Investors poured a record sum of money into private equity funds that specialize in distressed and bankrupt securities as the credit crisis headed toward its peak in late 2008. At least 67 distressed private equity funds raised a total of $92 billion in 2007 and 2008, according to London-based Preqin, which tracks private equity deals.
As investors and corporations try to emerge from the global credit crisis, the PE funds have moved from the fund-raising stage to the investing stage. And experts say there are more than enough deals to go around. “It is a phenomenal time to invest,” says Marc Lasry, co-founder of New York City-based Avenue Capital, which manages more than $17 billion, 90 percent of it in private equity or lock-up vehicles. “There are a lot of distressed opportunities.”
Of course, it is not surprising that fund-raising tailed off late last year as the credit crisis intensified. This year, just seven funds raised a mere $1.1 billion, according to Preqin. However, PitchBook Data, a Seattle-based private equity research firm, recently noted that Oak Hill Capital is seeking $1 billion to invest in distressed debt. It added that the new fund, OHA Strategic Credit Fund, would continue the firm’s strategy of investing in nonperforming and distressed loans, high yield bonds and other securities.
Most of the investors in the distressed private equity funds are institutions and endowments, which, like most other investors saw the value of their portfolios deteriorate last year. “Institutional investors don’t have money,” says Kelly DePonte, partner at Probitas Partners, a placement agent for alternative investments. “All areas are down about 60 percent from where they were in 2008.”
As global economies recover in general and the credit environment begins to ease somewhat, experts expect these private equity investors to return to the market later in the year as they become less concerned about liquidity. And they will especially look to those funds that specialize in the securities of, or the acquisition of, troubled companies. In fact, at least 54 funds are currently on the road seeking to raise as much as $52 billion, according to Preqin. “I think [fund raising] is likely to go back up to levels we saw a couple of years ago,” says Tim Friedman, head of publications and marketing at Preqin.
“It is a phenomenal time to invest. There are a lot of distressed opportunities.” -Marc Lasry, co-founder of Avenue Capital
Why is Friedman so confident? He cites the historic track record for distressed private equity funds. Investors are mindful that distressed PE funds with vintages from 1999 through 2004 racked up double-digit returns, including 30 percent for the 2002 funds. That year’s first-quartile performers generated, 46 percent returns on average. (There is no performance data for funds created after 2006.) Since many distressed asset funds operate on a J-curve, with most deals in private equity losing value initially, Preqin won’t typically start looking at performance until around three years into the life of the fund at the earliest.
Indeed, in a recent survey of institutional investors, Preqin found that about one-third believe small- to mid-market buyout funds are particularly appealing, followed by 31 percent, which singled out distressed private equity, including distressed debt, turnaround, and other special situations funds.
DePonte, however, says it typically takes five to six months to get to the first close and 12 to 18 months in total. These days, funds are looking at the longer end of that range and are raising less than they had hoped. In fact, he says many funds that planned 2009 fund raising are pushing back the timetable to 2010.
While investors have taken a pause, the PE fund managers haven’t. “All distressed funds are incredibly active,” says Jonathan Henes, a partner in the restructuring group at the law firm Kirkland & Ellis LLP. He says earlier this year managers were mostly loading up on senior secured debt as asset values were falling and companies were increasingly filing for bankruptcy. “That was the in-the-money security,” he says. Now, as asset values have moved up, distressed funds are looking at high-yield bonds.
PE managers are not so much looking at specific industries for value. Rather, they are looking for what they deem to be an inherently good company with a bad balance sheet that they can fix and then grow in value. Then they are going after the capital structure they believe could give them control of the company. “The goal is to find the fulcrum—the instrument that converts to equity,” Henes stresses. “The downside is we get par and the upside is we get substantially more than par by converting a portion of our bank debt to equity,” Lasry says.
In the past, Lasry says the fulcrum was in the unsecured or subordinated debt. However, these days he is finding it in bank debt because companies are still having trouble refinancing their debt. So, he is buying bank debt and being paid off at par or getting equity, which enables him to wind up owning the company.
Currently, he sits on the creditor’s committee of four companies, including: Six Flags, which runs amusement parks; casino operator Trump International; Spectrum Brands, a global consumer products company; and Ion Media Networks, a network television broadcasting company that owns and operates 63 broadcast television stations.
Altogether, more than $5 billion of completed and announced bankruptcy acquisitions have occurred since July 2008, according to Adley Bowden, managing editor of PitchBook. While 2008 saw just $875 million of completed bankruptcy acquisitions, there have already been $4 billion worth so far in 2009—a 350 percent increase.
There is also another $750 million of pending bankruptcy acquisitions. “There are no other investors right now providing nearly this amount of capital to these distressed and bankrupt companies,” says Bowden. “I believe as the economy continues to stabilize the number will only increase.”
And Lasry reasons there are more than enough deals to go around given the amount of capital recently raised in this space. For example, the American Bankruptcy Institute (ABI) shows that the number of businesses that filed for bankruptcy in the first half of this year totaled 30,333, a 64 percent increase over the previous year’s total of 18,456. Chapter 11 business reorganizations increased 113 percent to 7,396 during the first half of 2009 from 3,470 in the same period of 2008. Chapter 7 business liquidations increased to 20,375 in the first half of 2009, a 57 percent increase over the 13,002 business Chapter 7 filings during the same period in 2008.
Meanwhile, the number of companies with deteriorating financials has surged in the past year. So far this year, at least 205 global corporate issuers have defaulted—that’s four times the 54 defaults reported at this time in 2008, according to Standard & Poor’s. The number of bankruptcy filings has also surged to 53 issuers so far this year, exceeding the full-year 2008 total of 49 bankruptcy-related defaults. More than half of the defaulters this year either had or continue to have private equity involvement, S&P points out.
Meanwhile, the number of fallen angels—entities that moved to speculative-grade territory—has topped 62 affecting rated debt worth nearly $222 billion, according to S&P. In all 0f 2008, the fallen angel total came in at $226.42 billion. Says Lasry: “The amount of supply dwarfs the amount of demand.”