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By M. Isi Eromosele
The market uncertainty and volatility arising from the
massive debt overhang in the U.S.
and Europe vividly demonstrate the investment risks
associated with the developed world’s unprecedented build-up and unwinding of
leverage.
At the same time, that mountain of debt may create historic
investment opportunities as many lenders become forced sellers at depressed
valuations during this protracted distressed cycle.
What makes this moment unique is the sheer scale and breadth
of the opportunities. There will always be pockets of distress and
opportunities for those who can provide solutions.
But the huge build-up of leverage in the global financial
system over many years probably means it will likewise take many years to
unwind; and those rise in maturities will likely create opportunities.
In the current environment, the bond market or equity
markets cannot handle the sheer size of the refinancing necessary. As such, expect
to see an increase in forced deleveraging across a variety of asset classes. The
current situation is unique because the distress is global and spans many asset
classes and strategies.
The inter-connected nature of today’s markets across
geographies, legal structures, and political systems has created greater complexity and
decreased the effectiveness of diversification in periods of significant dislocation. As
a result, there is a lot more to work with than in previous cycles but
portfolio building requires a greater level of care.
Defining Distressed Markets
Distressed describes a market in which economic, structural,
social or other forces lead to selling decisions that are made for non-economic
reasons. As a result, the pricing of investments typically declines significantly below the
intrinsic value of the asset. A significant factor influencing distress is bankruptcy risk
or credit rating risk.
As a company’s risk of bankruptcy increases and ratings
decline, investors’ selling pressure increases due to many institutional
investors’ contractual limitations on holding riskier investments.
Overall, default risk in the market has been declining since
2009. In response, the broader markets have responded through rising prices (and
declining yields). However, many small- to middle-market companies remain in distress
because they are largely loan-financed, more heavily tied to U.S. GDP growth and
highly leveraged.
The loan financing concentration and lack of access to the
current broader public market refinancing wave is a serious obstacle, since the
availability of lending to these small-to mid-sized companies has declined substantially as banks, CLOs
and other lending institutions have migrated away from riskier and less liquid
investments.
Impact Of Low Interest Rates
Low rates have had a meaningful impact on distressed debt
opportunities, as the cost of funding has declined for high yield issuers and LIBOR-based
borrowers. The market’s ever present search for yield has driven newer buyers into
riskier assets.
This increase in broad market demand for liquid high yield
debt has further driven down yields and interest rates, and provided a long
life-line to riskier borrowers. Without very high global and, more particularly,
U.S. growth, the
market will re-price lower and there will be more distressed opportunities in
the broader market.
Financial institutions generate earnings by borrowing at low
rates and lending at higher rates. The steep curve of the last couple of years
has been very beneficial to lending institutions. Recent comments from the Federal
Reserve have indicated a desire to flatten the curve, which could have negative implications
for financial institutions as net interest margins collapse.
Distressed Opportunities In Private Markets vs. Those In Public
Markets
Public markets typically provide greater transparency and
liquidity. As such, demand for public debt is generally greater and more consistent. Private
market demand increases as yield buyers migrate away from lower-returning
investments.
Additionally, because of these factors, volatility in
private markets tends to be greater in down markets. However, because private
markets generally involve floating-rate obligations, private markets tend to
have less rate sensitivity and are therefore less volatile in stable markets.
Today, distress is more prevalent in private markets due to
the nature of borrowing by the small and middle-market borrower and the tighter
lending standards applied.
Supply and demand imbalances in these submarkets are driven
by declining demand for the product by traditional and structured credit
markets. Increasing supply (i.e., the demand for borrowing) is driven by the
expanding wall of maturing leveraged loans.
Coming Refinancing Wave
Due to the significant issuance of corporate bonds since
September 2009, the wall of maturities has been extended beyond the 2012 target that was
originally referenced. Bond debt has been pushed out to a more even maturity profile
through 2016.
Leveraged loan debt, however, has a significant wall
beginning in 2013/2014 with a second rise in 2016. Unless the high yield market
can nearly double over the next year to 18 months, the leveraged loan market
will begin to face significant structural challenges in 2013.
A key difference between high yield bond debt and loans is
that bonds can have very long maturities, whereas loans typically have much shorter
maturities.
Leveraged loans generally pay interest on a floating basis
linked to LIBOR, which has been historically low for the better part of 2010
through today, whereas high yield bonds typically pay on a fixed basis. This
low base rate has lowered cash financing costs, which has helped provide a
lifeline to highly levered capital structures.
The shift of emphasis to the top of the capital structure is
due in part to the large amount of secured debt residing on the company’s
balance sheet. Investors are willingly or unwillingly taking equity risk in the
debt instruments they are holding.
A strategy in this environment is the “loan-to-own” strategy,
which is a longer-term strategy of creating the equity position through an exchange
of debt instruments either through a bankruptcy process or in an out of court
resolution.
Certain managers excel at operational turnarounds which, when
coupled with a financial restructuring, can be a powerful tool for value
creation. A drawback to this strategy is that it is highly illiquid and very
long duration.
Idiosyncratic opportunities will continue in the public and
private markets with broader near-term opportunities in the small- and middle-market
loan-based borrowers. Longer-term, the opportunity set will expand as companies
struggle to grow into their bloated capital structures.
Risks Associated With Investing In Distressed Debt
Distressed investing carries many risks, all of which are of
primary importance at different points in time. More liquid strategies, such as
trading, rely on timely execution. So this naturally raises execution risk, counterparty
risk, and liquidity risk. Execution risk and counterparty risk are extremely important,
given the long settlement procedures related to bank loans.
Less liquid strategies, such as control or ownership, bear
more asset selection, enterprise/operational, or process risk. From an investment perspective,
one has to be concerned with enterprise risk and whether the investment bears more
equity or credit risk. As reelected in their ratings, distressed companies carry a
high risk of failure.
Additionally, the bankruptcy process requires a deep
analysis of all obligations to determine the ultimate distribution methodology
and a third-party valuation to determine the size of the pool of assets which
will be distributed using that methodology.
M. Isi Eromosele is
the President | Chief Executive Officer | Executive Creative Director of Oseme
Group - Oseme Creative | Oseme Consulting | Oseme Finance
Copyright Control © 2012 Oseme Group
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