Distressed Debt: a lifeline for businesses in trouble
Distressed debt is a form of alternative credit – a collective term that covers a variety of non-traditional bond classes. It consists of bonds issued by ailing business and that are trading at a price considerably below their par value. This big discount could be for two reasons: either the company is experiencing financial difficulties and is struggling to pay its interest and redemptions – and may have already applied for a suspension of payments – or because the market believes there’s a growing probability that the company will have to file for bankruptcy.
Traditional bondholders tend to sell their holdings when companies get into financial difficulty, pushing down the price of those bonds considerably. Demand for such bonds is low overall, but it is exactly this type of bond that distressed debt investors are hunting for. Their aim is not just to invest in the bond, but to get involved in restructuring the company financially and operationally so that it can survive and become profitable once again. Investors in distressed debt have a long investment horizon because it can take several years to achieve such a turnaround.
High risk, but high potential return
Investing in the bonds of ailing companies can involve considerable risk: while distressed debt investors aim to restore their patient to health, things can go wrong. The biggest risk is that a company cannot be saved, or that it’s worth less after the rescue operation than the amount the investor paid for the bonds. But at the same time, the potential upside is considerable: it’s possible to earn a very large return if a company is rescued financially and successfully resumes operations. The return of distressed debt is usually 10 percentage points higher than government bond yields.
A useful option when the economy is struggling
Distressed debt is a cyclical investment strategy. When the economy is doing well there are relatively few investment opportunities around as not many companies fall into distress in benign conditions, but more opportunities arise when the economy is struggling. In such periods, distressed debt investors can earn returns similar to those provided by equities.
Distressed debt investing at Van Lanschot Kempen
Van Lanschot Kempen invests in distressed debt on behalf of its clients via external funds managed by seasoned specialist managers, pooling these investments in the Kempen Diversified Distressed Debt Pool (the Pool).
Here, Remko van der Erf, managing director, fixed income & alternative credit in Van Lanschot Kempen’s Manager Research Solutions team, answers our questions about distressed debt, what’s required for success in managing the asset class and the type of investor it may be suitable for.
Can you describe Van Lanschot Kempen’s distressed debt investment strategy in three words?
Remko: “Specialists, flexibility, experience.”
And in more detail?
Remko: “Investing in distressed debt enables us to contribute to the successful restructuring of a company. And in doing so we can earn a sound financial return, albeit by taking on relatively high risk.
“Steering businesses through a restructuring process requires specialist knowledge and experience because market conditions can change quickly and each bankruptcy cycle is different. That’s why we work with specialists with international experience and who are flexible when it comes to seeking solutions to the financial difficulties companies find themselves in.”
Where do you look for companies in which to invest?
Remko: “The investment opportunities all share a single characteristic: they’re businesses in financial difficulty. You can’t predict in advance which countries or sectors will provide the most opportunities at any given time, so it’s important to cast your net wide.
“When searching for sound investment opportunities, we prefer good companies with bad balance sheets. That’s because a healthy company with excessive debts can generally be saved if a portion of its debt can be reduced in value as part of the bankruptcy proceedings. It’s much more difficult to save a company experiencing difficulties that derive more from its operations or from challenging conditions in its sector than from its debts.”
What constitutes a potential investment candidate?
Remko: “Given our preference for good companies with bad balance sheets, our specialists are currently particularly interested in robust companies that have been affected by the coronavirus crisis. There are several to be found in the tourism sector.
“They’re more cautious about retail companies that had to close during the lockdowns. If such firms don’t have a good online sales channel alongside their physical stores, they’re going to be in a relatively weak fundamental position over the long term.”
don’t distressed debt investors have a bad reputation? As the restructuring process can lead to employees losing their jobs or previous investors their investments.
Remko: “Yes, they do have a bad reputation but I don’t believe they deserve it. In most cases, quite the opposite. Once they’ve bought the bonds of an ailing company, distressed debt investors set to work. First, they need to strengthen the company’s balance sheet and then improve its strategy and operations. What’s more, when strengthening the balance sheet, they often pump more of their own money into the business at a time when banks or other investors refuse to do so. This is on top of the investment they’ve already made by buying the bonds.
“Jobs are always a delicate subject. Bankruptcies regularly result in jobs being lost at underperforming business units, but they’re created in those parts of a company that are doing well. Distressed debt investors profit if a company resumes growth and creates new jobs following its bankruptcy. They’re not obliged to sell their bonds. It’s up to them whether they opt for liquidity instead of a potentially complex and lengthy bankruptcy process.”
Distressed debt funds usually perform well in the wake of a crisis. Does the pandemic mean you’ve got the wind in your sails at the moment?
Remko: “The coronavirus crisis certainly created fertile conditions for distressed debt investment strategies in 2020, especially in sectors that saw their revenues evaporate overnight, such as car rental businesses and cruise ship companies. In many cases such firms have been able to survive thanks to a combination of government support and capital injections from distressed debt investors.
