt investing has been recognized as a distinct investment style for over the last two decades. Over that period, returns have outperformed most traditional asset classes with lower volatility, with the HFR distressed index providing 12.7% annualized returns vs. 8.0% for the S&P 500. In this report we begin by outlining the return characteristics and styles of distressed investing. One of the questions that investors ask about distressed investing is whether they should view distressed investing as merely a cyclical / opportunistic allocation or if one can make a profitable long term allocation to the asset class. There is no question that distressed investing follows the economic and credit cycles, with periods of extraordinary opportunities and returns. However, we make the case that, to be successful, one needs to have an ongoing allocation in order to be involved in the early stages of the opportunities that arise. Because most classic distressed investing is inherently a secondary market strategy, there is a “J-curve” effect whereas the critical mass of debt instruments is transferred from par buyers to distressed investors well- before the bottom of the market. Moreover, there are always idiosyncratic opportunities that arise at any stage of the credit cycle. Finally, after reviewing the investment analytics applicable to distressed investing in developed and emerging markets, we provide an overview of the market elements we see that should give rise to an extremely large opportunity set for profitable distressed investing over the next five years.
II. What is “Distressed Debt”?
The two lead quotes are often cited and ascribed to the Rothschilds, although there is no proof of them ever uttering such words. Nonetheless, the Rothschild dynasty was noted for its contrarian investing style and they are the most famous institutionalized distressed investors in early financial market history.
Distressed investing, at its most basic level, is a form of deep value investing typically with an event-driven element as well. Distressed investing can take many forms, although these days it is usually used in connection with distressed debt. One of the more widely accepted definitions of “distressed debt” is generally attributed to Martin Fridson, one of the deans of high-yield bond analysis. Mr. Fridson classified distressed debt as debt trading with a yield to maturity of greater than 1000 basis points more than the comparable underlying treasury security. Another commonly used criterion is debt that trades below 80 cents on the dollar. However, the distressed debt universe includes many other types of securities with different market prices, including defaulted fixed income instruments, stressed performing bonds, below-par bank loans, “busted” convertibles, credit default swaps, NPL portfolios, and post-restructuring equity, to name a few.
Distressed investing, sometimes pejoratively referred to as “vulture investing,” began to be recognized as a distinct investment style in the late 1980s/early 1990s with the problems with the US thrift industry and the collapse of the burgeoning high yield debt market and Drexel Burnham Lambert in 1990, followed by the success of investors in the mid-1990s involved with the Resolution Trust Corporation and other forms of distressed investing.
III. Long-Term Return Profiles from Distressed Debt Investing
Distressed investors can find value across the full credit cycle and their performance is mostly driven by both the overall credit market and idiosyncratic credit events. Performance tends to be better during and after economic turnarounds when spreads tighten. This is when the profits from the successful restructuring can be reaped. Distressed hedge funds can make money in all stages of the market cycle, by shorting overvalued securities in frothy markets and by moving to extremely high levels of cash in order to maintain the “dry powder” necessary to take advantage of when the market turns and opportunities arise.
IV. Distressed Debt Strategies
One of the most common strategies for distressed debt investing is buying securities at a distressed price to what the investor believes is the net present value of the recovery. Typically, investors focus on high yield bonds and leveraged loans (bank debt of non-investment grade companies), but investors also will consider structured credit products (such as mortgage backed securities and CDOs), trade claims, leases, receivables, vendor financing, and other debt-like instruments. Within this typical strategy, there are generally two types of institutional investing sub-strategies: passive and active.
A passive strategy is more trading oriented and investment managers do not receive non-public information. As such, they are not engaged in the restructuring negotiations and are not locked from selling their securities. The strategy tends to focus on larger companies with liquid securities with a shorter time frame to exit. Passive managers view the asset class from a cyclical standpoint and typically invest opportunistically. Passive managers can also make money by shorting securities they believe will decline in price.
The active approach is divided between non-control and control. Active non-control investors are often members of a creditor committee but typically do not lead the restructuring. They will likely receive non-public information
and, as such, be restricted from selling their securities until after the restructuring process is complete. Active control managers will look to influence the process through a blocking position (size depends on the jurisdiction ofthe bankruptcy). They also look to play an active role by taking a seat on the board of a company and work closely with management. Both non-control and control active investors view the asset class in all credit environments.
In addition to more traditional forms of distressed corporate debt investing, there exist numerous strategies that distressed investors can utilize. We outline a few of these briefly.
