The World Economic Forum is calling it ‘The Great Reset’ – those months in early 2020 when the Covid-19 lockdown caused the global economy to grind to a halt, ending the longest US bull market in history.
Now, as the global economy tentatively restarts, we are faced with a changed world and a transformed economic landscape. Previously buoyant sectors have seen revenues decline, and once-healthy companies can find themselves in a distressed position almost overnight.
Among the sectors hit hardest have been retail, hospitality, leisure and commercial real estate. The roll call of distressed brands forced to file for bankruptcy protection or enter administration include fashion brand Cath Kidston, Thai Airways, department store JCPenney and car rental giant Hertz.
On the downside, private equity (PE) managers whose portfolio companies have lost value are seeking to extend their holding periods. On the flipside, however, after more than a decade on the sidelines, distressed investment funds are now firmly back in fashion.
A recent survey found that 92% of PE managers across North America, Europe and Asia believe distressed fund activity will increase in the wake of the coronavirus pandemic. The survey shows that PE managers consider distressed funds the biggest fundraising opportunity in the near future, with 83% of managers indicating there would be more investor demand for strategies targeting distressed assets.
The growing demand for private equity in this area is expected to be further fuelled by capital constraints placed upon the banking sector, which prevent banks from injecting extra liquidity into the market.
As Gulsey Torenli, Director, Alternative Investments at Vistra in the US explains:
“Struggling companies aren’t getting the support they need from the banks to avoid defaulting on their loans, so they’re looking for governmental assistance, which has been forthcoming in some areas. But eventually something’s got to give and we’re expecting to see an influx of defaults in the US when government assistance runs out.
“Some of the bigger companies may not default as quickly because of stronger credit lines, but when the government assistance stops coming for the smaller ‘mom and pop’ companies, distressed debt will be up and rising.”
Measuring the bigger picture
Brooks Brothers, one of the US’s oldest apparel retailers, offers a glimpse of the landscape to come. It filed for bankruptcy protection on July 8 2020, but later clinched a $305 million ‘stalking horse’ deal, laying the ground for other offers in a bankruptcy auction.
To get a better idea of the risks and rewards associated with distressed assets geographic location should be taken into consideration. By mid-August 2020, the US, for example, was still in the midst of the pandemic, with authorities in the process of suppressing significant outbreaks. Europe was grappling with lesser regional outbreaks, while Asia had switched to recovery mode.
This fluid situation means that in the US, at least, it’s still too early to start trying to understand the full impact of Covid-19.
“Right now, there’s a general feeling in the US that it’s best to sit tight and see how the situation pans out,” says Torenli. “In Q2, we knew there would be some devaluation but in Q3, that’s when we’ll see more companies filing for bankruptcy, restricting impairments and loans on the asset side.
“At that point, company valuations and viability will be thoroughly scrutinised. If you’re interested in debt at any level you still want a company that is strong, with good management, that you can turn around or divide and sell at a profit.”
Preparing a game plan
For the US at least, it seems fund managers are using this time to devise their game plan so when the fog of uncertainty eventually clears, they will be ready to act and they will know the parameters within which they can work.
Compare the situation in the US to that in Asia where Covid-19 first appeared late in 2019. Here the situation is further advanced, with higher levels of distressed asset activity. Caroline Baker, Singapore-based Managing Director, Vistra Asia, says the region has witnessed a significant increase in activity among fund managers with experience in distressed assets.
“Activity levels among our client base alone have increased up to three-fold in Q1 and Q2 in the distressed space. In the previous Q3 and Q4 we had one or two transactions, but we’ve had at least ten in Q2, so managers are active and there are a lot of deals in the pipeline.”
Baker points out that it’s not just distressed asset managers that are active in this area, some PE managers are snapping up acquisitions opportunistically as a “bolt-on” to their existing portfolios.
Spotting the opportunities
“There are definitely some attractive buying opportunities out there,” Baker says. “Many of the big banks across Asia either don’t want to lend or they want less risk on their books so they’re offloading distressed assets, which is great news for distressed asset specialists.”
However, while some PE managers may be dabbling in the distressed space, Baker warns that any such activity should be cautious.
“Being a distressed asset manager involves a heightened level of risk and complexity,” she says. “When you start your fund strategy you have to be clear with your investors what level of risk and reward they can expect. So private equity managers can’t suddenly think they can be distressed managers, it’s a totally different level of exposure and skill set.”
Some PE managers, however, are being forced to adopt a distressed asset mindset as their own portfolio companies suffer the effects of Covid-19. When they find themselves in this situation, PE managers need to recruit as much expertise as they can.
As Baker says: “To a lesser extent we have been in this situation before during the global financial crisis [GFC] and the SARs pandemic of 2003, which affected 26 countries and slowed economic growth in China.
“Fund managers are bringing in restructuring experts with experience of the GFC and SARS to make their portfolio companies stronger. This kind of insight can be invaluable and it’s not something you will necessarily get from a bank.”
Hunting for value
Jervis Smith, Vistra Country MD in Luxembourg, says now is the time for experienced distressed asset PE managers to hunt for nuggets among the very well-defined risk.
“Warren Buffett said you should be greedy when others are fearful and that’s a great mindset during the current crisis” he says.
“Ultimately it’s liquidity rather than lack of profitability that makes companies bankrupt and the current crisis won’t last forever. Now is the time to be greedy before the market adjusts and valuations correct themselves.”
The ideal goal of any distressed asset acquisition is to snap up a strong company struggling with liquidity. But this is not the only opportunity they offer.
Acquisitions can also help grow market share for existing portfolio companies by opening up new geographies or generating new revenue streams. They can feature significant embedded debt financing, which may be valuable to the buyer in a tight credit market. Sometimes acquisitions can act as a defensive move to stop customers, market share or proprietary technology from falling into competitors’ hands.
Weight risk and reward
These benefits (and more like them) must be weighed against the risks. PE managers unfamiliar with distressed assets risk overpaying. Without due diligence they also risk taking on hidden liabilities such as underfunded pensions, extended payables or avoided spend, employment contracts with termination agreements and lockdown-related restart costs, to name but a few.
To mitigate these risks, fund managers need to ask the right questions – both of themselves and their target acquisition.
“The first and most important question managers must ask themselves has to be: Is the price correct?” says Smith. “Just because it seems affordable doesn’t mean it represents good value.
Fund managers must then ask themselves if they can handle the increased complexity of acquiring a distressed or impaired asset. A company may not be acquired outright but purchased through an insolvency process. This complexity can deter less experienced buyers and drive down the acquisition price, but acquirers must be confident in their ability to execute effectively and take advantage of this.
“Are acquirers working with imperfect information? Information quality and availability is often poorer for impaired assets and businesses,” says Smith.
“So, knowing what information you need to make a decision is critical — and identifying imperfections can even be an advantage, helping justify lower prices during acquisition negotiations.
“Assets are distressed for a reason. Are you able to make necessary operational fixes? Can you fix the acquisition and turn it into a profitable asset within your holding period? Two other important questions are whether you have the right advisers and management who can think on their feet, and do you have a well-thought-out exit strategy?”
With the resurgence of distressed assets set to be a feature of private equity investment for the foreseeable future, it remains to be seen if dry powder, due diligence and market savvy can be converted into the value investors and managers alike are searching for.
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