Distressed Investing

Alternative Viewpoints

March 25, 2016

March 2016

Patrick Doyle, Sara Tirschwell

Summary
For the past 25 years, distressed investing has been recognized as a discrete discipline; one that combines aspects of value and event-driven investing with a deep understanding of contractual entitlements and stakeholder rights under the Federal Bankruptcy Code here in the U.S. and under relevant bankruptcy laws in other jurisdictions. Distressed investing as a strategy encompasses a broad scope of investment scenarios involving situations in which companies are undergoing or likely to undergo bankruptcy, restructuring, reorganization or liquidation. Distressed investments are typically secondary market transactions, but can also occur through originations in the form of rescue and emergency financings.

Distressed investment opportunities can be found in all phases of economic cycles. As was the case with private-label mortgage-backed securities and single family housing, we believe that superior returns can be achieved by paying fundamentally derived risk-adjusted prices for distressed assets rather than paying inflated prices for ‘good’ assets. Distressed situations often occur because of a misallocation of capital while idiosyncratic events can occur at any time (for example, the telecom bust at the turn of the century).

In our view, deteriorating conditions at the end of an economic cycle often lead to an increase in distressed situations creating an inflection point where the potential for extraordinary returns justifies renewed investor attention. We believe we are in the very late stages of the current economic cycle, and high yield prices (aside from the obvious energy, minerals and mining sectors), are flashing signs that the breadth of systemic distress may increase significantly. While it would be folly to predict the exact inflection point, the combustible mix of broadening supply meeting historically limited liquidity may be setting the stage for outsized returns. Therefore, we believe investors should consider making a specific allocation to distressed investing strategies.

What Do Historical Returns Indicate?
Investors often question whether distressed investing should be approached opportunistically (i.e., at specific points in the economic cycle) or whether the strategy deserves a permanent allocation within their portfolio.

Exhibit 1 shows the relative performance of distressed investing as measured by the HFRI Distressed/Restructuring Index (the “Distressed Index”) over a 25-year period against the Barclays Global Aggregate Index, the MSCI Global Equity Index, the S&P 500 Index, and the Barclays U.S. Corporate High Yield Index. The Distressed Index outperformed all the other indices, with an annualized return of 10.65% versus 9.29% for the S&P 500 Index, its closest competitor. It is important to note that the Distressed Index’s returns were generated with significantly lower volatility as demonstrated by a 1.18 Sharpe ratio.

EXHIBIT 1:

Performance Metrics

Performance Metrics

Distressed Index vs. Traditional Indices
January 1990 – December 2015

Distressed Index vs. Traditional Indices

Over the 25 year period, the correlation between distressed assets and equities has been relatively low at 0.52, with almost no correlation to global bonds at 0.09, as shown in Exhibit 2.

EXHIBIT 2:

Correlation Matrix: Returns vs. S&P 500
January 1990 – December 2015

Correlation Matrix: Returns vs. S&P 500

Returns on distressed investing have generally trailed when examining only the period between 2009 and 2015, a period punctuated by aggressive central bank intervention (see Exhibit 3). During that period, Fed liquidity transferred more efficiently to liquid-exchange-traded instruments, and therefore companies that might have otherwise succumbed to capital constraints were artificially buoyed by the added liquidity.

EXHIBIT 3:

Distressed Index vs. Traditional Indices
January 2009 – December 2015

Distressed Index vs. Traditional Indices
As investors consider the long-term return profile for distressed investing it is important to note there is almost always distress somewhere and the market constantly exposes new, unexpected casualties. The S&P 500 Index posted a 5.81% return in 1987 during the sixth year of an eight-year winning streak but does anyone remember the Texaco bankruptcy?

