Companies are referred to as being distressed when there is doubt about their ability to service or refinance debt, creating a high likelihood of default. Most holders of corporate debt aim to avoid incurring defaults in their portfolios or becoming embroiled in restructurings. Many are inclined or forced to sell with little regard for value. This affords specialists the opportunity to acquire debt at attractive discounts to expected recovery, in companies that should emerge from a restructuring far healthier.

Most speculative grade companies, lured by tight credit spreads and relatively low interest rates, took on historically high debt relative to earnings when financing or refinancing their businesses in 2005-2007. These highly leveraged capital structures were often predicated on aggressive projections for earnings growth. When the bank loan market ground to a halt in mid-2007, doubts were raised about the market’s willingness to refinance this debt and when the financial system froze in the autumn of 2008, a massive 72 per cent of the US and European leveraged loan and high yield bond market traded to levels usually considered distressed.

Though driven by fearful and forced selling, prices reflected the reality that a huge proportion of speculative grade companies will almost certainly have to undergo some form of debt restructuring. Those with more cyclical earnings or near term debt maturities have already been forced to confront this reality, causing a surge in defaults. In the 12 months to September 2009, 19.5 per cent of US speculative grade debt rated by Moody’s experienced an event of default. In percentage terms, this equals the peak in 2002, but the total face value of $229bn (e152bn) is more than double the 2002 total, with a further $400bn continuing to trade at distressed levels.

While some of these defaults were triggered by bankruptcy filings that will result in a meaningful reduction in debt, many took the form of distressed exchanges that have resulted in only modest deleveraging. Many more companies avoided default altogether as wounded creditors opted to amend or waive covenants, while the remarkable revival in high yield bond issuance in 2009 has provided a further lifeline for companies to improve near-term liquidity, without necessarily addressing total leverage. In fact, many are more leveraged today as a result of widespread earnings declines. S&P notes that scheduled principal repayments for speculative grade companies do not peak until 2014, suggesting that bankruptcies and out of court restructurings will remain at elevated levels for several years, across a diverse set of industries.

The vast majority of investors in corporate debt do not have the mandate, investment horizon or analytical resources to behave in a recovery maximising manner. Most are driven by yield and constrained by credit ratings, meaning they have little appetite to hold defaulted, possibly non-performing debt through a protracted restructuring. Few can dedicate the resources required and, given typical portfolio diversification, maximising recovery on any one name would have negligible impact on overall performance. As a result, they frequently sell at or in advance of default with little regard for potential recovery.

Specialist funds and the proprietary trading desks of investment banks have historically acted as buyers, providing liquidity to traditional investors. With exposure to distressed structured credit already absorbing banks’ risk capital, ‘prop desks’ are not currently competing with the specialist funds. As a consequence, by far the biggest ever supply of distressed and defaulted corporate debt, with several years of robust restructuring activity ahead, is being met by much lower demand than previously anticipated. This is creating opportunities to acquire debt with a wider margin of safety than in prior cycles, offering greater excess returns.

Investing in distressed companies subject to restructuring events provides a highly idiosyncratic source of return and risk. Specialist ‘distressed funds’ target companies with solid franchise or asset value to support recovery, with more senior layers of the capital structure generally posing lower risk and more junior layers higher risk. Clearly the strategy should not be viewed as a source of funds during periods of heightened systemic risk, but the liquidity of individual investments normally varies according to the nature and size of holdings.

Face value of defaulted and distressed speculative grade debt, US and Europe

Private equity distressed funds typically seek to gain control of distressed companies through accumulating debt that will be exchanged for a majority holding of new equity under the restructuring plan. This may allow them to install management, oversee an operational turnaround and exit when capital markets are prepared to rerate the company. Control positions are inherently illiquid and easier to establish in mid-sized companies, both of which necessitate a long investment horizon.

Distressed funds with a shorter horizon rarely seek control, but may sit on creditor committees to actively protect their rights. Nearer-term exits are afforded by events integral to the restructuring, through the secondary market or cash distributions in the case of liquidations. Smaller, more nimble funds can trade around positions as market sentiment diverges from or converges with expected recovery and can recycle capital from one situation to the next.

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