How COVID-19 Has Shaped the Future of Distressed Debt Investing

We spoke with Andrew Amos, Director at M&G Investments, about how the rising levels of defaults are creating more opportunities in the space

The events of 2020 drew a record number of distressed debt funds to the market, while other funds have pivoted toward opportunistic or special situations strategies. How will the sizable pipeline of distressed funds impact the market in 2021?

We are currently witnessing imbalance between the supply of distressed debt opportunities in more liquid leveraged loans and high-yield bonds and demand for each of those assets. Distressed debt funds raised a lot of capital in 2020 and mostly chased the same liquid opportunities, but the yields on these opportunities fell after markets rallied from April. Though opportunities will continue to arise while the pandemic prevents economies from returning to ‘normal,’ we expect this imbalance to continue through early 2021.

This being the case, we will continue to target less liquid distressed debt opportunities and special situations financings. Our ability to source such deals enables us to minimize the impact of the very cyclical nature of distressed debt investing, and deploy capital at a target return of 15% p.a. throughout the cycle.

Our experience as investors during and after the Global Financial Crisis (GFC) has taught us that ‘good’ distressed debt opportunities might take some time to materialize, but corporate stress continues long after the initial crisis and market sell-off. We were still finding opportunities yielding 15% p.a. from corporates six years after the GFC; we expect the same long tail of attractive investment opportunities following the pandemic.

Consistent with our approach of sourcing interesting illiquid opportunities, we tend to raise smaller funds (€300-700mn). This enables us to be highly selective and focus on smaller, less liquid, more time-consuming, and less competitive opportunities if public markets become over-competitive. If the opportunity set turns out larger than expected, we can rely on long-standing relationships with repeat investors to quickly raise additional funds.

What are the key factors for success as a distressed debt fund manager?
There are many ways to invest in distressed debt, all of which require different skillsets. Most funds prefer to target more liquid leveraged loans and high-yield bonds. In our view, this creates competition for opportunities, which reduces returns or increases risk. We target smaller, less liquid deals and actively manage our investments, using a hands-on approach to bring companies back to financial and commercial health. To do so, we rely on several factors:

• Broad and effective market tracking. The best opportunities are often the ones that don’t hit the radar screens of liquid distressed debt funds and the investment banks, advisors, and consultants that service them. M&G’s extensive fixed income platform provides us with access to the entire universe of opportunities, including the smallest, least liquid, and least visible ones.
• A specialist restructuring view from inside the deal. M&G’s restructuring team has been acting as an in-house restructuring advisory service since 2003. This allows us to develop a much sharper picture of how a restructuring might pan out, and tells us the real value of the underlying business. Given M&G’s extensive fixed income book, we can develop this view on a large number of the restructurings in the market, enabling us to select only the most compelling opportunities in which to invest.
• Full set of restructuring skills. The 18-strong restructuring team has been built to have the deep expertise required for distressed debt and special situations investing: accounting, credit, legal, and the hands-on experience of helping stressed companies turn around.
• Network of industry specialists and experienced board directors. While we are a hands-on investor, we are cognizant of the fact that, in most cases, we are not specialists in the specific industry and in the day-to-day activities required for an operational restructuring. To address this point, over the years we have built a network of trusted senior industry specialists, who can help us achieve the positive change we target as members of a management team, board directors, or in an advisory capacity.

How can the risk/return profile of distressed debt be improved?
As a strategy that often targets a 15%+ IRR, distressed debt investing is considered a high-risk strategy. With that said, our experience over the past 20 years suggests there are a number of ways to reduce its risk profile.

We tend to choose investments where the main risks are in credit and execution of the restructuring and subsequent turnaround, i.e. aspects that we can control. In the vast majority of cases we only invest in opportunities where we can influence the restructuring process (in many cases by investing alongside existing M&G holdings) and exercise control during the turnaround phase (in many cases by obtaining enhanced governance rights as a condition of the restructuring). This allows us, to a large extent, to be in control of our own destiny.

Over the years, we’ve learned that even the most bullet-proof investment thesis can unexpectedly fail. For this reason, we only invest in situations offering a ‘Plan B’ option, enabling us to recover the invested capital and return it to our investors, usually by selling underlying assets or implementing an alternative recovery plan.  

A lot of time and effort is spent fine-tuning the legal aspects of our investments, which provides us with the maximum number of ‘levers’ to recover our investment if things don’t go as planned.

As specialists in distressed debt with direct deal experience in all jurisdictions across Europe, we are able to understand the idiosyncratic factors that impact risk/reward and deliver value from an investment.

What will be the medium- to long-term ramifications of the response to COVID-19 for distressed debt opportunities?  
We have known for a while that the next distressed debt cycle will be driven by payment defaults, not technical defaults or covenant breaches, due to the steady increase of covenant-lite loans since 2012. In some cases, government interventions are delaying the inevitable for companies that entered the crisis in poor financial and commercial health. When government support eventually comes to an end, we expect the majority of these companies to urgently require an injection of capital, followed by financial and operational restructuring. We expect the response to COVID-19 to have an impact in the short term by delaying defaults, but a limited impact in the medium to long term.

As investors, we prepare for this scenario by monitoring many companies, with the help of 200+ professionals in M&G’s fixed income business and through our in-house restructuring role. Additionally, we make sure we maintain access to dry powder, which will be needed to provide rescue financing. The ability to fund emergency liquidity is likely to be one of the more impactful ways of gaining control in a process.

We believe the coming months and years will offer attractive opportunities to invest our clients’ capital while helping companies ‘with a reason to exist’ regain a stable financial and commercial footing.

About M&G
M&G Investments is a global asset manager with a long history investing and innovating across both public and private markets. As an active manager we offer access to a broad range of capabilities that span both public and private assets including fixed income, equities, multi-asset, real estate, infrastructure, and private equity. Globally we manage over £271bn (at 30 June 2020) on behalf of individual and institutional investors including pension funds, endowments and foundations, insurers, sovereign wealth funds, banks, and family offices.