Distressed investing 2017: caveat emptor

May 2017 | SPOTLIGHT | FINANCE & INVESTMENT

Financier Worldwide Magazine

Distressed investment performance, with few exceptions, has been very strong over the eight years since the collapse of the financial sector in 2008. Fund indices have been up well over 200 percent during this period. Recognising that trailing averages are unreliable indicators of future performance, several months into 2017, pitfalls confronting distressed investors are clear, while opportunities are as elusive as ever. The long term trend of increasing corporate leverage, the rapidity and magnitude of business change, and the concentration of cyclical enterprises which populate the distressed market make calling investment winners and losers difficult under the best of circumstances. 2017’s market, far from optimal, poses extraordinary imponderables.

Overbought market

All factors being equal, investment returns are a function of the underlying supply and demand of capital. Certainly, there is no dearth in supply of distressed credits. Stressed industry sectors range from retail and restaurants to commercial mortgages, oil & gas production to merchant power and healthcare to international shipping. While the US economy appears to have recovered from the banking crisis of 2008, these sectors, under duress, represent more than 20 percent of the junk bond market. Adverse factors impacting these sectors include changing consumption patterns, commodity price volatility, over investment and product margin pressure. When magnified by indebtedness, such competitive dynamics inevitably lead to financial distress.

While a significant portion of the high yield market appears precariously balanced, the potential returns afforded prospective distressed investors depend on overall market liquidity and specific demand. Reflecting years of accommodative monetary policy, it is estimated that close to $50bn is currently allocated and available for distressed investing. As a result, not only have junk bond spreads collapsed and distressed security prices risen – two indicators of heightened demand – but the past year has seen an unusual volume of rights offerings affording new equity capital previously unavailable to these companies as they emerge from bankruptcy. This level of interest in such speculative equity propelled by excessive liquidity implies lower long term returns than realised in prior cycles.

Plethora of unknowns

Compounding the challenges of an overpriced market are an unusual and complex range of market factors, any one of which has the potential to cause a reversal. First on the list is the uncertain impact on markets and valuations of the pending unwind of central bank bond holdings. The Federal Reserve has taken the first steps in terminating its ‘quantitative easing’ programme. For the first time since 2006, the Fed raised short term rates in December 2015. Additional interest rate increases are anticipated in 2017, taking Fed Funds back to a range between 1.5 percent and 1.75 percent by year-end. Putting this into perspective, these levels have not been sustained since early 2008. Coupled with the prospect for additional bond sales by the two other major holders of US treasuries, China and Japan, this shift in monetary policy portends not only a strengthening US dollar impacting exports, but a brake on the economy of uncertain magnitude.

Second, the equity markets are focused on bullish employment and corporate earnings, while ignoring problematic statistics such as falling consumer spending and declining industrial production. A manifestly positive sentiment is expressed in year-end surveys of US small business, apparently based on the expectation of tax cuts, expansive fiscal policy and the promise of broad-based Federal deregulation. This belies the complexities, delays and compromise inherent in such broad-ranging political initiatives.

Yet another cloud overhanging the market for speculative securities is the elevated level of corporate valuations. A well-respected measure of stock market value – the cyclically adjusted price-earnings ratio (CAPE), is at an inflated level only previously recorded immediately prior to the Great Depression in 1929 and as the dotcom bubble imploded in 1999. Furthermore, capital markets have advanced uninterrupted for eight years. This technical measure now exceeds most cyclical advances observed since the end of the Second World War, a further cautionary indicator.

To better returns

Every market affords opportunities to invest. 2017 is no exception. While the current market appears overvalued, confronts the shift away from quantitative easing, and evidences indications of a pending correction, it still presents alternatives to better balance risk and return. Consider three options to this end.

First, reconsider the traditional view that uncommitted cash taxes returns with a high opportunity cost. Faced with considerable uncertainty and the likelihood of a substantial correction, maintaining a liquid position and attributing option value to cash rather than a cost, provides the ability to pick and choose from extraordinarily attractive securities available when markets do correct.

Second, maintain an absolute return hurdle for potential investments commensurate with risk. Tight spreads and high prices of distressed securities reflect an undisciplined approach to investing. Increasingly, distressed bonds are traded on returns relative to lower risk, conventional asset classes. This is a fool’s game, chasing yields downward with growing certainty of loss. The risks inherent in distressed investing dictate absolute return targets which exceed those traditionally achieved on speculative equity securities.

Third, seek opportunities in credits perceived as mismanaged or difficult to evaluate as a means to offset and overcome market risks. Consistent with the tradition of distressed investing, shift emphasis to identify credits where changes in business operations have the potential to improve income and enhance value. While these managerial improvements may require a longer investment horizon and the understanding of fund LPs, they have the potential to generate returns well in excess of traditional recoveries and mitigate broad risks of the market.

Given the uncertainties, 2017 may be a year for distressed investors in particular to emphasise returns of capital, rather than returns on capital. That said, the magnitude of the changes ahead, magnified by an accumulation of financial leverage, promise another cycle yielding highly attractive returns.

Anders J Maxwell is managing director at Peter J Solomon Company. He can be contacted on +1 (212) 508 1683 or by email: amaxwell@pjsc.com.

Anders J Maxwell

Peter J Solomon Company