EXHIBIT 4:

Modern History of Distress
There Is Always Distress Somewhere

State of the Market – State of the Cycle – Inflection Point
While distressed investing’s long-term return profile indicates that idiosyncratic events can create opportunity at any point in the credit cycle, it is equally true that the end of the cycle tends to be characterized by increased supply of distressed assets, creating windows of opportunity to capture truly outsized returns driven more by beta, at least initially, than alpha. Furthermore, continuing globalization and the increased interconnectedness of capital markets and businesses on a global scale have fundamentally altered the tool kit for distressed investing. In the context of globalization, distressed investing was first recognized as a discrete discipline at approximately the same time that a single man stood in defiance in front of a column of tanks near Tiananmen Square. Since then, China’s impact on the global economy has grown considerably. We are now seven years into a current credit expansion, driven by historic central bank intervention across the developed world, which has changed the dynamics of distressed investing.

EXHIBIT 5:

U.S. Gross Issuance ($bn)                                                        U.S. Market Outstanding ($bn)
U.S. Gross Issuance, U.S. Market Outstanding

Exhibit 5 demonstrates that we have seen historic debt issuance while prices, in the high yield market in particular, are flashing warning signs that capital has been misallocated. Cheap credit has fostered poor corporate decision-making that we believe has led to over-capacity and excessive leverage levels setting the stage for a deflationary wave. If we accept the market convention that debt is distressed when priced with a yield 1000 basis points (bps) greater than comparable Treasuries, or trading at a price below 70 cents on the dollar, then a note of warning is in order. The universe of distressed bonds priced below 70 cents on the dollar heading into 2016 rose to a post-financial crisis high of $143 billion, versus only $9 billion 18-months prior. Approximately 70% of this amount can be attributed to energy, minerals, and mining. However the par amount of high yield bonds trading at or below 90 cents rose to $367 billion, an amount nine times greater than 18 months ago, with non-commodity sectors contributing 53% of the total. Using 90 cents as a demarcation line, the conclusion can be drawn that the stressed opportunity set for investors has not been this high since the credit crisis. The year 2015 was the first year since 2008 when U.S. investment grade, high yield bonds and loans, CLO mezzanine and equity all had negative returns. As of mid-March 2016, the spread between B and CCC-rated bonds was over 900 bps, which is as wide as it has been since 2009 and sharply contrasts with the 296 bps historical average.

EXHIBIT 6:

BAML CCC Index

BAML CCC Index

Exhibit 6 demonstrates the current state of the CCC market which has seen option-adjusted spreads increase while high yield bond prices have decreased almost to the point where we have seen past cycles turn.

As investors, we must understand the past but constantly question how the next point in the distressed cycle may deviate from our expectations. At this point, we are questioning the lack of liquidity that has yet to fully reveal itself to the market. Since the early 1980s, U.S. credit markets have expanded and, until the credit crisis, intermediary capital and participation expanded almost in lockstep. New Dodd Frank and Basel III regulations have forced a widespread retrenchment in staff and capital committed to market-making. Price discovery can occur with the help of electronic exchanges but individuals have served as a necessary shock absorber during past downdrafts through their decision-making role to put capital at risk by expanding corporate balance sheets. The market generally recognizes distressed opportunities quickly but takes time to rotate capital – particularly the longer-term capital typically required to take full advantage of a distressed cycle. The lack of liquidity argues for sharper price movements than in the past and suggests that investors interested in the space consider how to take advantage of the potential opportunity now rather than reacting to what may come.

Characteristics of successful management
Distressed investing is unique because of the legal and procedural overlays. It is important to not only understand contractual entitlements, but how to enforce them, while being mindful that the backdrop of all restructurings is the equitable justice of a bankruptcy court. Understanding the cadence of the process – organization of committees, hiring of advisors, the role of a Chief Restructuring Officer, differences between Chapter 7, 11 and 15 bankruptcy procedures, nuances of 363 sales, roles of indenture trustees, the roles of court appointed trustees, the role of an examiner/mediator, in addition to the evolution of case law governing these issues – is integral to successful investing outcomes.

