Contradiction in distressed debt investing

By:
Duncan Kerr
Published on:

Fewer investors claim distressed debt investing is a core strategy in 2013, but more AUM is being allocated, according to a Debtwire survey.

Distressed debt investing is taking on a new contradictory form, as hedge funds and bank sell-side desks pull back from employing pure play strategies in the asset class yet are allocating considerably more capital in the hunt for returns.

Some 15% of 100 hedge funds, bank sell-side desks, private equity firms and institutional investors said distressed debt investing was a core strategy for them this year – down from 27% in 2012 and a high of 50% in 2010 – according to Debtwire’s annual North American distressed debt survey.

However, some 62% of respondents to the survey said they have allocated between 21% to 60% of assets under management to distressed debt investing this year – more than double the proportion of respondents compared with 2012.

“While the survey results show that investors increased their distressed allocations in 2012 – and expect to either ramp up or stay the same in 2013 – it will be interesting to see where the extra inventory will come from, especially with the very low default rates we have seen over the past few years,” says Scott Falk, partner at Bingham McCutchen, a survey co-sponsor.

Martin Nachimson, managing director, Macquarie Capital, the other co-sponsor, adds: “Distressed investing remains en vogue out of necessity rather than opportunity. However, it seems all forecasters expect a calm year, which rarely happens when forecast as such.”

Equally contradictory is that while 100% of respondents said they expect the default rate to linger below 4% in 2013 – and 46% say it will decrease to under 3% – respondents’ expectations for distressed returns this year are elevated.

Most respondents, or 45%, said they are running 10.1% to 15% return targets, down a touch on the proportion of respondents last year, while 29% of respondents are aiming for returns above 15.1%, and 7% are aiming for returns greater than 20% – both up on last year.

“While 2012 may have been underwhelming for a lot of distressed investors, it’s hard to imagine returns in 2013 outpacing 2012 – although, asset managers moving into riskier credits may be rewarded with outsized returns if default rates stay at historic lows,” says Mick Solimene, senior managing director, Macquarie Capital.

On which industry sectors respondents see most opportunity, 61% said real estate is a target for investment – up sharply from 45% last year – followed by financial services with 56%.

For asset classes within the distressed debt world, asset-backed securities and convertible bonds should provide lucrative opportunities this year, according to 59% and 51% of survey respondents, respectively.

Senior secured bonds are also attractive to investors, with 43% of respondents voting this year compared with 24% last year. Meanwhile, second lien loans are perceived as the least opportunistic debt instrument this year by 41% of respondents.

As to which macro issue holds the biggest influence on investors’ decision-making, an overwhelming majority of 75% of respondents said US economic outlook was the chief influence this year – supplanting the European crisis, which last year was the most widely cited by respondents. This year, only 25% of respondents flagged Europe as being the main driver in their decision-making.