Distressed debt investors are piling into a new strategy to make money from troubled companies.
For decades, their playbook was simple: buy corporate bonds and loans when they first drop in value and profit from either a gradual recovery or, if things don’t improve, from restructuring negotiations that could hand them an equity stake in the company.
Recent changes in the distressed-debt industry, though, have led some investors to change their approach after watching — and sometimes being stung by — the rise of so-called liability management exercises, which often pit creditors against each other in coercive, high-stakes battles that leave some participants nursing big losses.
Those skirmishes have pushed a growing number of investors to hold off on buying a company’s debt until after it has gone through this kind of disruptive transaction and made it to the other side. At that point, the investment usually still offers the juicy yields associated with distressed companies, but now with strengthened terms to protect creditors if the borrower runs into trouble again.
Rishi Goel, the global head of distressed debt at Aegon Asset Management, said he is spending more than half his time picking through such credits and anticipates they will soon account for half of his portfolio, up from a quarter currently. While holding debt tied to companies that have gone through a restructuring isn’t new to Aegon, it used to be a function of having owned it beforehand.
“We’re substantially focusing our time on post-LME structures we haven’t been involved with,” Goel said. “A lot of our new investments are coming from that pool.”
Winners and Losers
Goel’s pivot illustrates some of the unintended consequences of the rise in LMEs, which have come to dominate the distressed market and are now spreading into higher quality credits. Distressed exchanges, which can serve as a proxy for restructuring maneuvers, accounted for a majority of defaults in the second quarter of this year, according to Bloomberg calculations based on data from Moody’s Ratings.
While reshuffling debt through these transactions is supposed to make the underlying companies more attractive, it effectively divides existing lenders into winners and losers. Since creditors can’t always tell which side they’ll end up on, some are turned off altogether, preferring to skip the roller-coaster ride and invest when it’s over.
The emergence of this kind of debt is a relatively new phenomenon. But at least 100 companies have been through the ringer, according to Goel. And the appeal of sitting out the messiest stages is increasing, said Holly Kim, co-founder of distressed-focused Glendon Capital.
“In a lot of situations, participating in the LME is a consolation prize, trying to salvage some value from a loss-making position,” Kim said. But the investment becomes a lot more “interesting,” she said, “if you don’t have to lose money first.”
Irreparable Harm
Of course, post-restructuring loans and bonds still come with risks. Even with improved covenants, a company can run aground, especially when the transactions don’t significantly reduce existing debt and sometimes even add new obligations on top.
Andrew Axelrod, the chief executive officer of $2.8 billion opportunistic credit firm Axar Capital Management, emphasized in a June memo that the transactions often leave companies with even more debt.
Still, his firm has recently conducted diligence on around 40 situations that fall into the ‘post-LME’ category, invested in four, and is hunting for more, Axelrod told Bloomberg.
What’s underappreciated, he said, is that the debt is cheap, often with yields in the 15% to 25% range, while still offering some negotiating power if the company hits problems again. Borrowers often promise to keep leverage or liquidity levels within a certain range or risk triggering a default.
“The practice is doing some heavy lifting for us by surfacing stressed credits, shaking loose secondary market opportunities and setting up cleaner entry points for post-LME investments,” Axelrod wrote in the memo.
2004 ‘Throwback’
The new opportunity appeals to lenders of all sizes who are tired of playing four-dimensional chess as they approach restructuring negotiations. Even heavy hitters like JPMorgan Chase & Co.’s asset management arm and funds managed by Blackrock Inc. have found themselves on the wrong side of polarizing transactions. For those outside the inner circle of trillion-dollar managers, the allure of foregoing sharp elbows is even more clear.
This doesn’t mean that investing after the negotiations are over is an easy process, warned Goel, Axelrod, and Wariz Anifowoshe, the head of restructuring at Fortress Investment Group.
“Only people who really understand credit documents will be able to add all of the necessary protections to them,” Anifowoshe said.
“But once they are in, you have this beautiful situation where it’s just simple credit analysis,” he added. “It’s like a throwback to 2004.”
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