Distressed situations tend to be unique because of the asymmetry of information available to interested parties. While in a formal bankruptcy reorganization, monthly operating reports and other pertinent information must be filed publicly, but that is only part of the information investors need to make an informed decision. Relationships with financial and legal advisors, knowledge of the psychology of various creditor constituencies, case law, temperament of the judge and behavioral characteristics of other stakeholders is critical to success. Further, there is even less transparency in out-of-court reorganization processes. All of these factors lead to the need for expertise, experience and an ability to invest with imperfect or incomplete information. Because of this, it is important to have a strong view on the variables that affect the trajectories of drivers of outcomes such as: 1) value of assets/cash flow generation; 2) industry dynamics; 3) sector dynamics; 4) regulatory catalysts; and 5) macroeconomic dynamics.

Alpha is generated in the following ways:
  • Sourcing/idea generation
  • Experience with and knowledge of parties to the restructuring
  • Better diligence on valuations through primary research
  • Formulating a top-down view on industry, sector, geography
  • Investing in situations with more than one viable, positive path to monetization
  • Participation in the process by a reputable player with adequate resources
  • Understanding of leverage – actual vs. perceived
  • Using quantitative and qualitative inputs to determine security selection

The best managers avoid the pitfall of becoming so involved in the details of an issue that they miss the situation as a whole. This usually involves over-estimating leverage - not from the standpoint of just balance sheet debt, but rather the amount of influence of a particular variable on a given situation. Second, it is important to have a well-developed financial and legal perspective on each situation. This time and resource requirement is the base justification for taking more concentrated positions in distressed versus performing debt portfolios. It is far more important to know individual situations in depth than to base investment decisions on an overly broad view of distressed instruments being historically cheap. Lastly, it is vitally important to have an informed opinion of the macroeconomic drivers of value. Historically, this is where distressed investors have been burned, particularly in the era of globalization. Recent examples include underestimating the secular decline of coated paper, misjudging the overcapacity of Chinese manufacturing and the export of deflation to select industries abroad, misunderstanding the crash of the housing market and the timing of its subsequent rebound, and not recognizing the decline in the rate of change of global growth, to name a few.

The very best distressed managers remain wary of that which they do not know. Portfolio performance is often driven by avoiding the bad bets rather than playing a winning hand. While this is true in all aspects of investing, poor choices in distressed investing are rarely bailed out by time, general market rebounds or partial recoveries of principal. Rather the outcome can be a total loss on a given position. Conversely, skilled distressed investors continually incorporate new inputs into their investment analysis to sensitize outcomes. Managers who have access to elastic capital and the courage of their convictions to remain in cash often achieve the best outcomes for their investors. There is almost always distress somewhere, but the breadth of distress rises and falls at various points in the economic cycle, which argues for continuing but dynamic allocations.

Conclusion

Distressed investing should be approached both opportunistically at specific points in the economic cycle as well as through a permanent allocation that relies primarily on the skill of the manager to capture the returns generated by industry- or company-specific, idiosyncratic events. Investors should consider “flexing” their capital accordingly. At the end of this extended economic cycle, we are exiting an unprecedented period of central bank intervention that has floated marginal assets, businesses and activities and shifted preferences to debt from equity as a means of financing and capitalization. The natural outcome is very likely to be widespread restructurings and some liquidations. The market is standing very close to the inflection point where in past cycles the increase in option adjusted spreads and the decrease in the price of high yield bonds has created and excellent entry point for new capital.

Corporate credit has more than doubled in the period since the last credit crisis and yet, banking regulations have emasculated the intermediary market-making abilities that provided the shock absorbers during past periods of widespread distress.The revelation that capital has been historically misallocated in an era of diminished liquidity is setting the stage for experienced distressed managers to harvest superior returns for several years to come.

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This material is for general information purposes only and does not constitute an offer to sell, or a solicitation of an offer to buy, any security. TCW, its officers, directors, employees or clients may have positions in securities or investments mentioned in this publication, which positions may change at any time, without notice. While the information and statistical data contained herein are based on sources believed to be reliable, we do not represent that it is accurate and should not be relied on as such or be the basis for an investment decision. The information contained herein may include preliminary information and/or "forward-looking statements." Due to numerous factors, actual events may differ substantially from those presented. TCW assumes no duty to update any forward-looking statements or opinions in this document. Any opinions expressed herein are current only as of the time made and are subject to change without notice. Past performance is no guarantee of future results. © 2017 TCW