The lack of economic stress is becoming increasingly distressing for some firms.

Let’s be clear. Boom times are good – more companies have healthy balance sheets and more people are employed – but there’s also a subset of the investment world rooting for a turn in the credit cycle: the ones that make their livings from turmoil.

Sustained volatility in the fourth quarter of last year left distressed debt managers expecting a wave of defaults – or at least some businesses encountering hard times. But markets bounced back quickly, leaving turnaround specialists crestfallen.

It’s been the curse of distressed debt managers during the current cycle. In 2015, there was a rout of commodity prices and, early last year, stock markets began a rollercoaster ride. But no sustained downturn has kicked in.

The continued economic boom and persistently low default rates have put investors in a predicament. Should the strategy have a home in their portfolios? For those that do commit to it, how do they pick managers in the good times, and what is a fair fee structure when returns are depressed? These are not easy questions to answer.

Distressed debt funds have shown sub-par performance compared with private equity funds (not including funds of funds or secondaries), according to PitchBook data. The firm includes special-situations vehicles in its definition of distressed. In theory, private equity and distressed debt are comparable because distressed debt investors aim for equity-like returns. Cambridge Associates notes that the gross internal rate of return targets for distressed debt and special situations are both in the mid- to high-teens.

“Special-situations lending return targets typically range from 15-20 percent gross with multiples of 1.5-2.0x,” says Jess Larsen, a partner and head of the Americas at advisory firm First Avenue Partners. “Returns are manager- and vintage-dependent in the private markets world. A net return of low-teens over a cycle is pretty satisfactory, given the current opportunity set.”

But according to PitchBook, the one-, three- and five-year net IRRs for distressed debt for the period ending 30 June 2018 were all below 9 percent, a figure within the target range of many leveraged direct lending vehicles. Distressed debt had an annualised 12-month net IRR of 8.23 percent at the end of the second quarter of 2018. The three- and five-year returns were 7.41 percent and 7.86 percent, respectively. By comparison, the annualised one-, three- and five-year returns for private equity funds were 14.78 percent, 13.49 percent and 15.10 percent.

Even over the longer time horizon, 10-year returns for distressed debt funds stood at 8.89 percent, a notably low figure given that it includes global financial crisis-era funds. The 15- and 18-year return figures were 9.73 percent and 9.84 percent.

Most importantly, how do limited partners invest in a strategy predicated on letting the bad times roll when the last decade has largely been the era of easy money? The longer the economic cycle goes on, the more pertinent the question becomes. Surely the good times can’t continue for ever?

Distressed? Not me

“There has been very little distress, only a modest ability to buy at low prices, and so this has been a very tough period for distressed debt”

Howard Marks, Oaktree Capital Management

Looking at the return figures, some LPs have come to a simple conclusion: don’t commit capital to these funds – at least at the moment.

“We have not yet committed to a lot of standalone closed-end corporate distressed vehicles at this time,” says Eunice Han, who works in manager research at consultancy Willis Towers Watson. “The primary reason we have not done so is because default rates are still low and the opportunity set remains limited. We have seen certain corporate distressed strategies underperform, particularly those focused on the large situations.”

PDI data show distressed fundraising plunged in 2018, having increased over the three previous years. In 2015, distressed debt made up 19.3 percent of capital raised globally. In 2016, that figure rose to 23.7 percent, and the following year it jumped to 31.5 percent. In 2018, however, distressed debt made up just 17.38 percent of the total private debt capital raised.

Distressed investing guru Howard Marks concedes that returns in this part of the market have not been living up to investors’ expectations. However, Oaktree Capital Management’s co-chairman claims this is predominantly because their expectations have been too high. “What return should you expect from distressed debt investing when the world is not distressed?” he asks. “No asset class has the birthright of a return. A return comes from bearing risk, buying things well, maybe getting lucky on the way out, adding value while you own it. There has been very little distress, only a modest ability to buy at low prices, and so this has been a very tough period for distressed debt.”

The global financial crisis presented a textbook scenario for distressed debt managers. What it did was sort the wheat from the chaff.

“What you had in the GFC was a breaking and testing point for some distressed managers,” says Robert Crowter-Jones, head of private capital at Saranac Capital Partners, a wealth management specialist. “Some were in a position to monitor and work out those investments. Looking at that period, you get a real sense of how the portfolio performs during severe stress. Since then, distressed managers’ returns have been more linked to individual loan selection.”

Chris Gort, founding partner of Zurich-based consultancy SIGLO Capital Advisors, gleaned some insights into distressed debt performance during the crisis, when he was at fund of hedge funds Harcourt Investment Consulting.

“What I saw was several distressed debt managers making a ton of money from March 2009 onwards,” he says. “But there were also idiosyncratic opportunities. The dispersion of manager performance and their risk appetite was significant, from returns of 200 percent at one end of the scale to marginal gains at the other. Therefore, it’s very difficult to generalise.”

