Distressed Issues

Say Yes to Distress? A (Google Docs) conversation about distressed investing

Editor’s note: This was a live Google Doc conversation involving the more leveraged credit- focused Finance Twitter users about the state of distressed debt investing. The conversation took place over a few days before petering out and has been lightly edited for grammar, clarity, and anonymized.

Participant 1: So - did the short window of buying for 2020 raise any existential questions around distressed debt investing as a strategy? On one hand, a major issue with distressed debt investing is that there is so much dry powder out there compressing returns at the moment on top of keeping companies out of distressed in the first place. On the other hand, distressed is such a different beast from regular credit investing that it does require its own separate strategy and dedicated participants in my opinion.

Participant 2: I don’t think it raised “existential questions” as much as it showed that true good distressed opportunities, i.e. – good business, good balance sheet, with forced sellers – almost never happen like they do in classic distressed textbooks. That leaves the rest of the opportunities outside of 2020 few and far in-between, so having a flexible mandate and the ability to not only be in credits that you think will return 15%+ is an ideal strategy. Certainly though, with the forward path of rates, anything left >8-9% YTM will not be a good business…

Participant 3: I agree with Participant 1’s dry powder comment: someone on Twitter recently mentioned they ran a screen and there were only 190 (?) 1L issues trading below 95 in the United States and we all know that in our current environment, unsecured and 2L are mostly out in the cold. The upshot seems to be that there’s next to no classic “distressed” returns available which seems to be driving some of the creditor-on-creditor violence as people look to get their cost of capital through incremental fees and out of other creditors’ recoveries. Personally, I’m starting to think distressed is a great story for raising AUM but maybe not an “investment strategy”. It’s more of a toolkit for general opportunistic credit investing.

Participant 1: The issue is keeping your distressed analysts busy during a time like this while not forcing bad investments. I was talking with a [large distressed credit hedge fund] analyst once and was told how the fund had massively expanded around ’08 and proceeded to trim headcount since then as they couldn’t keep their analysts busy. I think this exists across the distressed debt investing universe as a whole today.

With rates and credit spreads as low as they are, it makes it really tough sledding to put up the returns allocators are probably used to. Anecdotally, the stressed liquid credit market has really been cannibalized by bored distressed investors.

Participant 4: I think part of the perceived lack of opportunity stemmed from the fact that we had such a long run of spread tightening that almost every corporate of reasonable size had done the amend/extend/reprice/refi game multiple times. There were few maturity walls in 2020.

If you had the balance sheet to both buy and be confident in your ability to write checks / take a credit through a process if the Fed didn’t bailout the markets AND were willing to take a view, there was a lot of opportunity in March and April. You could’ve bought a yard of Hilton 1L in the 70s – good business, good balance sheet, forced CLO sellers. You could’ve also bought a yard of Intelsat 1Ls in the 70s – good enough business, and by all accounts well covered through the 1L, forced CLO sellers. HTZ, CAR, AAL – tons of big, complex capital structures with liquid CDS where lots of money could have been and was made for those willing to take a view and with the capacity to defend their positions. Not A-quality businesses, but also certainly not E&P or coal.

Feels like every year we get at least one really classic textbook distressed opportunity. My vote for 2020 is Garrett Motion. 2019 was PG&E. Westinghouse before that.

Agreed with Participant 1 that there are issues keeping distressed analysts busy. It’s why the guys who do this in size all have or want to have CLO, BDC, or other businesses to keep junior and mid-level resources churning.

Participant 1: It’s a good point that a lot of debtors had already fixed their balance sheet heading into 2020. The defaults in 2020 were the walking dead like J. Crew, Tailored Brands, and J.C Penney where COVID just brought the defaults forward.

Participant 5: The question piqued my interest on Twitter because it mirrored a conversation I had the same day with a good friend of mine. His comment was that “from the outside looking in, distressed as a standalone strategy looks overcrowded/unworkable”. My first inclination was to push back angrily, but saner heads prevailed. I am not sure that distressed is “unworkable” as a standalone strategy, but I feel like there are far too many tourists still in this space and certainly way too much dry powder.

@Participant 4 – Completely agree with your thoughts above. There were definitely a far number of opportunities at the outset of the pandemic assuming that you A) had a strong view that you were willing to act on, and B) could/would defend it well. Also re: Garrett Motion – completely agree on that being the nomination for the classic, textbook distressed play of 2020!

The idea that I am current fixated on and ultimately believe is the path forward for “distressed” (lots of assumptions built in here), is a *highly* flexible mandate that allows you to move across “event-driven” strategies within each stage of the cycle. While I typically hate investment style drift, I think there is far more overlap for the great investors than most people are willing to admit. The ability to invest across the cap stack with a broad mandate to enter into stressed/distressed/special sits/etc. (more opportunistic investing as Participant 3 mentioned) is crucial to any future success in the industry – just my two cents though.

The opportunity set right now is pretty small from my vantage point. Guess that means more creditor-on-creditor violence is in the works…

Participant 1: Maybe we need an allocator to opine (can FinTwit recommend anyone?) but an issue I could imagine is “Why would I allocate to this full-cycle event strategy versus allocating to it when I really need it?”

Participant 3: Re: Participant 5’s “tourist” comment and Participant 1’s “crowded” comment, I think we are going in the right direction. It may not be a permanently unworkable state of affairs, but frankly I don’t think there’s much that’s happened in the last few years that is sufficient to spook senior creditors into trading out of their positions. Since the top 5-6 turns of the cap stack are all secured debt, full cash collateral, etc. etc., taking 70 or 80 from a distressed shop isn’t a great risk/reward trade.

It is starting to look like a fixed playbook for the CLO era has developed on the creditor side and anyone can get involved if they know someone who’s already in the club. It doesn’t require real knowledge to play a small part, the lawyers and the bankers and a handful of large funds seem to provide all of that. Company gets in trouble, buy into debt. Offer a Priority Term Loan or other priming prepetition financing, draft strict RSA, debtor covers your fees as a secured creditor, aggressive efforts to box out junior and non-group (ostensibly) pari lenders, transfer of economics away from CLOs via rights offering with backstop fee.

Until something happens to upset that model, it’s going to be easy for the giant credit shops to ride through and #neversell, limiting distressed supply – at least that’s how it looks to me.