Factors Resulting in Default
There can be numerous reasons leading a company to default. Often, it can be ascribed to leveraged balance sheets arising from aggressive expansion plans. An ensuing economic downturn can impact revenue, profitability and debt-servicing ability, and may ultimately lead to a default. A major contributor to the supply of distressed debt in the past was the Asian economic crisis, which was triggered by a steep devaluation of local currencies. As a significant proportion of many companies’ revenues were denominated in local currencies, versus debt obligations that were denominated in US dollars, many companies’ ability to service debt fell sharply. In addition to declines in revenues and profitability, overall capital markets liquidity evaporated due to capital flight, resulting in an unprecedented number of defaults. The commodity sector proved most vulnerable, with steel, cement, textiles and paper companies suffering the worst during the downturn. In addition, external factors such as bird flu, the December 2005 tsunami, the September 11 terror attacks and natural calamities have severely impacted companies in the tourism, poultry, airlines and insurance industries. Moreover, firm-specific factors such as employee fraud, as well as flawed strategy or poor execution, often lead to cash flow issues or the erosion of a competitive position, which may also result in default. Nevertheless, weak credits in-and-of themselves do not lead to higher defaults. A spike in default rates can be triggered by a war, a consumer meltdown or even a weak housing market. As the market is cyclical, industry pundits expect global default rates to skyrocket within the next two years.
Distressed debt opportunities are counter-cyclical, that is, opportunities increase as the economy slows. The most fruitful periods for distressed debt opportunities normally follow periods that have recorded a large quantity of low-quality debt issuance. The stage seems set for a return of higher default rates, as evidenced by an increase in volatility of the world’s financial markets. Recent years can be characterised by a steady economic growth rate and cyclically low default rates. In fact, as calculated by Standard & Poor’s, default rates have fallen to their lowest level in 20 years, reaching 1.08% in April 2006. History reveals that all credit cycles eventually turn, and the volume and extent of lending over the past three years have led to experts predicting an eventual rash of defaulting loans, ushering in the next distressed debt cycle. With the Federal Reserve on a steady interest rate-raising spree to suppress inflation, the Fed Funds rate is expected to touch at least 5.5%. The spillover effect is expected to be seen soon in Asia, which feeds on the United States as its main market. In fact, fears of US stagflation have led to a massive sell-off in the global debt and equity markets in May and June 2006, and markets still seem to be in a state of heightened volatility. As global economies begin to slow, the era of easy money will likely give way to further panic-selling and possible bankruptcies. Defaults are also likely to increase after a three-year boom in bond issuance by borrowers rated at least seven levels below investment grade. These securities, about one-fifth of which typically default in the first 12 months of issuance, comprised about 31% of all high-yield debt sales in 2005, up from the 3.6% average from 1996 through to 2003, according to Moody’s.
In addition to such economic drivers, systemic factors such as the push from regulators and governments to clean up the accumulating non-performing loans (NPLs) on the balance sheet of banks are another key trigger. Basel II norms require that banks, with a larger appetite for risk, set aside more capital to meet unexpected losses and protect depositors and counterparties from on- and off-balance sheet risks. This has resulted in stricter capital adequacy and provisioning requirements. As a result, banks have steadily reduced their NPLs, lowering the gross NPL ratio from 7.86% in 2003 to 5.48% in 2005. A common solution includes the creation of asset management companies (AMCs), which act as a centralised agency responsible for purchasing bad assets from the banks at a discount. AMCs, therefore, have resulted in the existence of both ‘good banks’ and ‘bad banks’ within the same banking system. The bad loans are centralised in a few hands, leaving the financial institutions with a cleaner balance sheet. The AMCs are thereafter able to pool together a portfolio of assets and sell to buyers willing to undertake the arduous recovery process. Since default-rate statistics typically do not include the assets of the bad banks, true NPL levels are significantly higher than reported numbers.
Return Profile of Distressed Debt Investing
Shortly after the Asian financial crisis of 1997-98, commercial banks, in a rush to shore up their balance sheet and raise liquidity, began selling both performing and non-performing assets at deep discounts to face value. This was a unique period in that not only were the assets distressed, but also the sellers, otherwise known as ‘non-economic sellers’. This created a welcome opportunity for distressed debt investors, resulting in a period of several years of exceptional returns. In normalised periods, defaulted assets are typically sold at prices that can deliver double-digit returns to the disciplined investor.
Distressed Debt Methodologies
Despite the attractive returns, distressed debt investing is associated with phrases such as ‘vulture investing’, and it is often confused or used in association with high-yield or ‘junk’ securities. However, this is not the case. Distressed debt investing can take several forms. Investors can focus on individual opportunities or opt to purchase ‘pools’ of defaulted assets. The Asian Debt Fund focuses on individual assets. Pools of NPLs typically consist of corporate, retail and real-estate exposure, and require a time frame of 3-5 years to resolve. Individual assets afford the investor a greater level of control and typically require a time frame of under 18 months.