Daniel Zwirn, chief executive and chief investment officer of fund manager Arena Investors, notes that there can be incentives for distressed debt managers to time the credit cycle, but that this often does not work out well (see also p. 14).

“When capital is raised for the strategy, it implicitly creates an incentive for the manager to speculate on the entry point as well as pressure to deploy the capital,” he says. Zwirn likens this to providing a hammer to managers, who will “only see nails”.

The Employees Retirement System of Texas has not made a distressed debt investment in several years. However, Sharmila Kassam – who spoke to us in May shortly before her departure from the pension, where she had been deputy chief investment officer – sees potential in the distressed market on the horizon: “The best time to invest in distressed is when valuations are significantly lower.”

The bull market is contributing to high valuations across the board, which is part of the pension fund’s reasoning against making recent commitments to the strategy. However, Kassam does not rule out distressed debt and says pension funds want and need to be ready for distressed investing when the credit cycle turns.

Some investors remain drawn to the strategy, even in good times. Those that are emphasise the need to pick a manager that can take advantage of idiosyncratic opportunities – such as the massive Pacific Gas & Electric bankruptcy filing that arose from tens of billions of dollars in liabilities after the California wildfires.

“We try to find good managers independent of the cycle,” one CIO at a university endowment says. “We stay focused on the managers that are better at some of the complex workouts rather than those that just sit around waiting for bond spreads to gap out. We would favour what we call the complexity premium.

“What that has also led us to do broadly speaking is to favour smaller managers. If you’re a bigger manager, that’s a positive in terms of trying to buy control, but you’re loading on a few larger deals rather than diversifying your portfolio.”

Disregarding the cycle

Saranac’s Crowter-Jones echoes the notion of finding firms that perform well no matter the stage and state of the credit markets.

“We’re looking to managers to find interesting returns across the cycle,” he says. “We find opportunities to deploy capital with distressed managers [which perform well] after a period of economic headwinds to the strategy.

“In distressed debt we’d look for managers to have a deep understanding of insolvency and workout processes, to be able to respond to challenging situations effectively.”

First Avenue partner and head of the Americas Jess Larsen points to transactions where requisite ticket sizes are much smaller as an area of potentially underappreciated investment opportunities.

“There probably is more distressed activity in the middle market than what is reflected in current default rates,” he says. “Perennial opportunities exist because smaller companies experience idiosyncratic financial issues outside the broader default cycle.”

In Europe, distressed debt managers may have more reason to be optimistic than those in the US. Brexit and disappointing economic performance in the eurozone have created interest.

“The buying opportunity has remained with the banks’ non-performing loans [in Europe],” Larsen adds. “The US market is much more cyclical in nature.”

There is no sense – yet at least – that anything in Europe is approaching the magnitude of the 2008-09 wave. However, SIGLO’s Gort is taking a greater interest in distressed strategies. The key, he says, is to identify the best managers to back before a crisis – “when the sun is shining” – rather than when investors are in the thick of it.

For those that do commit money to distressed debt vehicles, returns can show plenty of variance.

“It is hard to pinpoint how realised returns are different compared to proposed returns as we have not exited yet,” says Jang Dong-Hun, chief investment officer of Korean pension fund the Public Officials Benefits Association. “But from what we have studied about invested funds and their peer group, the performance levels were fluctuating a lot.”

According to PitchBook, post-GFC funds that have probably completed their investment periods – those with vintage years from 2010 to 2013 – show a wide range of net IRRs.

Distressed funds launched in 2010 and 2011 have returned median net IRRs of 11.46 percent and 10.00 percent respectively, largely meeting return expectations because of post-GFC turmoil. Vehicles with vintage years 2012 and 2013 posted returns of 7.58 percent and 9.93 percent respectively.

Mikael Huldt, head of alternative investments at Stockholm-based AFA Insurance, believes that because distressed managers tend to get in and out of situations rapidly, the strategy tends to deliver in IRR terms but not on a return multiple basis.

“Stress periods tend to be over very quickly, within weeks or months,” he says. “Firms make a number of investments and then look to refinance, and it has become a short-duration market as there is so much liquidity.”

Funds from 2010-13 have posted a range of figures for median total value to paid-in multiples. The 2010 and 2011 funds have TVPIs of 1.38x and 1.49x respectively, while the 2012 and 2013 vehicles reported respective TVPIs of 1.22x and 1.31x.

However, there is also a wide variation in returns from funds in the same vintage. Take 2010, for instance. The top quartile posted a 14.09 percent net IRR, while the bottom quartile reported 3.14 percent. On a TVPI basis, 2010’s top and bottom quartiles returned multiples of 1.54x and 1.25x respectively.

For 2012, funds in the top quartile returned 12.48 percent, while those in the bottom quartile returned 2.35 percent. On a TVPI basis, the returns for the top and bottom quartiles stood at 1.38x and 1.08x.

