Established distressed strategy investors have not been so excited about the current investment envi...
Established distressed strategy investors have not been so excited about the current investment environment since the early 1990s and before that 1933. In each of those prior periods, a recession coupled with an abundant supply of distressed investment opportunities created an exceptional investment environment for distressed investors.
Default rates on bonds (a good measure for the supply of opportunities in this asset class), was 12.8% in 2002, a record year. The last time default rates were above 10% was 1991 (10.3%). At present, there are close to $1tr in face value of defaulted US bonds with around $97bn of defaults in 2002 alone.
However, this only tells half the story; corporate bankruptcies filing for Chapter 11 in the US last year with liabilities greater than $100m amounted to $337bn. This brings the total Chapter 11 bankruptcy marketplace to well in excess of a trillion dollars. In addition, this does not reflect any defaults or bankruptcies outside the US where statistics are a little harder to come by. Either way, there are plenty of opportunities.
For those readers not familiar with distressed investing, distressed securities are investment instruments of troubled companies who are in financial distress, in a bankruptcy procedure, or in a major reorganisation. For instance, any debt that trades above 1000bp (10%) over treasuries is generally regarded as distressed.
However, all companies that file for bankruptcy are not necessarily bad companies. In many cases, a particular event may have caused them to be in trouble. Examples are; management problems, natural disasters, over-expansion lawsuits and economic slowdowns.
However, an opportunity presents itself especially when a company still has a strong core market and is going through financial as opposed to operational difficulties. Distressed investors take advantage of these events to invest in troubled/distressed companies where the existing investors (creditors) do not have the time, flexibility or skills to reorganise a distressed company, which may take years.
These creditors may be institutional investors who are restricted by mandate not to invest in distressed securities and will be willing to get out at any price. A good example is a pension fund restricted to invest in investment grade bonds where a bond loses its investment grade and the pension fund is forced to sell despite the viability of the underlying company or the price it receives. Another example is a creditor who has a trade claim against the distressed company. These creditors are in the business of producing goods or providing services and therefore have no expertise in evaluating the likelihood of getting paid once the company files for bankruptcy.
An excellent distressed example is WorldCom (now MCI), the biggest bankruptcy ever. Its bonds went from an A investment grade to default within a few months last year. It filed for Chapter 11 and is expected to emerge from bankruptcy shortly with a healthy balance sheet.
This company was regarded as blue chip but over-leveraged in the late 90s and therefore a 'good company with a bad balance sheet' ' a favourite buzz phrase of distressed investors.
In addition, 'orphan' equities (those companies that have successfully negotiated themselves out of Chapter 11), have historically produced excellent returns as they have healthier balance sheets and are better positioned relative to their 'surviving' peers.
In fact, there are complaints about this situation at present as those companies with heavy debt burdens are uncompetitively positioned against those companies emerging from Chapter 11. MCI (WorldCom) is a case in point.
The outlook for 2003 is considerably brighter and the Altman Index (US industry standard) expects bond defaults falling to around 7.5% this year. Defaults generally peak soon after a recession, which bodes well for recovery rates going forward.
As seen after 1991, in the immediate years after a peak in defaults, distressed investors have made exceptional returns; we believe we are in that period now.
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