Dry powder increases mirror the Global Financial Crisis. If history repeats itself, it will only be a matter of time before distressed opportunities emerge
Dry powder increases mirror the Global Financial Crisis. If history repeats itself, it will only be a matter of time before distressed opportunities emerge
Dry powder at distressed debt funds is rising, as fundraising has been boosted by investors looking for post-COVID opportunities that have yet to emerge. At funds targeting Europe in the first five months of 2021, dry powder jumped by 53%, from $12bn at the end of 2020 to $18bn as of June 2021. This reversed the trend of decline that has seen dry powder fall steadily from a high of $19bn at the end of 2015 (Fig. 1). In North America, however, distressed debt dry powder has climbed from $48bn to $70bn over the same period.
Market Adjusts for Post-COVID World
Distressed debt investors in Europe have found plenty of opportunities to deploy capital over the past decade. Analysis of the most-up-to-date assets under management (AUM) data shows that the proportion of dry powder to AUM in funds targeting Europe has declined steadily over the past decade, falling from 63% in 2011 to 29% as of September 2020 (Fig. 2). Using an obviously flawed but still useful comparison that likely overstates the proportion of dry powder, we can adjust for the huge jump in 2021 by comparing May 2021 dry powder with September 2020 unrealized value. In this scenario, the ratio is 47%, a level last seen in 2015 but lower than pre-2013 levels. Dry powder in the more mature and established market of North America has ranged between 25% and 40% over the past 10 years.
The distressed debt market is characterized by a small number of large funds, with an average size of more than $2bn across the seven Europe-focused funds that closed in 2020 (Fig. 3). Fundraising, which had been rising since 2017, was boosted by COVID-related funds coming to market, including the $7bn Fortress Credit Opportunities Fund that closed in December, KKR’s $7bn Dislocation Fund, which closed in May, and a $2bn Arrow Credit Opportunities Fund that closed in November.
Fiscal stimulus and support measures have staved off a wave of credit defaults. According to S&P data, the lagging 12-month default rate on European leveraged loans began to creep up from the summer of 2019, but has hovered between 2% and 2.5% since July 2020. US defaults share the same trend but are slightly higher, touching 4% in H2 2020 then dropping close to 3% in 2021.
Deal flow – No Cause for Distress
While this may be a cause for concern, the experience of the GFC suggests there is a delay of several years between market dislocation and investment opportunity. Fundraising surged in 2010 and 2012 (Fig. 3), leading a dramatic increase in the proportion of dry powder to AUM (Fig. 2), which peaked for Europe-focused funds at 63% in 2011.
However, what may have looked like a dangerous wave of capital in 2011 subsided over the next five years as funds were deployed, with the dry powder to AUM ratio falling to a balanced 34% by 2017. In business terms, financial markets were the first to feel the pain of the pandemic, but it is only a matter of time before that feeds into the corporate world.