The end to the coronavirus health crisis is in sight, however, it may take much longer to recover from the economic slowdown that it caused. The loss of revenue attributable to COVID-19 and stay-at-home measures resulted in many companies taking on significant debt, which could create stressed scenarios if revenues fail to recover. Bloomberg recently analyzed 3,000-listed U.S. companies and concluded that nearly 20% may now qualify as “zombies,” businesses with insufficient earnings to cover their interest expenses after adding an extraordinary $1 trillion of debt to their balance sheets during the pandemic.1
The result is a favorable dynamic for distressed investors with the global opportunity set nearly 2.5x larger than the capital targeting it — approximately $140 billion of capital is seeking to invest in a $320 billion universe. Distressed fund capital deployed during previous market dislocations – the Global Financial Crisis (“GFC”) and the dot com bubble bursting (“Dot Com crash”) – delivered historically high returns, suggesting that 2020, and even 2021, could be strong vintages.
Zombie firms are sitting on an unprecedented $2 trillion of obligations
Source: Bloomberg, as of September 2020. For illustrative purposes only.
MONETARY STIMULUS PRODUCED A LIMITED PUBLIC MARKET RECOVERY
To mitigate the negative economic effects of the COVID-19 pandemic, Congress and the Fed – along with other governments and central banks across the globe – injected unprecedented fiscal and monetary stimuli. These included the $2.2 trillion CARES Act; an expansion in the eligibility of quantitative easing and existing stabilization programs by over $3 trillion; and a reduction in interest rates to near zero.
While the Fed’s toolkit eased the initial liquidity crunch, businesses still face a deeper, long-term solvency crisis. Companies able to access financing either drew down on their revolving credit facilities or took out new debt to help weather the initial storm caused by the abrupt reduction in revenues. This provided many with a sufficient liquidity runway for the first or even second half of 2020 and delayed the onset of widespread distressed opportunities. However, many of these businesses may now find themselves over-levered, with difficulty servicing their additional debt load in the face of reduced revenue capabilities in 2021 and beyond. Highly levered companies (those with debt multiples of 6x or higher of EBITDA) that were not part of the Fed’s stimulus package are particularly vulnerable, affording distressed investors an opportunity to provide rescue financing loans, or acquire a claim on a company’s assets through a restructuring or distressed-for-control transaction.
SIZING THE U.S. DISTRESSED OPPORTUNITY
Overall, distressed investors in this cycle are expected to benefit from compelling supply-demand dynamics. The lower-rated corporate debt market is vast, representing $4.6 trillion of assets2 ($3 trillion in the United States3). Using Moody’s projected default rate of 7%-8%4 (down from an initial projection of 11%-12%), the anticipated default wave is approximately $320 billion to $370 billion ($210 billion to $240 billion in the United States). Although lower than during the GFC, this represents a massive opportunity set. The pace of these defaults is expected to rise through 2021, with Moody’s projecting a peak in March 2021.
This supply of distressed opportunities is expected to exceed the capital targeting the sector. In addition to the $68 billion of distressed dry powder as of June 2020, distressed funds in the market were seeking to raise an aggregate $70 billion in capital, much of which has been closed on in the last few months.5 Together, this translates to approximately $140 billion of capital targeting a global opportunity set of $320 billion or more — an attractive imbalance in favor of distressed investors. While other investment types, such as hedge funds and other forms of private credit, may also selectively target distressed debt opportunities, the supply-demand imbalance is significant and should favor experienced managers.
We believe that the distressed debt market cycle is still developing, and it is a compelling time to invest in the asset class. Historical data from past market downturns supports this view, as distressed funds raised during both the GFC and the Dot Com crash outperformed their counterparts from other vintages, as well as other private debt funds. Given zero interest rates, however, the returns on the new funds may be lower than earlier funds. Vintage 2008 distressed funds generated a median net IRR of 15%.6 In the years following the Dot Com crash, the HFRI Distressed Index was up over 100% in the five years post-2000.7 If we are entering a similar slowdown period that affects multiple aspects of the global economy, then we may be in the early phases of a distressed opportunity set that lasts for several years.
For more on the current state of the distressed debt opportunity, see our paper, Is It Too Late for Distressed?
(1) Source: Bloomberg, “America’s Zombie Companies Rack Up $2 Trillion of Debt,” November 2020.
(2) Source: Oaktree, September 2020. Represents non-investment grade debt outstanding.
(3) Source: Source: S&P Global, “Credit Trends: Global Corporate Debt Market: State Of Play In 2020,” June 2020.
(4) As of Q4 2020.
(5) Source: Preqin, “Record Number of Distressed Debt Funds in Market amid Downturn,” June 2020.
(6) Source: Institutional Investor, “History Suggests Distressed Debt Funds Raised This Year Will Outperform,” October 2020.
(7) Source: eVestment, as of November 2020.
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