Distressed and Special Situations Funds Attract Investors
By some estimates, almost $1 trillion of high-yield debt and leveraged loans will mature and need refinancing between 2012 and 2015. Distressed and special situations funds will be able to help fill this need by injecting necessary funding into capital hungry firms. In a report on its outlook for the 2010 private equity market, a prominent asset manager proclaimed: “Distressed situations, with a focus on the U.S. and Europe, should continue to be available throughout the economic recovery given (i) the ongoing difficult operating environment, characterized by depressed demand, low capacity utilization and restricted pricing power; (ii) negative pressure on recovery from relatively high unemployment and ongoing issues in the real estate market; (iii) historically high default rates; and (iv) a looming non-investment grade debt refinancing overhang.”1
Distressed and special situations investment firms often get a bad rap for preying on the weak and feeble. However, by investing in companies facing bankruptcy or other serious financial strains, these firms can help support job retention, or at least slow job loss, at a time when unemployment is at its highest levels since 1982-1983. In fact, before the current economic downturn, unemployment of at least 9 percent has happened only twice in the U.S. since World War II: May 1975 and from March 1982 to September 1983. Today, unemployment stands at 9.7 percent and has been more than 9 percent since May 2009.2
Combing through the countless firms in financial peril is the first step in the process of identifying a viable investment with a sustainable business model. As one industry professional said at a Harvard Business School Private Equity conference, “the key to [distressed private equity investing] is determining between the train wrecks and the company that is just underachieving but has lots of potential.”3
With so many companies currently unable to finance day-to-day activities and operate efficiently, there are many firms which fall into the “underachiever” category. If these businesses do not receive financing of some kind, they will file for bankruptcy or close their doors. This is where the distressed and/or special situations investor enters the picture. By providing long-term plans and necessary capital to promising firms, distressed funds infuse stability and help retain jobs.
BHA analysts have seen a sizable increase in demand for distressed funds in the past months. During the fourth quarter when unemployment was at or slightly above 10 percent for three consecutive months, 44.5 percent of all private equity leads were for distressed or special situations funds. In the first six weeks of the first quarter, that number jumped to 47.4 percent. Finally, during the week of February 15, 50 percent of all private equity leads were for distressed or special situations funds. It is clear that private equity investors are increasingly turning to this type of fund to fulfill their private equity commitments. This is due to the vast opportunity within this investment realm.
Many critics believe that distressed and special situations funds are poachers that invest in promising businesses when they are most vulnerable and are at the mercy of their creditors. However, to those critics one can say, What would happen if these funds never made the investment? Most likely, the companies would continue to struggle until they shut down or filed for bankruptcy, neither of which are desirable outcomes.
Rather, with commitments from distressed and special situations funds, these companies are able to keep doing business and retain jobs in a time when every job counts. Furthermore, because these businesses are not closing their doors today, they provide added potential for economic output in the future.
In a time of widespread economic uncertainty, it seems these occasionally mislabeled villains should be lauded. Whether or not distressed and special situations funds get the appreciation they deserve, however, look for these funds to retain investor interest throughout 2010.
1 PEHub.com, NB Alternative Advisers, “2010 Private Equity Outlook,” January 2010.
2 U.S. Department of Labor, Bureau of Labor Statistics, “Unemployment Rate (Seasonally Adjusted.”
3 Harvard Business School Working Knowledge, “Distressed Private Equity: Spinning Hay into Gold,” February 16, 2004.