In recent years, investors have become increasingly concerned that many traditional growth assets, like developed market equities, are hovering near all-time highs. At the beginning of May, the S&P 500 hit 2,945, double the level of January 2013, while the MSCI World Index was near its all-time record set in January 2018. Meanwhile, low yields from income assets are frustrating investors who require a certain level of returns to meet their liabilities.

1. More money is arriving

These two trends have already directed investors to look at alternative assets, but the prospect of an economic downturn has stimulated interest in distressed debt and special situations opportunities.

“In this environment, where yields are generally low and many asset classes seem at, or near fully-valued levels, we find there is strong appetite for distressed debt globally, including in the UK and Europe,” says Brad Bauer, partner and deputy chief investment officer at Värde Partners.

Bauer explains that there has been a build-up of corporate leverage in Europe and investors have been increasingly mindful of headlines suggesting geopolitical headwinds and the prospect of additional economic distress.

2. Fund managers are under scrutiny

However, with lots of new money arriving into the sector, experts are warning investors to scrutinise the skillset of their chosen fund manager. JPMorgan advises investors to look for “continuity” and “experience” along with “strong sourcing networks” to find top notch opportunities.

Prior to the global financial crisis in 2007, real estate managers faced a similar problem. The arrival of large sums of cash in quick succession forced some managers to deploy cash too quickly in assets they didn’t fully scrutinise. When the crash happened, some saw their funds wiped out.

3. New launches are everywhere

One of the upsides of greater investor interest in distressed debt is that there are an ever-increasing number of funds to choose from.

Since the start of 2019, there have been new launches or fundraisings from a host of major players including Cerberus, Contrarian Capital, Ninepoint and Safe Harbor Equity.

“There is a huge amount of dry powder chasing deals,” explains David Ampaw, a partner at DLA Piper. “There is huge demand for distressed debt across Europe. The proof of this is evidenced in the multi-billions raised by a number of regular distressed debt investors as well as by newer entrants.”

4. Investors expect geography to determine returns

Despite the keen interest in distressed debt and special situations more broadly, fund firms are warning that the opportunity set may be riper in some geographies than others.

Duncan Farley, a portfolio manager with BlueBay Asset Management, says: “Within oil and gas, there is always a good constant source of opportunities, including US shale. We are also seeing a growing emergence of problems in Germany, in the industrials space, and issues relating to how a fall in Chinese demand is hurting the automotive market.”

Värde Partners’ Brad Bauer said he is focused particularly on markets where there are “systemic problems that drive motivated sellers” or where there are gaps in capital availability.

5. New opportunities will come from downturn

Market participants believe that any global downturn will result in a shake-out of opportunities in the distressed market. As a result, fund firms have been bolstering in-house expertise in anticipation that market experience will be useful. In its 2019 distressed debt outlook, JPMorgan concluded that the risk of a global recession “in the next few years” underscores the need for investors to seek out a fund manager with multiple private credit strategies that include both special situations and distressed debt.

Words of wisdom

PDI recalls some standout quotes on distressed debt opportunities and special situations over the past year

“This situation cannot continue, especially at a time of weakening economic growth.” 

Christoph Rieche, CEO of lending platform Iwoca, in a statement commenting on UK finance data, showing that since 2011 the number of approved business overdrafts in the UK has declined by nearly 30 percent (July 2018)

“Smaller enterprises, the backbone of the economy, are suffering under the weight of high costs, skills shortages, and weak productivity.”

Tej Parikh, senior economist at the Institute of Directors, on a business leaders’ survey it conducted that showed UK business confidence plunging to new lows (September 2018)

“The prospect of a severe downturns has strengthened the case for more explicit safeguards on investment portfolios.” 

Toby Goodworth of bfinance on a report showing investors gravitating to “explicit” downside protection strategies (February 2019)

“If historical trends persist, in the event of a credit crunch, approximately 10 percent of BBB-rated debt could transition to the high-yield universe […] Catching fallen angels may very well be a major theme when this credit cycle turns.” 

2019 Private Equity Market Outlook, TorreyCove Caital Partners (February 2019)

“Standards for credit issuance have been very loose. And so, all things being equal, the defaults will come later than they otherwise would have, but they’ll probably be worse.” 

Howard Marks, co-chairman of Oaktree Capital Management, on the covenants packages, or lack thereof, on the asset management behemoth’s fourth (March 2019)