VIRTUALLY EVERY WEEK brings news of another stunning corporate collapse. Debt default rates – at more than 12% – are at historical highs and credit downgrades are outrunning upgrades by six to one. Whole industry sectors are in deep trouble. And the volumes of bank loans and securities caught up in bankruptcy, restructuring or distress keep on rising.
Enron, Global Crossing, Kmart, NTL, Energis, Marconi: the corporate casualty list is long, the sums involved enormous and the causes diverse.
But in all these cases, and hundreds more besides, there is one link: the vulture funds are there, and in force. Whether these companies live to fight another day – and in what shape – will largely be determined by these super-activist fund managers.
For years a relatively small band of specialist investors has made fantastic returns – and occasionally fantastic losses – by buying up the bank loans and securities of companies in financial difficulties in what is effectively a gamble on recovery.
They attract admiration and opprobrium in equal measure. To their admirers the vultures epitomize the capitalist ethos, performing a process of cleansing and renewal. They take risks – and provide liquidity – when no-one else is prepared to do so. And they provide a last chance of rehabilitation that would not otherwise exist.
To their detractors, though, they are the unacceptable face of capitalism, using sharp business and legal practices to enrich themselves at the expense of others. They exploit companies’ distress, force them into bankruptcy or restructuring, grab what they can, liquidate the company if necessary and move on to the next target.
Whatever view one takes, one thing is clear: the world of distressed investment is attracting capital on an unprecedented scale as new entrants scramble to get involved.
Edward Altman, professor of finance at New York University’s Leonard N Stern School of Business, reckons that the capital available for investment in distressed securities has more than doubled in the past two years to $50 billion from around $20 billion to $25 billion.
Distressed investing is not an easy business. It involves intensive research, requires almost as much understanding of the law as of company and industry analysis and demands a robust appetite for risk.
It is also still an extremely specialized affair. Although money is pouring into distressed-investment funds, the demand is still minuscule compared with the supply. “Shockingly low” is how Stuart Gilson, professor of finance at Harvard Business School, describes it. Most analysts and investors put the total outstandings of defaulted and distressed debt in the US alone at over $600 billion. Even at its highest estimates, demand is less than 10% of supply.
“Despite the rise in demand and the new entrants, supply is dwarfing the available capital,” says Martin Sass, chairman of MD Sass Investors Service. “It’s peanuts compared with the overall opportunity.”
Sass runs one of the longest-established and largest distressed investing operations in the US, with about $1.4 billion of funds under management dedicated to distressed debt. He set up his company in 1989 and profited mightily from the last surge in corporate failures in the early 1990s.
“That was a wonderful time from a distressed investor standpoint,” he recalls. “We were one of the few firms around with the capability to invest in these types of situations.”
But even he has never seen such favourable conditions. Last time, debt defaults peaked at $18.9 billion in 1991. This time they are in a different league. In just the fourth quarter of last year, bond defaults alone – quite apart from defaulted bank debt and trade claims – were $18 billion. For the first quarter of this year they were $30 billion. “The wave of opportunity now is greater than I have ever seen,” says Sass. “The opportunity now – not just in the hedge fund area but also in the private-equity control area – is just extraordinary.”
This time around, though, there is also a lot more competition. Faced with a dearth of opportunities in merger arbitrage and other risk arbitrage – their lifeblood in the past few years – hedge funds have been moving into distressed debt in a big way.
“We are seeing new funds being launched almost every day,” says Susan Oh, analyst at Tremont Advisers, a New York-based hedge fund advisory firm. “In the hedge fund world this is one of the hottest areas – if not the hottest. Risk arbitrage was the darling of the late 1990s. Now it is distressed debt.”
Among the large number of new hedge funds being set up to specialize in distressed debt is Silver Point, a new fund headed by former Goldman Sachs partners Edward Mule and Bob O’Shea. Another is on its way from Quadrangle, a New York boutique headed by former Lazard Frères deputy chairman Steven Rattner which recently hired Lazard’s distressed debt team to set up a $500 million to $750 million distressed debt fund.
Wilbur Ross – the former head of bankruptcy at Rothschild Inc, who set up his own firm WL Ross&Co two years ago – has also just raised a further $50 million for the firm’s Absolute Recovery Hedge Fund, capping it at $200 million.
And in Europe Gary Klesch, chairman of London-based Klesch&Co, is marketing what he describes as the first European fund dedicated to distressed-debt investment. The Klesch European Distressed Fund has an initial target of $100 million, mainly from fund-of-funds managers.
The other major new source of capital is private equity. Estimates suggest that there may be as much as $75 billion of excess capital in the venture capital industry. With the public leveraged buy-out market moribund, distressed debt offers attractive opportunities to gain control of companies by buying up their bank loans or bonds, taking the driving seat in restructuring and ending up with control.
