The past few weeks have been a time of unprecedented volatility in the debt and equity markets due to the uncertainty and impact of COVID-19. For reference, the S&P 500 Index was down 20.0% and the Dow Jones Industrial Average was down 23.2% for the quarter ended March 31. The impact of the coronavirus has been widespread, affecting countries across the world including China and the United States. As a result, a number of industries have struggled to conduct business as supply chains have been disrupted, consumer sentiment has changed dramatically and shelter-in-place mandates have shuttered many businesses. The pain has been felt across industries, from the obvious impacts to the travel and leisure sectors as well as what are generally considered more defensive industries like health care, where quarantine directives have canceled elective surgeries and routine dental visits. This disruption has sent investors scrambling to raise cash by selling securities, resulting in depressed asset prices. Armed with significant levels of dry powder (roughly $1 trillion) and waiting for such a dislocation, distressed and opportunistic credit investors have entered the market and are buying aggressively.
Hedge funds and special situations firms have been active in raising and deploying capital to purchase assets that have seen violent downward pricing pressure, such as collateralized loan obligations, high yield and convertible bonds, and public and private loans, as well as providing funding for struggling companies through bridge and debtor-in-possession financings. These opportunistic credit vehicles range in size, style and focus. For instance, there are funds that focus on the small- to mid-cap universe (companies with roughly $100 million to $1 billion in enterprise value), while others target larger public entities (companies with $1 billion or more in enterprise value). These funds invest across the capital structure, with a portion focusing solely on first and second lien debt with greater expected downside protection. Others elect to purchase mezzanine debt or common equity of distressed companies, taking on more risk in hopes of generating outsized returns. Additionally, the objectives vary by fund. Some managers focus more on trading opportunities, buying fundamentally good assets at discounted prices and looking for pricing to recover, while others look for debt of troubled businesses as a way to gain control of attractive assets, also known as a loan-to-own strategy. The trading strategies are more immediately actionable as the pressure to raise cash and de-lever has created attractive entry points. Loan-to-own strategies will be longer in duration, as the true impact of virus-related shutdowns hits balances and debt maturities trigger difficult decisions around defaults, restructurings and bankruptcies.
The current opportunity set has exploded over the last month and a half, as the amount of distressed debt (securities trading at less than 80 cents on the dollar) in the marketplace has increased from $250 billion to over $1 trillion in value. In addition, as shown in this week’s chart, credit spreads have widened across the debt markets. One contributor to the increased amount of distressed debt can be attributed to “fallen angels,” or companies that were recently rated investment grade by the rating agencies but have now been downgraded to high yield due to a myriad of possible reasons. Furthermore, there have been a number of forced sellers in the market including exchange-traded funds, retail mutual funds and levered sellers in search of liquidity. This has allowed distressed funds to scoop up debt at deep discounts, in some cases 50 to 80 cents on the dollar, in hope that these securities will trade back up to par or a defined price target.
More specifically, some sectors have been hit harder than others, with software and technology faring better than hotels, gaming, retail and the airline industry. In addition, a number of businesses have drawn down their credit lines and revolvers to maintain liquidity in order to ride out the near-term uncertainty of the pandemic. Jason Mudrick, founder and chief investment officer at Mudrick Capital Management, a distressed credit hedge fund, spoke of the struggles of companies in these lagging industries, stating, “Never in my career have I looked at an income statement and plugged a zero into the revenue line.” As these enterprises face looming debt maturities, potential defaults and bankruptcies, it will be fascinating to see where distressed investors find the best value, opportunity and risk-adjusted returns across the capital stack. It will be key for limited partners (LPs) to properly conduct due diligence on managers based on their historical track records, sourcing engines, restructuring and workout experience, in addition to their ability to ascertain value and avoid falling knives.
Key Takeaway
Markets have experienced unprecedented volatility during this health and economic crisis. Due to the dislocation in the credit markets, special situations investors have found themselves drinking from the firehose as the amount of distressed debt in the marketplace has increased to over $1 trillion. These distressed investors execute varying strategies on where to invest in the capital structure, with some focusing on senior secured debt, while others believe outsized returns can be generated through common equity or the bottom part of the capital structure without perceived risk of capital loss. I am interested to see which firms choose the best individual credits and utilize the most effective trading strategies in order to provide LPs with the highest and most prudent return on capital.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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