A surge in defaults and distressed opportunities seemed likely when COVID struck—but stimulus measures and creative financing solutions have reshaped both the opportunity set and the timing.
Last year brought with it one of the most acute economic disruptions in our lifetime, with virtually every business experiencing some disruption as a result of widespread lockdown conditions and ongoing restrictions on activities.
Against this backdrop, it is perhaps no surprise that distressed debt has fairly quickly returned to the forefront. Given the amount of capital flowing into the asset class, some investors are now questioning whether there will be enough investible opportunities going forward. In our view, the answer is ‘yes’—but understanding the evolving opportunity and casting a wide net will be key.
A Longer, Flatter Default Curve
The massive spike in defaults that some market participants were calling for after the initial onset of COVID has failed to materialize, thanks in large part to the unprecedented support from global policymakers. Whether injecting liquidity into the capital markets or allowing some companies to defer certain fixed costs from their balance sheets, these support measures have effectively given issuers more time and flexibility to work through this prolonged, low-revenue environment.
While this has been largely positive for businesses and markets in the short term, there are some potentially significant longer-term implications. For instance, much of the capital and liquidity that has gone into businesses has served the primary purpose of balancing losses or making up for the earnings that didn’t materialized over the last year. As a result, many companies will emerge from this crisis with lower revenue and higher levels of debt, and will need to begin deleveraging and rebuilding their working capital as the economy begins to normalize.
To be sure, some companies look well-positioned to manage higher debt levels going forward, particularly those that had strong balance sheets coming into the crisis. But for a number of sub-investment grade issuers, the room for error has narrowed, leaving capital structures ripe for the redistribution of value as stimulus programs expire and certain triggers approach—from covenant violations, to pending maturity walls to liquidity shortfalls. This suggests that defaults will happen, but rather than coming in a widespread surge like we have seen in previous cycles, they may play out over a longer (multi-year) timeframe and in a more organized manner.
As these expected defaults materialize, there may be opportunities for distressed debt managers to take control positions in companies, which often results in forgiving some debt in exchange for a majority equity stake. Becoming part of a company’s shareholder group, in turn, can give managers the leverage to implement change and drive an outcome—whether that’s through a management team change, a board change or a strategy change. In addition to potentially generating attractive returns for investors, this process can help right-set the distressed company and, ultimately, lead to significant value creation.