“Private-equity investing around the world has been very depressed, mainly because of the limits on leverage that banks have imposed on private-equity firms,” says Bob Dangremond, principal at Jay Alix&Associates, a leading US advisory firm on restructurings and corporate turnrounds. “Distressed debt is a very hot topic for the private-equity firms. If any private-equity house has the ability in its charter to get involved in this business, it is doing so.”
Carlyle Group, a highly regarded Washington-based private-equity firm, is just one example. Last year Carlyle hired Afsaneh Beschloss, formerly treasurer and chief investment officer of the World Bank, to head the firm’s new asset management operation. The firm is looking at ways of increasing its involvement in distressed-debt investment, including the launch of a new $500 million fund aimed at distressed companies.
The best way to buy control on the cheap
So are other major buy-out firms, such as Hicks, Muse, Tate&Furst, and investors such as Warren Buffett – who see the distressed securities world as a cheap and effective way of buying companies.
“Just as LBOs were the outstanding asset class of the early 1990s and venture capital funds led the pack in the latter part of the decade, the first five years of the millennium will belong to the distressed funds,” predicts Ross.
But the specialist vulture funds are not worried about having their rich pickings pinched by upstart new entrants. As they see it, there is more than enough food to go around.
Take Oaktree Capital Management. Based in Los Angeles, it runs around $7 billion in dedicated distressed investment and is by some margin the largest player in the business – described by a leading New York-based restructuring lawyer as “the Big Daddy of distressed debt”.
Howard Marks, Oaktree’s chairman, is unfazed by the wave of new players on the scene. “The hedge funds – people who have previously been in merger arbitrage and are looking for somewhere else to put their money – don’t worry me,” he says. “They’ll be going into the liquid, public, late-stage investments rather than the pre-bankruptcy situations where you have to ride out the restructuring over the long term. Those are different strategies and there is room for us all.”
Unsurprisingly given Oaktree’s size – one analyst reckons that it runs about half as much in distressed-debt money as all the hedge funds combined – it has a predilection for investing in the biggest, most high profile situations. In recent months it has made big returns from the restructurings of Finova, Conseco and Service Corp in the US. Now it has taken a large position in Enron’s bonds and is following developments there with even keener interest than most.
“We’ll do the medium-size stuff as well but the best thing in the world from our point of view is when a big public issuer defaults and all that debt suddenly comes onto the market,” says Marks. “That’s what we really like – a great opportunity to buy big on the cheap.”
He adds: “We’re not unhappy going into the high-profile situations because their size sometimes scares other people off or makes the price better. Everything is a trade-off based on price and we like anything so long as the price is right. Next up is Enron – let’s see what happens.”
Oaktree is one of a number of investors that have taken positions in Enron securities, gambling that something can be salvaged from the wreckage. “Enron is a prime target for distressed investors,” says a seasoned New York-based distressed investor. “There is a rich capital structure with dozens and dozens of types of securities, all with different rights.”
Enron is a special case, attracting political and legal heat on an unprecedented scale. There are, though, equally high-profile situations where the question of survival or disappearance is driven by more commercial factors.
High on this list at the moment is NTL, the UK-based cable company involved in a record-breaking restructuring after being laid low by $18 billion of debts. In mid-April, after months of intensive negotiations with creditors, the company announced the details of its planned recapitalization. Under this, bondholders, including a number of specialist US distressed players including Oaktree, Franklin Resources, Appaloosa Partners and Angelo Gordon, will end up with about 95% of the equity.
It is questionable whether such a recapitalization could have been hammered out with creditors if these players had not taken an extremely active role. And it is also questionable whether NTL can survive, even in its new form.
Increasingly, though, market observers are taking the view that distressed-debt investors can be a force for good. “There is this idea that distressed-debt funds do nasty things to you but that’s usually just a ruse by the company’s management to deflect the blame,” says Klesch. “Is it the distressed investors’ fault, for instance, that NTL borrowed over $18 billion?”
“Because of the nature of the investment, things tend to be confrontational,” says Gilson. “But people are keen to get rid of the vulture term, just like with junk bonds in the 1980s. It sends out the wrong image.” He adds: “The vultures clean up the carcass and help to expedite the restructuring process. Once they establish a position, they have a huge financial incentive to resolve things as quickly as possible. Par investors, on the other hand, have an interest that is political as much as it is financial.”
Vultures don’t hang around
Lawyers who have worked with distressed-debt investors on numerous occasions – either for or against them – believe that they provide vital impetus to the process of recovery. Jonathan Landers, partner at US law firm Gibson, Dunn&Cratcher, says: “Discount investors are much more eager to get cases over with and get their money out. They don’t push so hard for the last dollar.”
He adds: “I’ve been involved in several cases where things were dead in the water for a couple of years before banks sold out to the vultures and then things started to happen very quickly. The vultures don’t want to hang around because, as a rule, companies don’t get any better while they are in bankruptcy.”
