Low rate environment seems to have made the model struggle — curious if rate hikes and sentiment that rates will stay higher longer spell more viability / opportunities for the distressed players to capitalize in the near future.
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Based on previous WSO threads, distressed hedge funds are facing challenges in a low-rate environment, but the landscape is changing. Here are some key points:
Current Performance: Distressed and credit opportunity funds have shown flat to slightly negative returns recently, with 10-year averages around 3.5-4%.
Impact of Rate Hikes: Rising interest rates are expected to create more opportunities for distressed funds. Higher rates can lead to increased bankruptcies and financial distress, which distressed funds can capitalize on.
Market Sentiment: There is a sentiment that higher rates will persist, which could revitalize high yield and restructuring sectors. This environment may test the skills of many funds, especially those that emerged in the past decade.
Future Prospects: The potential for a paradigm shift from growth to value-based strategies could benefit hedge funds, including distressed ones. The liquidity available in public markets might become more appreciated compared to the long workout processes in private equity.
Career Considerations: For those entering the distressed asset class, the current environment might offer significant exposure and development opportunities, potentially making them more competitive compared to traditional IB analysts.
In summary, while distressed hedge funds have struggled in a low-rate environment, the anticipated rise in interest rates and prolonged higher rates could create more viable opportunities for these funds in the near future.
Sources: https://www.wallstreetoasis.com/forum/hedge-fund/the-future-of-special-situations-distressed?customgpt=1, Credit/Special-situation HF performance this year?, HF Industry Dying?, 3rd Year HF Analyst Q&A, Bridgewater Layoffs - Sign of Troubled Times for HFs?
I’d certainly hope so.
All jokes aside, one of the consistent themes we hear from LPs is the pivot of capital and dry powder into private credit / special situations (distressed is a much maligned term now, and most shops have the “full spectrum” with a combination of true distressed trades through to some type of private financing). I think a good litmus test is to look at the senior level hirings - tons of movement in the last year or so in the space as funds want experienced folks who can deploy and generate returns in what they view as a strong macro environment for credit that is coupled with senior folks who have been in their seats for a long time also repositioning themselves for the best payout/largest capital base to deploy when stuff does inevitably hit the fan.
Insightful, thank you. To what kinds of funds have you seen the movement you’re describing — any examples I could look into?
Farallon, SVP, Ares, TacOpps, HIG, Hayfin, Oakhill, Oaktree, etc (London all)
I hope it’s true. I decided to trade my PE career on my macro bet rates will continue to be high 📈
So you pivoted to a distressed HF?
To be honest, I dont know (nobody does)... But here is my take on the enviorment and I would be happy to hear what others think
Funds that have the ability to invest across situations, performing, distressed, etc, and funds that also have the ability to make structured private investment may do better in the short run. I’m saying this because I believe that the private credit and the move to more flexible structured financing like hybrid value will allow a lot of firms that would typically be stressed or distressed due to higher rates or maturities to figure out solutions that wouldn’t have been available 5 years ago. So for now I can see default rates staying stubbornly low and the economy will keep chugging along as financing opens up.
But as Howard Marks says, A Tree can’t grow to the sky (I think that’s the quote). I believe we are in his phase 2 of a bull market, “a lot of people realize things are improving and the economy is strong”. Phase 3 is when everyone thinks things will go up forever, and after that is when the opportunities in distress will present themselves.
But for now, i think (but don't know) things will be a similar pace to the last few months. Eventually, after credit markets continue to open, compete for deals, and be forced to take on more risk to achieve returns (cov-lite, lending to riskier borrowers, etc), at some point, things will need to unravel.
In a sense, distress debt will always be around because cycles will always be around (even though people seem to forget that) but firms that are a bit more flexible in their mandate might have more consistent activity, not necessarily performance.
I kind of disagree with the view that default rate will stay “stubbornly low” and that the “economy is strong”. There’s sort of two opposite forces at work - on one hand tons of dry powder has been raised for these “distressed” funds, which are really more oriented today as Capital Solutions / Opportunistic Credit today that look to form partnerships with Sponsors and corporates as liquidity providers. These funds have obviously promised a certain return to their LPs so need to deploy capital but these are typically locked-up/PE-style drawdown vehicles with 3-5 year investment horizon with added “dislocation” vehicles that allow them to tap LP for more capital in a market dislocation. This means that there is theoretically less pressure to deploy if the opportunity isn’t ripe and fund managers can afford to be patient.
This comes to the real problem today, which is higher rates leading to higher interest costs/lower interest coverage/worse cashflow. This has two impacts: first on valuation, as your cost of debt has sky rocketed the V in you LTV has shrank; the second and real problem is cashflow and debt servicing. While neither of these are inherently a problem if you have maturity runway, that maturity wall is getting closer for a lot of corporates but rate still hasn’t moved. A lot of corporates today with capital structure put in during ZIRP simply cannot support an increase to their CoD from a cashflow perspective. So this means either debt holders need to take a haircut (why would they when they can take the key) or sponsors need to kick in equity to reduce overall debt burden to get it in line with the business’ new debt servicing capability. Neither are palatable.
Yes you are correct that there’s tons of dry powder, but fund managers at these distressed funds aren’t dumb so they won’t be chucking money at these corporates with no debt servicing ability. So I suspect you will continue to see a bigger and growing divide between the have and the have not - the corporates that are able to actually service their debt will get (and has gotten) a flock of these funds circulating trying to give them capital but there’s a host of very overlevered businesses that don’t have the consummate earnings growth to offset their CoD increase that sponsors won’t necessarily want to kick in more equity to support. Against that backdrop, which I think most people in the industry are alive to, it’s hard to see default rates not starting to tick up given the stress in the system - we’re starting to see cracks form already. The good corporates that can refinance or reprice have done so already; but there’s an avalanche of lower quality corporates that are hoping and praying that rates come down quickly and violently.
Definitly agree with some of the points - A lot of those already fairing badly are going to continue to fair badly, but still, even low rated borrowers have been able to push of maturities at a good rate through amend and extend transactions. To your point on cash flow, we are seeing IG and HY coverage ratios improve and with the number of cov-lite structure in place, I don’t know how much breaches would be a major drivers of default or a need to take action. Can definitly agree that default rates will begin to tick up, but I also think it will be pretty marginal and be contianed to some of the very poor preformers. Another point, I think you may be underestimating the number of investors willing to come in junior through prefs or something similar. obviously, some companies are so troubled that it wouldn't make sense to lend at a junior level, but there are many companies that this structure would be feasible and give the breathing room to figure out longer term solutions, and not to mention immense amount of dry powder to do this. Not saying anything is a right or wrong take, I'm actually pretty uncertain, but I think most people are.
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