We mentioned to readers a few weeks ago about the 13th Annual HBS Turnaround Conference. Representatives from Distressed Debt Investing were in the audience. Here are some of our take-aways/notes from the conference:
- Distressed investing is very cyclical and professionals operating in this space should be aware of where they are in the cycle. In the last 20 years there were three opportunities where there were large cap opportunities in distressed: 1990 (fall of Drexel), 2002 (Enron), 2008-2009 (Great Recession). And after EACH of those periods, a violent snapback followed in the market in terms of recovery.
- What is happening in the market now is that when it comes to refinancing pre-recession over levered LBOs the bank debt is effectively in the money and it is being refinanced with secured high yield bonds (with fixed coupons vs LIBOR based rates) maturing not in 2012 but in 2017
- This has caused many people to say the oft-iterated “Wall of Maturity”/massive amount of maturing debt has been pushed out with these recent refinancings and we are okay. But are we? The unsecured bonds from the original buyout are the fulcrum under current valuations – can these be refinanced? No. They could not be and have not been refinanced in the recent HY issuance boom. (Equity is wiped out)
- In effect what the speaker is saying is that these large cap opportunities for distressed investors still exist and will present themselves in the next couple years – because smaller, more junior pieces of the cap structure were not refi’d and probably will not be capable of being refi’d, the LBO’d companies will have to be restructured, presenting opportunities for distressed investors
- As the distressed "opportunity set" gets smaller (at least until borrowers hit the sub- and mezz-debt wall), distressed investors are getting "back to basics." This means creating value in small to mid cap companies through operational improvement and optimization
- Stages of a Distressed Cycle: 1) Doing Nothing -> 2) Credit: Fear is Your Friend -> 3) Credit / PE: Back to Basics -> 4) Warm & Sunny
- First Stage: Doing Nothing. Patience is a virtue – single hardest thing for an investor is to do nothing – he just goes home early from work when he’s in this stage. But Wall Street doesn’t work that way because it is transaction driven. On the other hand, investors get paid to make money, not do deals.
- Second Stage: Fear is Your Friend. You can buy a lot when things get bloody. With that said, one issue for hedge funds is that duration of investment timelines don’t often match the amount of time it takes for a distressed play to pan out (i.e. one, two-year lockups are difficult to deal with when sometimes you have to ride out the storm before an investment pans out)
- Third Stage: Back to Basics. The speaker believes this is where we are presently where distressed investors go back to what the majority of distressed investors focus on in most time periods - small/medium size companies
- Fourth Stage: Warm & Sunny. This is the period that most people make mistakes: When people overpay and EV will eventually become less than amount of debt and companies are going to become insolvent – insolvent b/c they can’t refinance.
- Companies become insolvent because they can’t refinance
- Discipline is central (hallmark of investing).
- Investors always chase yesterday’s performance which causes mistakes
Europeis interesting right now because bank shakeout has yet to occur but will happen. And there are complexities there. The risks are many w/ legal, currency, cultural etc. but if you can buy really cheap, there is a margin of safety that can protect you against some of these risks
- In a world of extraordinary liquidity, big focus on Europe. European banks forced selling at pretty depressed prices. Basel will cause lots of deleveraging and asset sales.
- With that said, certain prop desks used to be much bigger competitors, especially with the ability to source deals and investment opportunities. Now they are a much smaller operation.
- There are a lot of financial professionals with the quanitiative skills to identify balance sheet issues and structure a solution -- but far fewer with the operational skill set required for day-today turn around mangement.
- With record inflows, where are the opportunities: "Looking at $1bn company, 40 distressed guys show up. Prefer to have 3 other guys with two looking for jobs."