Notes from iGlobal's Global Distressed Investing Summit: Part 1

This past week, iGlobal hosted its 3rd Global Distressed Investing Summit at the Park Central Hotel in NYC.  The event covered a broad range of topics and opportunities from distressed middle market bank debt, distressed CMBS and Commercial Real Estate, to the return of CLOs and the impending maturity wall. Distressed Debt Investing's contributor Joshua Nahas was in attendance taking notes (and speaking on panels). This article will cover the morning session, while his next article will cover the afternoon  panels. Enjoy!

Distressed Strategies and the State of the Capital Markets
The morning panel started off with a discussion of Distressed Strategies and the State of the Capital markets.  As anyone following the High Yield and Leverage Loan space knows, the market has been experiencing strong performance since December and is up almost 3.5% in the December-February period.  As a result many of the larger on-the-run HY credits have been accessing the capital markets and pricing for all risky assets has improved.

Access to capital is much more credit specific which is creating opportunities for distressed players.  Additionally, the improved overall market has led banks to be more willing to put loans up for sale at distressed prices.  From a distressed PE perspective this has limitations given their focus on a 2x return on capital, not an IRR. In many instances there is not enough of the loan available or the size of the issue itself does not allow for the deployment of sufficient capital to meet the return threshold.

Nevertheless, panelists pointed out the there are always opportunities resulting from poor management to economic dislocation that there is no lack of potential deals.  In 2011 Versa looked at over 640 deals in 2011 and is seeing more opportunities coming in from distressed trading desks. Given the uncertainty over the elections and regulatory environment she predicts less robust M&A activity from strategics and feels that PE firms will have to look to dividend recaps for liquidity.

With respect to distressed real estate, Spencer Garfield of Hudson Realty Capital is seeing strong deal flow, albeit at higher prices than a year ago. Where they were once able to purchase pools of distressed CMBS at 18 cents on the dollar they are now seeing prices in the 30-50 cents range.  Both securitization and conduit lending have returned as many distressed CMBS deals have been cleaned up and recapitalized and can be placed in to securitization vehicles. S&P did throw a monkey wrench into the process when it without warning altered its ratings methodology for CMBS deals, but the market has adjusted.

Another area of the market rich in opportunities is special situation lending.  As pointed out earlier, the markets are open for selective credits, however, most lower middle market and small business have little or no access to bank or capital markets.  Brenden Carroll of Victory Park Capital sees a market with increasing negotiating leverage for lenders. When companies think they can access the capital markets they tend to shop deals for a long time before coming to a specialty lender such as Victory Park. However, he has seen more CEOs increasingly concerned about the operating environment who are willing to accept onerous term sheets on the first go round.  In cases of sponsor owned companies they are more willing to accept higher interest rates in lieu of equity give ups while family owned business will accept dilution in exchange for a lower yield. This is driven by fact mention earlier that sponsors need to affect a 2x return on capital, any dilution significantly impairs returns from that perspective.

Tracing the Liquidity Squeeze
As a result of the liquidity squeeze and 2008 credit contraction we saw many new players entering the distressed space.  Robert Koltai of Hain Capital pointed out that many of these players entered to take advantage of large cases such as Lehman and began trading products such as trade claims. However, outside of the Lehman complex many of these instruments are incredibly illiquid and labor intensive to administrate.  It is not clear whether these players will remain in the market absent significant new large Chapter 11 filings. While this should increase expected returns, it may impact liquidity. Liquidity has become a major factor as dealers begin to implement the Volker rule and allocate less capital to trading and holding inventory. This is likely to exacerbate volatility and have negative unintended consequences.

Another factor that will be impacting liquidity and market opportunity is the shifting of many large PE funds to their harvesting periods. It was pointed out that 6,000 companies were acquired by Financial Sponsors between 2005-2009. Given the average fund has a life of about 10 years, sponsors are going to need to star realizing investments. Moreover, there is still an overhang of $400bn in undeployed capital in the hands of Private Equity. Since they are unlikely to return the cash to investors and forgo fees and carried interest, they will need to begin to put the capital to work before the investment periods of their funds close. While these windows can be extended, it cannot be done indefinitely and it will be interesting to see how the deployment of this capital impacts the market. Assuming 4x leverage the $400bn in equity capital equates to $1.6 trillion in buying power.

