The COVID-19 crisis has produced fewer opportunities for European distressed debt investors than many had hoped for this year, as liquidity from central banks and governments artificially keeps borrowers afloat, according to fund managers. Because of this situation, these investors will need to look beyond the leveraged loan and high-yield bond markets to create returns.
Distressed debt and special situations funds, which profit from buying debt or assets at deep discounts, have $131.8 billion of cash — or dry powder — to deploy globally as of November this year, almost 40% more than five years ago, and 150% more than ten years ago, according to Preqin. Yet, five-year returns of 3.2% through to March this year for distressed debt funds are well behind returns seen from other private debt strategies over the same time frame, such as direct lending (which returned 4.2%) or mezzanine (with 7.6%), Preqin data shows.
The record collapse of debt prices in March — when the S&P European Leveraged Loan Index (ELLI) and U.S. S&P/LSTA Leveraged Loan Index (LLI) fell to 11-year lows of 78.92 and 76.23, respectively — had many bargain hunters hoping they would find plenty of targets through which to deploy their cash, after an elongated credit cycle with low defaults.
Yet, managers say they were left disappointed with the amount of such opportunities available, as the window to invest at steep discounts or buy into a company in restructuring or insolvency was cut short by the scale of central bank liquidity pumped into the financial system. Government interventions such as eliminating directors’ obligation to file for insolvency in some countries has also kept the number of defaults artificially low, sources say.
"There has been a window of opportunity of around 3-4 months this year amid the market dislocation in March, but overall the opportunity for deployment in stressed and distressed debt opportunities has disappointed given the amount of liquidity in the market and government interventions this year have shielded many critical situations to evolve," says Hans-Jörg Baumann, partner at private debt and equity investment firm StepStone Global.
Unlike during the global financial crisis in 2008, there were very few forced sellers this year, especially in the lower-rated leveraged debt markets, while debt prices recovered much quicker from their lows in March, market sources add. "If you are not forced to sell, then you don’t really sell. I see very few transactions this year in the distressed space. There have been opportunities in the property space and some publicly listed opportunities, but generally no major restructurings," said another manager at a prominent distressed investment fund.
CVC Credit Partners' recent move to trim down its distressed debt strategy and instead build out its private credit platform is understood to be partially prompted by the lack of opportunities in the distressed space. The firm has let go a number of managing directors from its Credit Opportunities and Special Situations team in London, while some have moved to CVC's large-ticket primary credit platform.
How quickly discounted debt prices can be eroded was seen recently in the syndication of the debt backing U.K. gym chain PureGym Ltd. The debt was due to be marketed to investors in March, but lockdown measures to curb the spread of the COVID-19 pandemic thwarted plans to sell the deal. A number of distressed debt investors said they were ready to buy PureGym's debt in the high-80s (cents to the euro), but news about a potential new vaccine led to debt prices rising, and special situations funds walked away when the debt was offered at 90 cents to the euro, distressed debt buyers comment.
This is not to say there have been no specific opportunities for funds to get involved in this year, however. The volume of defaults and debt restructurings across the European leveraged finance market by total debt has risen to €34.8 billion as of November 20, from €13.8 billion in 2019 and only €5.6 billion in 2018, according to LCD, as the coronavirus crisis caught a number of firms in the much-cited travel and leisure exposed sectors off guard, or pushed firms such as restaurant chains that were already in distress last year into further turmoil.
This backdrop has allowed loan-to-own investors to step into some situations, such as luggage handling firm Swissport International AG, whose equity will be taken over by lenders including distressed debt giant SVPGlobal, which invested in Swissport bonds at a discount. Returns for special situations managers are also boosted by providing new liquidity lines to businesses with cash crunches.
Opportunistic investors have also profited from buying debt at heavy discounts in secondary markets and selling at higher prices when markets have recovered. French industrial firm Vallourec SA is a case in point, with its bonds trading as low as 45 in March, to recover to close to 70 in June. The firm is now being restructured, and some funds say they see further value in the name through a debt-for-equity swap. There is also a list of credits, including names such as Lowell and Aston Martin, that traded at stressed or distressed levels (below 80 in the secondary market) that are attractive to distressed buyers and which moved back up after having been refinanced at par following support from shareholders.
These opportunities mean global managers will continue to raise funds, as SVPGlobal, for example, in October, completed a close of its new Strategic Value Dislocation Fund, for which $1.65 billion of capital was raised in roughly four months this year — entirely through virtual meetings.
Cycle to work
Still, the distressed investment cycle has not yet fully played out. "In the global financial crisis, we saw a much longer-term opportunity across multiple sectors. In the current crisis, we have seen a great shock, but it is not yet a broad distressed opportunity set, but rather more of a special opportunities theme," said Graham Rainbow, co-chief investment officer at Alcentra (which runs various debt investment strategies, including special situations). “We think defaults will continue to go up, but not to the 8.5% levels or higher in the next six months, which were previously expected".
Meanwhile, fund managers at a distressed debt panel organized by WM Group last week said that opportunities are currently being found beyond the European leveraged loan and high-yield bond markets, in areas such as the hotel and property spaces (with a focus on office buildings), and airline securities, which are offered at steep discounts, according to panelists.
What’s more, industry players expect a rush of non-performing loans currently sitting on bank balance sheets to be sold as soon as bank lenders have stopped dealing with providing state-backed loans in Europe. "I think banks have been too busy dealing with KfW credits [firms taking debt provided by German state-owned bank KfW Bankengruppe as part of that country's coronavirus emergency loan scheme] than with the sale of non-performing credits," said one of the panelists. Finally, another asked whether "Once central bank liquidity and government interventions are stopped, and borrowers need to refinance, will the distressed opportunities get more interesting?"