 “Distressed, as it is now packaged as an alternative strategy, is highly dependent on a ‘market call’ regarding when it is the right time to jump in”

Daniel Zwirn, Arena Investors

One hot topic that often crops up in conversation is the relationship between distressed debt and special situations – and whether it’s possible to switch successfully between the two.

Sources say some distressed managers have managed to keep the lights on during years when genuine distress has been thin on the ground by diversifying into special situations. But something for investors to stay alert to is the fact that although a crisis is good for distressed, it is generally tougher for non-distressed special-situations investments. Switching from one to the other at the right time is therefore a difficult feat to pull off.

“Special situations is a catch-all and covers a lot of different strategies,” says Tim Atkinson, a principal in consultant Meketa Investment Group’s London office.

“It often involves companies that have some issues where the investment is in the middle or at the bottom of the capital structure so, if there’s a downturn, these companies will be very sensitive to it. Because of this we are starting to move into distressed a bit more now, and away from special situations.”

Patience is a virtue

He has no concerns about money being ready to flood into distressed when the opportunity crops up. “Managers have had to diversify into other areas, but that’s a good thing as it allows a distressed strategy to be patient,” he says.

“Some managers have certainly gone away or got smaller. But I think the capital will be there when the next crisis comes along. There’s a lack of attractively valued high-return opportunities, so people remain keen to support distressed.”

The special-situations label seems to generate impressions of a wide-ranging strategy from others as well, and the concept of distressed debt may have evolved with it.

“I think it depends on each house’s definition,” POBA’s Jang says. “For instance, some use the terminology of ‘special situations’ to broaden their investment scope to invest in other products, like CLOs. I think the traditional meaning of a distressed debt strategy has been transferred into a broader definition now.”

First Avenue’s Larsen adds: “Classic distressed investing is generally more correlated to the market cycle than special situations.”

Distressed investing, many say, is dependent on timing. But Arena’s Zwirn – a hedge fund legend from his time spearheading the multibillion-dollar DB Zwirn – agrees with Larsen, and has a blunt message for those who think they can predict the next distressed cycle.

“Distressed, as it is now packaged as an alternative strategy, is highly dependent on a ‘market call’ regarding when it is the right time to jump in,” he says. “Few if any investors are capable of making profitable market timing bets which combine a view on macroeconomics as well as the behaviour of other market participants. How do you get conviction around something which is so empirically unpredictable?”

That’s a question many LPs may be asking themselves as they scan the horizon for signs that different market conditions are on their way.

Fees in focus

With an array of results comes the question of fees. Distressed debt vehicles are blurring the line between credit funds and their private equity equivalents. 

“A 20 [percent carry over an] 8 [percent hurdle rate] is pretty typical,” says Haroon Chishti, a director at advisory firm First Avenue Partners. “If it’s a new manager, it may need to drop its management fee to as low as 1.5 percent. Management fees are typically charged on invested capital.” The firms that have been able to keep charging top dollar are the ones that have consistently outperformed their peers and relative indices. “The top-tier managers have been able to retain their headline quotes and pay near full rate,” says a university endowment CIO. “If you’re not in the top tier of that industry, there’s been pressure on the fees for years.”

Tim Atkinson of Meketa Investment Group says one of the biggest challenges for backers of distressed strategies is reaching an appropriate arrangement on fees: “If the [management] fee is based on committed capital, there’s less incentive to put the capital to work. But if it’s on invested capital only, then there may be less scrutiny in how they are putting capital to work. Or you can have a hybrid fee, where some of it is based on committed and some on invested. Identifying the right fee structure is important given that distress-focused capital may spend a long time sitting on the sidelines as optimum conditions take time to materialise.” For its latest flagship distressed fund, Oaktree cut the fees its LPs pay while distressed situations are scant.

Then there’s the carried interest: it’s the easiest figure to explain and can generate unflattering headlines. “We want our clients to be aligned and pay appropriately for alpha,” says Eunice Han of Willis Towers Watson. “If you think about how corporate distressed-focused strategies have done recently, versus liquid performing markets, some might say the fees appear a little high [compared with] the alpha they’ve generated.”

The same but different

There is a grey area between special situations and distressed debt funds. Should they really be seen as part of the same category?

Jess Larsen of First Avenue Partners says he has “always viewed distressed as a sub-strategy of special situations”.

Many GPs view it this way too. Atalaya Capital Management’s founder and managing partner, Ivan Zinn, runs a Special Opportunities fund series. “From an investor’s perspective, that ‘distressed’ label is a relevant strategy for only three out of 10 years,” he told PDI in early 2017. “Because most people want to invest for 10 out of 10 years, debt fund managers need to maintain a broader mandate for marketing purposes.”

Zinn said at the time that he considered any situation with complicated circumstances or a tight timeframe as falling into special situations.

We have included special situations within the broader definition of distressed debt not only because the return profiles are similar, but because many special situations vehicles can double as distressed debt funds in the right conditions.

Additional reporting from Andy Thomson, Adalla Kim and Rebecca Szkutak