With respect to the single-credit strategy, there are two types of investors: early stage and late stage. Early-stage investors normally purchase assets around the time of default. Such investors create value by negotiating advantageous restructuring terms with the company. This investor frequently uses the legal system to enforce a desired restructuring. The Asian Debt Fund, however, is a late-stage, or ‘event-driven’ investor. This investor waits for a restructuring plan to materialise, and subsequently invests at a discount to the perceived value of the restructuring plan. The event-driven investor is typically passive.
Distressed Debt Risks
There are few investors who have the patience, relationships, expertise and information required to overcome the difficulties of investing in Asian distressed debt. For the event-driven investor, there are several risks to be addressed when investing in distressed debt situations: event risk, valuation risk, liquidity risk and legal risk. The Asian Debt Fund has developed a unique approach to handling such risks. First, it is imperative to understand what a restructuring process truly is. Simply, it is a competition for value among all those who are owed money by the company that has defaulted on its debt obligations. The manner in which this competition unfolds depends largely on the players and the country. However, for the purposes of this article, we will analyse it from a risk perspective.
The first step in the restructuring process is negotiation, which can proceed quickly or slowly depending on the intentions of both the troubled company and the creditors. Legal risk can play a significant role here. As such, The Asian Debt Fund is not involved at this stage. On average, negotiations take 12-36 months, with most taking 18 months. A major contributor to the lengthy process is the banks themselves. Frequently incapable of absorbing the large haircuts to properly restructure a company, the banks delay the negotiation process. As the regulatory environment changes, restructurings are expected to progress more efficiently. Nevertheless, such delays can be expected for the foreseeable future. Please note this relates to loan defaults; bond defaults are typically remedied at a faster pace, although historic recovery rates pale in comparison to loans.
Next, the negotiation, or competition, will result in a draft ‘term sheet’. This typically reveals the results of the competition, that is, who gets what. While the laws may change from country to country, some principles apply universally, such as the concept of absolute priority of claims. This means that secured debt instruments rank ahead of unsecured debt instruments, which in turn rank ahead of equity. To limit valuation risk, The Asian Debt Fund focuses predominantly on the most senior debt instruments in the capital structure. This protects the Fund’s capital in the event that the value of the company shrinks. Normally, senior debt instruments are not affected by slight changes in valuation. Equities, on the other hand, can fluctuate wildly.
The Asian Debt Fund has a strategy of minimising valuation risk and maximising event risk. Examples of events can include, but are not limited to, the completion of a debt restructuring, a Dutch auction, tender offer, asset sale, liquidation, refinancing, or perhaps a merger and acquisition (M&A) . The event typically 1) results in increased liquidity for the debt, and 2) creates value for the investor. By investing at the top of the capital structure, and only after the term sheet has already been negotiated, The Asian Debt Fund avoids undue exposure to valuation risk and maximises event risk.
Finally, liquidity risk is managed by focusing on the best 20-30 ideas each year. The Asian Debt Fund accomplishes this by maintaining a relatively small fund size and avoiding pools of NPLs. Nevertheless, it is important to keep in mind that the strategy performs best in periods of tight liquidity. It is during these periods that the Fund is able to purchase assets at extremely deep discounts.
Other Forms of Distressed Debt Investing
Distressed debt investors also adopt other strategies to generate attractive risk-adjusted returns. The most common are control investing and bridge lending.
From time to time, distressed debt investors may seek to achieve superior investment returns by 1) acquiring a controlling position in a company’s debt obligations, or 2) converting an existing debt position into a majority of a company’s reorganised equity. As such, the investor may seek an active role in the restructuring process, or perhaps play an active role in the management of the company via board or management representation. At times, distressed debt investors will compete against private equity or real estate investors in such situations.
Distressed debt investors may also extend, on a first-priority basis, Bridge and Debtor-in-Possession (DIP) loans to select companies. Superior, low-risk returns can be achieved through these short-term financing activities due to the highly senior position in the capital structure. Bridge and DIP loans rank senior to existing debt obligations, pay high interest rates, pay attractive fees, are secured and amortise quickly. Investors normally target companies that wish to buy back their existing debt at a discount, engage in an M&A transaction or access capital markets via a debt offering.
Low Correlation of Distressed Debt Funds to other Asset Classes
Studies have shown that distressed debt exhibits a low correlation to other asset classes such as equity or bond markets. This relatively low correlation can temper the volatility of a larger investment portfolio.
Historical Performance of Distressed Debt Funds
Over the past decade, the hedge fund market has seen a number of new managers proliferate and the growth of hedge fund assets accelerate sharply. This large influx of market participants has created the need for a benchmark to evaluate the performance of each fund. We now have a number of indices created by investment banks such as Barclays and Credit Suisse, and independent agencies such as Eurekahedge.
As mentioned previously, the performance of distressed debt funds is counter-cyclical. As shown in the graph below, the returns of various indices dipped in 2002 when global economies recovered after the technology bubble burst in 2001. The performance of distressed debt funds subsequently peaked in 2003 following events such as September 11 and SARS occurred. The preceding years saw a decline due to a buoyant economic scenario. However, the economic outlook moving forward appears bearish, which bodes well for distressed debt investing.
In fact, the sale of distressed assets has accelerated rapidly in 2006 as banks rush to raise liquidity prior to a new wave of defaults. The Asian distressed debt market remains vibrant and is expected to provide opportunities to the sophisticated investor for many years to come.