A time to invest in distressed debt?

Investing in private markets can make sense during volatile times, with the opportunity a selloff offers for private funds looking to deploy cash. With a sharp, but likely relatively brief, recession beckoning, this is particularly true for a strategy like distressed debt.

What is a distressed debt strategy?

This strategy focuses on acquiring a company’s debt at a fraction of its value and working with the company to restructure the overall debt. The acquired debt can be at any level of the entity’s capital structure. The debt may be regarded as distressed due to perhaps idiosyncratic reasons, a company may be overleveraged, suffer from a blow to its cash-flow, or an event affecting many companies like a global recession.

A good environment for distressed debt investing

The COVID-19 outbreak has caused many businesses to halt operations. While a traditional recession usually results in a slowdown, the confinement measures put in place to contain the virus have brought activity in some sectors to a complete stop.

Despite the unprecedented fiscal and monetary measures announced globally in recent weeks, many companies will have burned through much of their cash reserves and find it much tougher to service their debt. The tough times are reflected in public markets, with US high yield spreads reaching 1,100 basis points in March. Based on historical data, this suggests that default rates could increase towards 10% from 3% in the first months of 2020.

Cash ready to be deployed

Around 35% of assets under management, for the distressed debt funds tracked by financial data provider Preqin, are held in cash. This amounts to $65bn of cash ready to be deployed.

Anecdotal evidence suggests that institutional investors’ appetite for distressed debt funds is increasing as opportunities arise in the sector. Downturns not only offer opportunities in public markets but also in private ones. This is particularly true for distressed debt funds.

While the median net internal rate of return (IRR) for such strategies is usually lower than other private equity or private debt alternatives, the severe crisis seen in 2008 helped distressed debt provide the best net median IRR across all private capital strategies, according to Preqin data.

Enhancing portfolio diversification

Distressed debt funds can provide welcome diversification to a portfolio in periods of stress, when many asset classes move in lock-step with each other. While traditional portfolios tend to suffer during global recessions, distressed debt assets can prosper during economic downturns.

The distressed debt index is negatively correlated, or moves in the opposite direction, with global equity and commodity indices, two asset classes that are typically impacted the most during a downturn. The performance of equities and commodities since the COVID-19 outbreak confirms this vulnerability.

Investments can fall as well as rise in value. Your capital or the income generated from your investment may be at risk.

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