Debtor-in- Possession Financing (DIP Financing), for example, is a unique form of working capital provided tocompanies in Chapter 11. This form of working capital is secured and usually more senior than all other securities issued by the company. It is often thought of as a life line provided to the company in dire need of capital. DIP financing typically has a maturity of between 12-24 months and allows the company to operate while restructuring its obligations. Such financing can ensure a better overall recovery for other creditors throughout the capital structure, as the obligor can use the rescue financing to hopefully avoid a liquidation and remain an on going concern. DIP financing is often provided by investors who have exposure in other parts of the capital structure and view the more senior lending as a way to increase the recovery value of their existing exposure. Additionally, DIP lending has become quite common among hedge funds and private equity funds and not just banks.
A similar type of strategy is rescue financing which is used to alleviate working capital issues for a company that might otherwise have to file for Chapter 11. Rescue financing can come in the form of secured lending and consist of equity and or warrants. Significant value can be garnered by providing desperately needed capital to a company that can in turn overcome liquidity constraints and turn around its business.
Another strategy employed by investors is a short executed though credit default swaps (CDS). Credit default swaps are derivatives whose value increases/decreases inversely with the underlying security. For example, if an investor has a bearish view of a company and believes it may default, purchasing a CDS contract will reflect that change in value.
Capital structure arbitrage is a strategy also commonly used by distressed investors. This strategy involvesidentifying mis-priced securities in different areas of the capital structure and taking advantage of the arbitrage opportunity. For instance, after considerable analysis of recovery valuation, discount rates (yields), asset coverage and a thorough understanding of all claimants within each class an investor may buy senior secured debt and short a security that ranks lower in the capital structure. Such a trade would profit if there is not enough to go around, that is to say either through liquidation or a restructuring the recovery on the senior instrument is significantly higher than the junior. Specifically, the difference in the recovery value of the two instruments is greater than the prevailing market price difference at the time the trade in implemented. Another capital arbitrage trade could include buying unsecured bonds and shorting the equity if the investor believes, for example, the common shareholders will get wiped out and there is something left over for bondholders.
There has been an active market for investments in NPL portfolios of defaulted bank loans – typically mortgage, commercial, and consumer loans – since the early 1990s with the RTC in the US. Such portfolios usually are offered only after significant pressure by regulators for banks to clean up their balance sheets (or after a bank is actually intervened) and there have been active markets in the last 20 years in the US, China, Thailand, Germany, and Mexico. One of the impediments to NPL investing is that it requires active servicing in order to realize value, an administrative and people-intensive burden many investors are unwilling to take on. In the most recent debt crisis, securitizations and CDOs offered analogous opportunities to specialists willing and capable of doing the appropriate analysis and work through the underlying instruments.
Post-reorganization equities can often present compelling risk-reward opportunities for a value investor. However,even though stocks of the companies that recently emerged from Chapter 11 can provide outsized gains to investors, there are issues such as concentrated holdings, illiquidity, lack of coverage, and the bankruptcy stigma that can make this a difficult investment strategy. For example, in their 2004 study “A Chapter after Chapter 11”, Lee and Cunney of JP Morgan looked at 117 companies that came out of Chapter 11 between 1988 and 2003. They found that relative performance (to the S&P 500) of these companies’ stocks averaged 85% in the first year after emergence. However, the same study showed that volatility of these stocks had been very high, with only 50% of the equities outperforming during the period.
C: Should investors make a long term allocation to distressed or merely a cyclical / opportunistic allocation?
One of the questions that investors ask about distressed investing is whether they should view distressed investing as merely a cyclical / opportunistic allocation or if one can make a profitable long term allocation to the asset class. There is no doubt that distressed investing follows the economic and credit cycles, with periods of extraordinary opportunities and returns. However, there are technical factors inherent in most distressed investing which suggest that, to be successful, one needs to have an ongoing allocation in order to be involved in the early stages of the opportunities that arise. Because most classic distressed investing is inherently a secondary market strategy, there is a “J-curve” effect whereas the the critical mass of debt instruments is transferred from par buyers to distressed investors well-before the bottom of the market.
It is important for investors to have cash ready to deploy as distressed opportunities arise and “forced selling” (the sale by par investors who are not allowed to hold defaulted or non-investment grade securities) puts pressure on asset values. Investors that allocate cash to distress opportunities late can easily miss the most attractive opportunities. Exhibit 10 shows the difference between early and late investing after the 2001/2002 recession (it is still too early to calculate the impact in the most recent downturn). Although there is no pure data on defaulted debt, we use high yields bonds with a two year holding period as a proxy. The analysis demonstrates that the optimal date to invest would have been October 2002 by generating a two-year annualized return of 23.4%. As it is difficult to capture the bottom of a credit cycle, it is better to invest early rather than late. In the aforementioned period, the average two year annualized return for investing 1-12 months earlier than the optimal month was 16.3%, whereas the average for investing 1-12 months later was 14.6%.