Opportunities in Distressed Private Equity 
One of the more interesting panels was the Opportunities in Distressed Private Equity discussion. The participants were heavily middle market focused, and it given how picked over the large cap distressed/HY universe is more and more funds are wading into the middle market. In essence they are willing to exchange liquidity for better returns.

In middle market deals there is far less liquidity and when you enter a distressed one, you have to assume your only exits are a refi (unlikely if its in distress), sale, or restructuring and converting to equity. The returns are more akin to PE than HY/Distressed but you need to have the expertise and appropriate fund structure. Many large distressed funds have rolled out middle market platforms to capitalize on these opportunities. Interestingly, the PE firms that used to have this space to themselves are finding increasing competition from their distressed debt counterparts and are having to become more flexible, including taking non-control stakes, purchasing debt in the secondary market and making DIP loans.

Another phenomenon pointed out by Todd Feinsmith at Pepper Hamilton is that in the wake of GM and Chrysler, courts more comfortable approving accelerated sales. We have seen companies routinely using 363 sales to be out of bankruptcy in 60-90 days. These quick sales used to be frowned upon by the courts and were viewed as disguised or Sub Rosa plans of reorganization. However in the absence of financing or aggressive DIPs that were de facto credit bids, courts have become more accustomed to approving deals that usually leave junior and unsecured creditors out of the money. Most middle market bankruptcies are now filed with a Stalking Horse/Plan sponsor which can have a chilling effect on auctions or producing other viable bidders. Nonetheless, this was not evident in the recent

Hussey Copper auction where you saw companies vying for the stalking horse bidding slot and the asset was finally sold for almost 12x EBITDA.

According to Varun Bedi of Tenex Capital we have entered a Dickensian “tale of two markets” where larger companies with international diversification have access to capital while smaller domestic companies do not. This creates opportunities for funds such as his that have significant operating expertise.

Most middle and lower middle market companies are experiencing gross margin pressure from both rising input and energy costs.  Their lack of international diversification makes it hard for them to generate pricing power and leaves them vulnerable to deflating consumer demand in the US.  At this point these companies have taken out most of the low hanging fruit in their SG&A and now need to restructure their balance sheet and pursue more operationally intensive restructurings.

Another factor impacting these companies is that deferred capex which has moved from 4% of revenue to 2% of revenue over the last couple of years. This leaves little opportunity to drive growth and generate the necessary working capital to fund expansion. Given that we are likely in protracted period of below potential GDP gowth, or worse potential GDP is has moved lower, these businesses will need to restructure and recapitalize.

As mentioned earlier Distressed PE firms are seeing increasing competition from their distressed debt counter parts. David Simon of Littlejohn & Co pointed out the need for increased flexibility and creativity in structuring deals including finding ways to effect control without having 51% of the economic ownership through board control or other provisions.

Moreover, PE firms are becoming more active in the secondary debt markets as way of being in position prior to a trigger event.  In general, he has found that the PE funds and Hedge Funds are a good compliment to one another as most hedge funds do not have the infrastructure or operating principals to manage businesses and are more than willing to let the PE firms handle those aspects.

As far as future opportunities, Littlejohn expects corporate carveouts to be a good source of deal flow as companies have now stabilized from the 08-09 dislocation and are willing to divest lagging businesses. It was also noted that while in distressed for control transactions funding is still available, the diligence process has become much more disciplined and takes far longer.

In concluding the Distressed Private Equity panel, Mr. Simon provided an interesting observation with regards to corporate turn arounds.  It is getting more difficult to attract and retain top talent even in light of significant equity should the turnaround succeed. In most cases these positions are not in the most desirable locations and younger executives are less apt to stay for the duration of a turnaround.

Trends and Opportunities in Distressed Investing 
The morning session concluded with panels covering trends in distressed investing as well as one covering domestic opportunities. One of the trends highlighted was the changing structure of many distressed and PE funds. Many distressed funds were structured to offer quarterly or annual liquidity during the credit bubble because that made it easier to attract fund-of-funds money. However, this had a disastrous effect during the 2008-09 period as many funds were hit with a wave of redemptions when they needed to be deploying capital. In addition, many distressed funds had suffered from style drift and had taken on large amounts of leverage through TRSs in order to flip new issues and juice returns on leveraged loans.

