Distressed debt

"The best period for buying distressed debt in our careers was 12 to 18 months ago," declared Apollo Management’s Leon Black in February this year. "Now there are opportunities for restructurings on a selective basis but it is not as easy as it was a year ago." This view is supported by the drop in the S&P/LCD rate of default figures, which have seen the default rate for large US corporates slump from a peak of 11% in the fourth quarter of 2009 to 3.75% today.

But the story is very different in the mid-market, which has been left largely untouched by the revival in syndicated lending and the boom in high-yield bond issuance. While large and middle-market corporate default rates tracked each other relatively closely until mid-2009, the fall in large corporate defaults has been against a continued rise in mid-market casualties – with defaults in this part of the market now approaching 12%.

"Small corporations are where steep discounts still exist and this is where the opportunity in distressed investing is"

Patrick Flynn, Neuberger Berman Fixed Income

"One view is that the markets have fixed themselves and distress is over," says Patrick Flynn, managing director at Neuberger Berman Fixed Income in Chicago. "But smaller companies are too marginal for the high-yield market and banks are still not lending to them. Small corporations are where steep discounts still exist and this is where the opportunity in distressed investing is."

It seems that a fair number of investors agree with him. When Neuberger Berman announced its intention to float a distressed debt investment fund in April this year it was targeting $150 million. However, it attracted $197 million of interest. It is therefore now raising a second fund with a target of $75 million and is confident of exceeding this figure.

"There was a sense that the first fundraising was disrupted because of the sovereign debt crisis earlier this year," Flynn explains. "People want exposure to distressed opportunities and many prefer this structure to an LP structure [the limited life fund has a three-year investment period from the time of the IPO]."

Neuberger Berman is not alone in seeing the distressed debt opportunity as far from over. Hedge fund CQS recently spun off its distressed debt strategy as a standalone hedge fund after it returned 55% last year.

The new CQS Distressed Opportunities Fund manages about $50 million. Also in the US, asset managers Avenue Capital and Tennenbaum Capital announced plans to raise $3 billion and $1 billion respectively for distressed funds earlier this year.

In June European Credit Management announced that it had hired Milos Brajovic and Sohail Malik to launch and manage a new European Special Situations Credit Fund. Alchemy Partners, Oak Tree Capital Management, Intermediate Capital Group and Apollo Management have all raised new distressed funds focused on Europe this year. And Dubai-based Essdar Capital Managers (which is majority owned by the Abu Dhabi royal family) is planning a new $500 million fund to exploit distressed situations across the Gulf region.

With general consensus that the so-called ‘extend and pretend’ game has played itself out, these investors expect that the much-vaunted refinancing wall of 2013 to 2014 will provide rich pickings for them.

However with leveraged loans and high-yield bonds both enjoying a robust 2010, that refinancing requirement is not looking as bleak as it once was. According to Credit Suisse, $208 billion of leveraged loans larger than $500 million are due to mature between 2011 and 2014.

But $392 billion of leveraged loans smaller than $500 million are due to mature during the same period, many of which have little chance of being refinanced in either the syndicated loan or high-yield markets before then.

Institutional leveraged loan maturities

As of March 2010

Source: Credit Suisse

Best opportunities

It is for this reason that Flynn emphasizes that the small-cap sector is where the best opportunity lies: "The billions of dollars that have gone into distressed investing have gone to a few very large buyers which focus on large cap. They do not go down this small." The competition in the mid-market has historically come from bank prop desks and hedge funds.

Neuberger Berman is targeting its funds in the US and Canada, where lending to mid-market companies was dominated by CLOs before 2007.

"Between 50% and 60% of this market was CLOs as they had to show a high degree of diversification in their portfolios," says Flynn. Although he admits that "the easy money is in the rear-view mirror" he explains that evaluating the underlying assets can be far more straightforward in the mid-market as the capital structures are far simpler, with few of the intercreditor complexities that have plagued some of the larger distressed corporates. "The difference in the situation of large and small companies is the world that structured credit has made," he says.

There is no doubt that the days of 2008 when you could simply buy performing loans at 60 cents on the dollar and watch them trade back up to 80 cents later are long gone – this is the opportunity that firms such as Apollo Management took such advantage of and that Black was referring to earlier this year. But the number of firms still prepared to focus on the hard graft of corporate restructuring shows that plenty of opportunity – and distress – remains.

Source  Euromoney.com