Published on June 10, 2022 by
Acuity Knowledge Partners' Private Equity (PE) team shares concerns about the pandemic’s global impact. However, the current market situation has shifted the focus of PE firms and credit investors, possibly making this the best investment scenario for distressed debt investing since the global financial crisis.
We have seen significant growth in debt outstanding, deepening excesses, over-leverage and deteriorating investor protections such as a lack of covenants as laying the foundations for a major distressed investment opportunity.
These factors, coupled with the economic downside due to the pandemic and the oil-price shock, as well as the knock-on effects on issuers’ balance sheets and liquidity, have created what we believe will be a very large and attractive distressed investment opportunity. Credit markets have not yet reached peak (distressed) levels witnessed during the global financial crisis.
There are several key differences between this distressed cycle and the global financial crisis: there is now more than 2.5x below-investment-grade and BBB-rated debt outstanding. Past cycles saw one or two years with a double-digit default rate on high-yield bonds:
This suggests significantly higher defaults, assuming a similar rate on a larger amount of debt
Little competing capital, with only USD60bn+ of dedicated distressed debt dry powder currently
Global central banks have far less flexibility to use monetary policy to dampen the cycle
China’s growth engine is no longer a source of dependable secular growth
Market infrastructure, such as dealers, is limited in its ability to provide liquidity to holders of credit, which are larger than ever, creating even more opportunities for distressed debt investors
Immediate opportunities in the distressed markets
Just a few years ago, opportunities were concentrated in a few key sectors in the US and Europe such as energy, telecom, healthcare and retail, as well as some private opportunities in Europe and Asia such as recap lending, platforms and NPLs. These opportunities have now expanded.
We see a significantly broader set of opportunities, including in airlines, cruise operators, automotive OEMs/suppliers, hospitality, gaming and entertainment, and primarily in liquid securities.
We recommend that investors approach the opportunity set with prudence given the level of economic uncertainty and focus on the following method:
Stay senior in the capital structure, sticking to quality and diversifying holdings
Target companies that have the best staying power and the liquidity to weather the storm
Avoid fulcrum securities (focused on debt that will stay debt)
Seek returns through capital appreciation as opposed to debt that would provide a claim on assets through a potential restructuring, although restructuring opportunities are likely down the road and investors would be ready to take advantage of them when the time is right
We expect the economic aftershocks to broaden, likely leading to an expanded opportunity set, including rescue financings or restructuring targets
Time to raise new focused funds
We expect the current environment to last a while, until the economic aftershocks of this crisis work their way through the global economy.
It is becoming increasingly clear that companies of all kinds are likely to see revenue declining faster than costs, creating cash flow problems. This may be exacerbated by limited or no access to the capital markets during this unique period of dislocation. New distressed funds would attract more commitment, existing dry powder would be fully deployed and investors would have more return in their bank accounts.
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