“Support for businesses from governments and central banks ensured that the number of bankruptcies, and their magnitude, fell sharply in 2021. But that doesn’t mean that distressed debt investors can sit on their hands. There are plenty of businesses that have received state support but that are finding that support stifling due to the conditions attached to it. For example, because they aren’t allowed to raise wages or expand their workforce.
“Many of these companies are seeking partners to help repay the funds they received from the state so they can get on with running their businesses properly again. Many, such as gyms, are companies in sectors that have experienced sharp fluctuations in their revenues over the past two years, so the banks aren’t exactly queuing up to help them. This is where distressed debt funds can step in to help and, hopefully, achieve attractive financial rewards in return.”
Distressed debt is a high-risk asset class. How do you minimise the risks it involves?
Remko: “First of all the fund managers we work with in the Pool try to pay the lowest possible price for the bonds. This provides us with a safety buffer to absorb some of the risk they involve. In addition, our managers spread risk by investing in a variety of companies in different countries. Similarly, the Pool invests in a number of different distressed debt specialists.”
Can you tell us about an investment you’re proud of?
Remko: “When Van Lanschot Kempen – back when it was still Kempen – started investing in distressed debt in 2005, we decided to invest in Silver Point Capital, a distressed debt fund based in the US. Our clients continue to benefit from this investment to this day. Since it was launched in 2002 it has returned an average of over 10% per year after the deduction of fees.
“But it hasn’t been plain sailing for this investment. We’re proud that we remained calm when Silver Point Capital went through a tough period in 2008, when it fell in value by 33.5%. Our patience and trust were rewarded when the fund rose by 44% in 2009 and another 19% in 2010. It has also distinguished itself during the coronavirus pandemic, rising by 13% in 2020 and 24% in 2021 as of the end of November.”
Is there scope to adopt a sustainable approach when investing in distressed debt?
Remko: “There’s ample opportunity to enact positive change at companies that are being restructured, and in so doing improve their sustainability profile, whether that be in terms of the environment, social issues or good governance. When a company comes under financial pressure everything becomes fluid so there’s plenty of scope to encourage them to embrace sustainability when they’re at the negotiating table. And that’s not purely from an ideological standpoint: distressed debt investors know perfectly well that investors will pay more for a company with a robust ESG profile when it exits bankruptcy proceedings.
“We’re proud of the fact that five of the six distressed debt funds we work with have already signed up to the Principles for Responsible Investment, a code of conduct for sustainable investment drawn up by the United Nations. In fact, the funds signed up at the request of Van Lanschot Kempen. What’s more, two of the six specialists are now applying the Van Lanschot Kempen exclusion list to the investments they manage on our behalf and another two are reviewing their options for doing so.”
What kinds of investor is distressed debt suitable for?
Remko: “Distressed debt is suitable for investors with a relatively high risk appetite and an investment horizon of at least three to five years. They should also have enough investment experience to be able to weigh up the risks it involves properly.
“Investors need to bear in mind that distressed debt is less liquid than many other asset classes, often up to 25% per quarter at 90 days’ prior notice. That means they’ll be holding their investment for a long time. And they would do well to compare investing in distressed debt to investing in equities or high-yield corporate bonds.”
Is there any experience that has shaped you as a fund manager?
Remko: “In March 2009 I travelled around the US looking for potential new distressed debt funds to invest in and to talk to the managers we were already working with. That month marked the equity market trough in the aftermath of the 2007–08 financial crisis.
“It was an extraordinary experience because no one had been through anything like it before. The lesson I learned is that it’s always darkest just before dawn. And it is at exactly at those times that you mustn’t panic as an investor. This belief gave us the strength to increase our investments in distressed debt when the coronavirus crisis erupted in March 2020. And it was a decision that turned out to be a good one for our clients later that year and in 2021.”
This document is prepared by the fund managers of fixed income & alternative credit, managed by Kempen Capital Management N.V. (‘KCM’). The Strategy currently holds shares in Silver Point Capital. The views expressed in this document may be subject to change at any given time, without prior notice. KCM has no obligation to update the contents of this document. As asset manager KCM may have investments, generally for the benefit of third parties, in financial instruments mentioned in this document and it may at any time decide to execute buy or sell transactions in these financial instruments.
This document is for information purposes only and provides insufficient information for an investment decision. This document does not contain investment advice, no investment recommendation, no research, or an invitation to buy or sell any financial instruments, and should not be interpreted as such.
This document is based on information that we consider reliable, but we do not represent that it is accurate or complete, and it should not be relied on as such.
The views expressed herein are our current views as of the date appearing on this document. This document has been produced independently of the company and the views contained herein are entirely those of KCM.