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Distressed Credit Can Shine, But Beware Risks

Charles Paikert, New York, June 29, 2020

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A large supply of public and private companies in distressed and default situations should emerge over the next year or so. The question, however, is what are the risks of these types of investments and how should wealth managers address them?

Attractive upside potential
For those investors willing to incur risk, however, the rewards could be sizable.

Successful distressed funds can generate returns of approximately 17 per cent to 20 per cent net of fees, according to Bennett. “It’s a very attractive return profile,” he said.

Middle-market Canadian companies with distress issues that no longer qualify for bank loans from the country’s four largest lenders offer “a very compelling” alternative investment opportunity, according to Barlow.

The lack of lenders competing to make loans to those companies has resulted in higher yields, about 250 to 300 basis points above market rates, Barlow said. “They’re turning to non-bank lending and the spread is widening.”

Distressed cycle opportunities
Investors will have three sets of opportunities during the distressed credit cycle, according to the UBS report.

The first stage of “post-shock liquidation” in listed credit markets, where funds can buy oversold credit at a discount following the COVID-induced economic decline, has largely passed because government and central banks quickly shored up the system with liquidity.

But UBS says “idiosyncratic opportunities remain” in areas not targeted by government spending, including convertibles, collateralized loan obligations and other structured finance vehicles.

The next few months will see increased activity in the second stage of the cycle, providing liquidity to stressed businesses, Lee said.

Fund managers may provide capital to companies in the form of “opportunistic sale leasebacks” or through hard money loans in the form of senior secured loans and/or preferred or convertible equity that offer “higher return potential.”

As the economy recovers in the third stage of the cycle, companies will start to borrow to fund working capital and labor needs and will also consider restructuring. Investment opportunities typically take 12 to 24 months from the start of the downturn to present themselves but “last longer and also present the highest reward,” according to UBS. 

Congressional question mark
One of the big question marks hanging over the distressed credit mark is what the US Congress will do in July when it is expected to pass another relief package to aid the recovering economy. 

“I think it will have a big impact,” Barlow said. “Depending on the extent of the legislation, the number of defaults could be suppressed quite meaningfully by more loans to businesses and benefits for unemployment. Additional stimulus could suppress the negative impact of a declining economy and further mitigate defaults, reducing the amount of inventory of distressed loans available to investors.”

No matter what happens, wealth managers need to make sure that their clients choose distress fund managers carefully.

“Investors need to look for fund managers who are experienced and not just trying to take advantage of the pandemic,” Bennett said. “Distressed funds are totally different than other forms of investments.” Patience is also critical, he added.

Distressed funds require investors to be ready for a “capital call” when the money is needed - but that could take several years. The pandemic and the damage to the global economy have added “another layer of uncertainty” to the distressed credit market, Bennett explained.

Which fund managers should investors look for?

Distressed private market funds and hedge funds are “best positioned” to identify and source opportunities, provide financing solutions and manage potential downside risks, according to UBS.

“Investors should look for seasoned managers that can invest across the different stages of the credit cycle and are well-versed in different strategies,” Lee said. “[Fund managers] need a deep understanding of a distressed company’s fundamentals, capital structure and operating model as well as expertise in the legal framework.”

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