Because of the negative connotations traditionally attached to vulture investing – such as the huge job cuts that are usually involved in restructurings and the aggressive, confrontational stance adopted by some of the most high-profile funds – many institutional investors have been wary of getting involved… until now.
The endowment funds of Harvard and Yale universities invest heavily in distressed debt and are increasing their commitments. PPM America, the US arm of the fund management division of UK insurance company Prudential, is also a well-known and respected investor in the market. Fund manager Fidelity is regularly involved. And the Franklin/Templeton group is also highly active, through its mutual and institutional funds.
Specialist distressed-debt funds see a great opportunity to penetrate the mainstream institutional community. Most are out marketing for all they’re worth.
For the time being, investors in distressed securities are spoilt for choice. Last year in the US 171 companies with liabilities of more than $100 million filed for bankruptcy – totalling $230 billion of liabilities. This all-time record figure was 148% up on the previous record of $92.8 billion, which was set in 2000.
The increase is even more striking where large companies are concerned. A total of 45 companies with assets of over $1 billion filed for Chapter 11 bankruptcy protection last year, compared with 21 in 2000.
It is the same story worldwide at the moment. And it is quite clear that there will be many more bankruptcies, defaults and restructurings to come before this cycle is done.
At the end of 2001, 13% of US non-investment-grade bonds, worth $96.3 billion, were already in default. Even more striking was the fact that a further 22% of the high-yield bond universe was in distress – that is, issues yielding 1,000 basis points over treasuries or an equivalent benchmark.
“In today’s low interest rate environment, the only reason a bond yields 15% or more is because the coupon is in real danger,” says Ross. “We expect that half of this 22% will default within the next 12 months or so.”
According to Ross, the prospects further out are equally good for distressed-debt investors, mainly because US high-yield bond issuance, which he describes as “the best factory for creating defaults” – continues to be strong. Despite the massive defaults, some $87 billion of new high-yield bonds were issued in the US last year – more than twice the amount that went on the market in 2000. And new-issue supply so far this year indicates a full-year total in excess of $70 billion.
“In the past when you had a very high incidence of defaults you’ve also had a shake-out in the new-issue market,” says Ross. “This time that hasn’t happened. We’re still seeing around $1.5 billion of new high-yield issuance every week.”
Let the bad times roll
Evidence from previous cycles suggests that the best returns for distressed investment are typically in the two to three years following the peak in the default rate. “The near-term outlook is extraordinary and continues to be so because it takes around 48 months from default to work-out,” says Ross. “Our industry has never had this kind of backlog before.”
As for Europe, Klesch reckons the peak is some way off yet. “We don’t believe we’re anywhere near the end of the cycle, or even anywhere near the middle,” he says. “Defaults will continue to increase, downgrades will continue to increase, there will be another Enron or two to come – probably in the European banking sector – and the peak is still 12 to 18 months out.”
Many of the newer entrants are banking on a pretty simplistic strategy – buy cheap, wait for the upturn, sell out at a profit and move back into more consistently rewarding asset classes such as risk arbitrage, equities or leveraged buy-outs.
But the specialist distressed-debt firms – the likes of Oaktree, Angelo Gordon, Appaloosa Partners, Elliott Associates, MD Sass, WL Ross, Apollo Partners, Questor, Black Diamond or Cerberus – see things from a different perspective. They need to be investing and trading through the economic cycles. They need to be monitoring companies and sectors that may be heading for distress far in advance – and which Wall Street analysts have neither the time nor the inclination to cover.
They need to understand exactly what their legal rights are in restructurings and exactly how holders of different pieces of a company’s capital structure will be treated. And they need to be prepared to stay in for the long haul and to fight their corner hard if necessary.
“This kind of investment requires a lot of very specific expertise – about the law, about accounting, about valuations, about equity,” says Gilson. “It is about fundamental, roll-up-your-sleeves analysis. The successful players have demonstrated over the years that they can do that. My concern is that some of the new guys don’t.”
There are three main types of distressed-debt investors. The first are the long term, buy-and-hold, private equity-type funds, which get heavily involved in the restructuring or bankruptcy process. The second are the more trading-oriented managers, which look to exploit inefficient markets and mispricing opportunities. These tend to be much more short-termist in their arbitrage positions and investment strategy. The third are funds that buy senior debt – either bank loans or bonds – solely on the basis that it will be converted into equity, with a view to becoming the controlling shareholders of the company.
“Those that do best tend to be distinctive in two ways,” says Gilson. “They are very good at valuing companies and businesses. They are also very good at understanding exactly how the land lies in the bankruptcy courts – in terms of seniority of claims, whether management can be changed, whether and which assets can be sold, and so on.”
They also tend to understand that distress is not simply a function of the economic cycle. “The likes of Finova, Service Corp or Enron had nothing much to do with the economy, they are all subject-specific,” says Marks at Oaktree, whose firm has been in the business for 14 years. “Throughout the 1990s we were always able to find investments. We always had debt on our books because there is always some business or industry that’s in trouble.”