In the aftermath funds are now looking to lock up capital for longer periods and we are seeing longer lock ups as well as PE based structures with investment and harvest periods and 5-10 year locked up money. Better matching of assets (investments) and liabilities (investor capital) is critical for the distressed asset class where a bankruptcy can last several years or an operational turn around can take several year to realize. As was mentioned earlier PE funds are also having to adopt as more  distressed funds move down market and are taking larger, less liquid stakes in private companies.  The morphing of the PE and Hedge Fund structure is likely to continue in the distressed space as PE funds seek the ability to invest in debt instruments and hedge funds look for more stable capital.

Micahel Cerminaro of Sound Harbor Partners pointed out that funds need to have the flexibility to pursue opportunities that maximize risk-adjusted returns across the capital structure. The ability to capitalize on senior secured loans with high teens to low 20s IRRs is essential when there are fewer opportunities to write larger equity checks for control.

Having the right structure including being able to make your pref return (usually around 8%) and still generate a sufficient return is essential. This may include more flexible recycling provisions and the ability to utilize side cars with you LPs when necessary. Duran Curis of Ocean Avenue Partners which invests as both an LP and a co-investor relayed that they want to be active in investing alongside the GPs in order to maximize returns and minimize the drag from fees. Again we are seeing increasingly more creative structures as funds learn from the 2008-09 and adapt accordingly.

In addition to trends in fund structures, Robert Kline of R.W. Kline Companies which specializes in distressed commercial real estate is seeing opportunities in discounted note purchases and restructurings of CMBS tranches. They have been active in recapitalizing and restructuring distressed CMBS pools and are seeing a lot of interest in Real Estate assets, particularly luxury hotels which have attracted sovereign wealth funds attracted to their premium brands.

Another trend in the lower middle market space was highlighted by Raquib Abdullah of BFG Holdings which specializes in distressed lending and private equity for small and middle market businesses. They generally offer debt financing at reasonable rates (12-15%) to privately and family owned businesses in exchange for taking a large share of equity 50-80%. Unlike traditional sponsor owned companies, these businesses are willing to give up large shares of equity in order to keep their businesses afloat.  Mr. Abdullah has seen more of these opportunities being sourced from banks who need to clean up their balance sheets and are looking to move problem loans and avoid liquidations which will yield de minimis  recoveries.

In the next article we will cover some interesting topics including the impending maturity wall, risk management and economic fundamentals for the US and Europe as well as the global macro picture. Stay tuned.


Anonymous,  2/10/2012  

"From a distressed PE perspective this has limitations given their focus on a 2x return on capital, not an IRR. In many instances there is not enough of the loan available or the size of the issue itself does not allow for the deployment of sufficient capital to meet the return threshold."

If anyone wants to take a moment to explain this concept, I'd appreciate it. THANKS!

Anonymous,  2/13/2012  

From Author,

PE funds target a return that is 2x the capital invested, so if the fund starts off with $100mm, they must grow that to $200mm. They do not target an annual IRR on an individual investment per say.

Also, when a PE fund invests its capital it executes a capital call to its LPs. If fund cannot deploy the amount of capital it wanted to in the investment (which may be the case with distressed loans or bonds) they will have difficulties achieving their hurdle.

PE funds are structured differently from hedge funds. For one PE funds are not co-mingled the way hedge funds are. PE funds raise fund I,II, II etc, while hedge funds generally take money into a comingled pool (ignore on-shore/off-shore for simplicity) In exchange for locked up money, PE funds pay a pref return of 8-10% before they can receive any of their carried interest. This again influences their need to target a 2x return, rather than an annual IRR.

I hope this was helpful.

jnasr 2/13/2012  

I would frame the point differently. Because hedge funds have evergreen pools of capital, any realization in their portfolio can be invested in another investment. Thus they can compound their capital through multiple investments, whereas private equity firms have to compound their investment through a single investment. IRR and multiple are inextricably linked, but the PE fund must look at a single transaction's IRR and multiple, where the hedge fund can simply focus on IRR.

Anonymous,  2/14/2012  

True, although many PE firms now have the ability to recycle during the entire investment period as well as add to existing portfolio companies during the harvest period.


hunter [at] distressed-debt-investing [dot] com

About Me

I have spent the majority of my career as a value investor. For the past 8 years, I have worked on the buy side as a distressed debt and high yield investor.