With many high-profile distressed debt funds raising record levels of capital this year, we evaluate how previous vintages performed during economic crashes
With many high-profile distressed debt funds raising record levels of capital this year, we evaluate how previous vintages performed during economic crashes
Distressed debt is often a focus for investors during times of economic and financial stress. Bond prices can sell off dramatically as investors cut exposure and reprice perceived default risks when economic conditions start to bite. This can provide attractive opportunities for specialist distressed managers in securities where they view that, amid the panic, risk has been mispriced. The primary market can also provide a source of opportunity as companies may need to issue at higher rates in order to shore up their balance sheets.
How strong is the case for distressed debt outperformance? To find out, we use fund-level return data from Preqin Pro across past financial crises. To measure performance, we have selected the median net IRR of distressed debt funds and accompanying standard deviations, compared to the median net IRR of all private debt funds within Preqin’s benchmark tool.
How Distressed Debt Funds Generate Returns
A distressed debt fund takes either a large controlling or minority stake in corporate debt of companies facing financial hardship. The fund would seek to purchase the debt at deep discounts to face value in the belief that company financials will improve, driving a re-rating of the security. Alternatively, funds can assess that the liquidation value of the company will allow a larger portion of the bond’s principal to be paid compared to what they were able to purchase for the bond.
How Distressed Debt Funds Performed in the Early 2000s
The recession of the early 2000s, which coincided with the dot-com bubble and subsequent crash was the first major global recessionary period of the 21st century. As the chart above shows, the median net IRRs of distressed debt funds launched during this time are the highest of any three-year period in the 17 years since. However, so are the variations in returns, as shown by the 22.1% standard deviation in 2002. Despite this, these funds were able to outperform private debt as an asset class in each year up until 2006. 2003 in particular outperformed by the highest amount, as high-yield bond yields decreased substantially throughout the year, ultimately boosting prices.
In response to the recession, the Federal Reserve reduced interest rates from 6% to 0.75%. This helped US corporate debt issuance spike to an all-time high at the time of $849bn in 2001. High-yield bond issuance more than doubled from $32bn to $78bn, increasing the scope of the market in which distressed debt funds can find opportunities. Issuance spiked even while default rates soared to 16.8%. This provided a favorable environment for selective managers that were able to take advantage of higher yields.
For GFC-Era Vintages, the Pattern Is Similar
Distressed debt funds with vintage years during the Global Financial Crisis (GFC) show similar elevated returns as with the early 2000s recession. Net IRRs were slightly lower for the GFC period, but reduced standard deviation made up for this. 2008 proved a standout year for distressed debt funds in this time period, with a median net IRR of 15.2% and the lowest standard deviation recorded of 4.3%. It is important to note that the low standard deviation can stem from low liquidity in this period.
Interest rates declined globally during the GFC, with the key US discount rate hitting 0.5% – its lowest of the 21st century – a drop from 5% in November 2007. US corporate debt issuance skyrocketed in 2009, with high-yield issuance jumping 2.5x from $42bn to $146bn year over year. Massive amounts of high-yield issuance continued in each year following the GFC, but the percentage increase was unmatched. Similarly to the previous recession, default rates and default premiums spiked.
Will 2020 Prove a Strong Vintage?
While past performance is not necessarily indicative of future results, distressed debt funds typically perform well during certain economic conditions. This includes periods when monetary conditions have been dramatically eased and when high-yield debt issuance is high. At present, global interest rates are near all-time lows, following a steep drop in March in response to the COVID-19 pandemic. Corporate debt issuance is also now at an all-time high – US high-yield issuance in particular has already met 2019’s issuance number by August.
Responding to investor demand, distressed debt firms were quick to launch new funds during the COVID crisis. To put this appetite into context, Preqin data approximates total H1 2020 private debt fundraising at $54bn, which is not extraordinary, but around the average level for H1 or H2 in a given year since 2015. What is substantial, though, is the 25% increase since January 2020 in aggregate capital targeted by private debt funds on the road. The figure stood at $239bn at the end of H1, making it the largest six-month rise since 2015. Special situations and distressed debt funds raised the most capital of any strategy, at 36% and 29% of the total respectively. What’s more, a majority (60%) of private debt investors tracked on Preqin Pro are seeking to commit to at least one distressed debt fund in the next 12 months.
If the worst of the COVID crisis has played out, then 2020 vintages have a favorable economic playing field to generate higher returns in the distressed debt space. And if financial market conditions worsen further, subsequent vintages could stand to benefit.
To learn more about how COVID-19 is affecting the alternative assets industry, visit Preqin's COVID-19 Knowledge Hub.