Risky business: Distressed investing generates healthy returns, but one market veteran advises caution and diligenceBy Thomson Reuters Alpha Now
Investing in distressed assets has plenty of appeal in a low interest-rate environment, and yet interest is outpacing activity levels, particularly in what many investors had hoped would be an active European market. Veteran banker Robert Willoughby explains to Alpha Now why that might be the case, and lays out the real risks associated with this investment strategy.
In an investment universe characterized by ultra-low interest rates and rock-bottom yields on the safest of fixed income securities, investors are succumbing to the temptation to push the envelope and set out in search of ever-higher yields. At its most basic level, this has been reflected by the strong and sustained interest in high-yield mutual funds on the part of both retail and institutional investors; among more sophisticated institutions, it has also led to a growing interest in putting money to work in the distressed debt markets. The latter trend may have been sparked by the high yields available to savvy investors, but it has been further fueled by the returns that some have been able to capture.
According to data from Eurekahedge, distressed debt was the top-performing hedge fund strategy in 2012, generating an average return of 13.67% for the year and an additional advance of nearly 4% in the first two months of 2013. (Data for March were not available at the time of writing.) Despite what Robert Willoughby, the former chairman of the Leveraged Finance Origination and estructuring Group at Credit Suisse, describes as growing interest in distressed investing as an asset class â€” especially on the part of insurance companies, pension funds and others trying to reconcile the need to meet fixed payout obligations to their clients with the low-yield investment environment â€” inflows and investment activity in this space has yet to take off. Indeed, data from Eurekahedge show that while assets under management in distressed strategies totaled 6% of all assets under management in strategic mandates as of December 2007, that had declined to 5% as of December 2009 and a mere 3% as of December 2012. Indeed, net flows were negative to the extent that for every dollar of performance gain, they witnessed $2 of net outflows on a relative basis.
It was in the context of this data that a group of distressed investing specialists gathered at the global headquarters of Thomson Reuters in New York in mid-April to discuss this conundrum and other issues related to the emerging asset class. The audience was treated to an overview of the macroeconomic trends driving interest in distressed investing as well as insight into some of the specific opportunities that may be emerging, in the defense industry and cyclical businesses such as shipping here in the United States, for example, as well as those arising from Europe’s twin banking and fiscal crises.
The latter issue is of particular interest to Willoughby, whose own views have been shaped through his work in the banking universe, which has included posts overseeing high-yield bond issuance and working on corporate recapitalizations and restructurings. Having just returned to the United States after 19 years spent based in Europe, most recently with Credit Suisse, Willoughby, who in his previous role rarely discussed these topics publicly but who now is making an exception for Alpha Now, says he has watched as the interest in distressed debt has increased along with the difficulty in investing in the asset class. One hedge fund CEO Willoughby said he has spoken to recently confirmed his interest in the asset class, and in particular the opportunities that the European crisis might create. But, as the CEO told Willoughby, “we haven’t figured out how to crack the Euro market” yet.
It isn’t just the European market that offers challenges to potential investors in distressed securities, however, as Willoughby pointed out in a far-ranging conversation with Alpha Now only days before the panel discussion. “As a distressed investor you are buying something someone else created; you have to be a forensic financial analyst to understand what the instrument is really worth, and to understand the appropriate discount,” he explained. “A lot of the debt instruments that people are chasing, are discounted because they should be, because the borrower can’t pay or because the current owner needs to sell and there isn’t a demand” for the assets in question, so the prices plunge.
As an investor moves further along the risk spectrum â€” from analyzing investment-grade corporate bonds, to seeking out opportunities in high yield securities and ultimately trying to understand the nuances of distressed investing â€” the complexity and magnitude of the due diligence challenge increases. The further along that continuum an investor moves, Willoughby says, the more due diligence he or she must be prepared to undertake, and the more aspects of the transaction must be scrutinized. For instance, investors in investment-grade corporate debt and the better quality of high-yield issues can “borrow confidence” from analysts who publish research on the company or who apply a credit rating to the specific security. That kind of guidance is absent from the distressed investing arena, where potential investors don’t just have to understand the asset they are buying, or the motivations of the seller and of other potential buyers. For instance, Willoughby points out, “the value of leveraged loans in Europe in 2007 and 2008 fell off a cliff; prices went from 96 to 76 (per $100) without hard evidence of impairment (of the credit quality) just because demand fell off a cliff.”
Willoughby believes that similar issues are constraining growth in today’s European market, which logic suggests should be full of opportunities for eager investors in distressed assets. Certainly, those investors have been anticipating a big influx of supply, he says, in which they could go “trawling” for deals. Theoretically, Willoughby adds, that would create a pool of bargains made up of assets that are cheap because of the volume of supply rather than the poor or deteriorating credit quality. In practice, he says, what has happened is that European banks, in particular, have been slow to dispose of assets. “The slow pace of selling has forced the creation of a much more rational and rational market price,” he says. “If something trades at 65 (cents on the dollar), either that is what it is worth or the unknowns justify the price.”
How does Willoughby explain the mismatch between the degree of interest in European distressed debt and the level of activity? Part of the answer, in his opinion, has to do with banks’ accounting treatment of their loan portfolios and other assets that could end up in the distressed market â€” but only if the banks are willing to write down those assets and then accept the need to raise more capital to compensate, at a time when regulatory requirements for bank capital are rising.
The difficulties associated with cross-border investing in distressed assets is another reason that activity in the European market has been constrained, Willoughby suggests. Moving offshore simply magnifies the existing challenges associated with distressed assets. “When you have multiple assets, each of which has a legal claim whose validity you have to investigate” the level of complexity increases, he says. “And when you are in the Spanish market, where a secured interest isn’t understood the same way, you really don’t understand what the net value of the claim will be because don’t know when or how much you will be repaid.”
The end result is a tug-of-war of sorts between highly-motivated investors, eager to capture a few extra percentage points of yield and the kind of upside return that this corner of the financial market already has demonstrated its ability to generate. The questions that have weighed on Europe’s potential to become a hub for distressed investors are simply some of the more obvious ones that came up for review during the panel discussion, but they capture some of the broad issues of valuation, liquidity and risk that any investor in this space must take into consideration, those panelists agreed.