Prior to the Asian crisis, buoyant economies ignored the accumulating Non Performing Assets (NPAs) that operated through heavy reliance on easy credit and loose debt covenants. However, this market was going through a quiet transformation over time. When the crisis hit the world, these companies were brought to surface and all turnaround efforts were hampered due to inadequate bankruptcy laws and more importantly, the absence of a distressed debt market. Such assets were available at huge discounts. Several fund managers identified a potential alpha and purchased these assets to turn them around through operational efficiency and exit at premiums. Such NPAs which are purchased with the objective of restructuring and exiting, are called Distressed Assets. These are assets whose values are severely depressed not because of general market conditions but due to some reason specific to the company.
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Several distressed fund managers today believe, that the tidal wave of PE deals made during the peak of 2006-07 will go bad in the coming years. The lack of bankruptcy credit and inefficient laws will lead to several of these distressed assets seeking liquidation outside the court. Several Fund Managers in Asia believe this market is growing rapidly and is highly inefficient with opportunities in excess of $2 trillion waiting to be exploited.
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Distressed debt investing is ideal in times of recession. Though a rebound in commodity prices and signs of a global recovery have renewed investor confidence and revived investment flows in the equity markets, the most lucrative opportunities are said to be lying in the debris of the credit crunch - the debt of troubled companies in the emerging and developed markets.
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In the aftermath of the financial crisis, there is still ample supply of distressed assets in various parts of the world. Long-term private equity funds with patience and restructuring experience can buy into these troubled companies at deep discounts and unlock value in the companies to bring them back on their feet.
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Investment Process
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Unlike traditional private equity funds, distress funds assist banks and institutional investors in getting illiquid assets off the balance sheet by purchasing and managing the assets themselves. They adopt a proactive approach in reorganizations by heading the creditors committee and taking key decisions on restructuring of debt maturity and principal repayments. They also play a key role in limiting the company’s ability to cash out until their investment is paid off. Given the high risk and fund involvement required, the integrity and objectives of the promoters are key investment decision considerations.
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Key Risks / Challenges of Distressed Asset Investing
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A study conducted by Morgan Stanley stated that distressed assets lead to an increase in the portfolio hedging, an increased alpha, and an increase in the tracking error (i.e., the standard deviation of a portfolio’s return relative to a given benchmark). Hence the addition of distressed assets to a Fund Manager’s portfolio must compensate for the risks associated with it. This is not easy given the inherent challenges this asset class presents today. For starters, unlike traditional PE transactions that are based on leverage, distressed assets do not have the cash or the borrowing capability to unlock value. Secondly, a company’s assets is owned by different stakeholders and it becomes difficult to align the interests as some may prefer to hold out for a better price while others may seek to sell. Operationally, it is often challenging to understand where revenues will bottom out, which makes it difficult to introduce measures to counter the decline and initiate growth strategies. Moreover, given the distressed situation the firm is in, vendors and creditors are unwilling to provide favorable credit terms to help the bail out. Apart from that, country specific factors such as regulatory, liquidity and political factors also pose serious issues for investors in this space.
Growth Opportunities for this Asset Class
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The West has traditionally been the most favored destination for distressed investments. However, there seems to be a growing consensus that significant opportunities lie in the emerging markets. Estimates show that a bulk of the $ 2 trillion NPAs on the books of Asian banks are in Japan. While Asia has not been able to take action on such assets as quickly as one would expect, central governments across have realised the crippling effect these distressed assets are having on the performance of financial institutions. With the Asian shores opening up to more efficient MNC banks competing with local institutions, Asian economies have little option but to resort to international investors to offload a part of their assets. Sovereign Wealth Funds (SWFs) which traditionally focus on private equity and direct investments are also looking to diversify into the riskier distressed asset class. While the exposure to such investments is not expected to account for a very large proportion of the investible funds, such diversification may help alleviate some of the huge losses made by these funds in the recent past through investments mostly in western financial companies. Such large inflows of money into the sector should augur well for the industry as a whole.
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Valuation and Exit Strategies
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Exit strategies of distressed funds depend on the fund’s mandate and investment philosophy and as such, funds can be categorized into Turnaround operators and Asset liquidators. The turnaround operators believe in the entity’s growth potential and thus work to turn-around the troubled entity over a period of several years. They play an active role in key management decisions and their investment is valued based on the cash flows generated from regular business operations. Investment exit is available in the form of a stock exchange listing or through a strategic sale.
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On the other hand, the asset liquidators believe in generating value by acquiring a portfolio of distressed assets and then negotiating with borrowers to strike the best deal possible. Such transactions are completed in a relatively lower time period with very little time commitment and involvement from the management. The investment is valued based on the discount realized while settling each lender whereas investment exit is available through liquidation of the debt portfolio or through securitization.
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Overall, distressed assets as an investment class is evincing keen interest world over, as funds seek to replicate the success this model received in the West. With rapidly rising NPAs, pressure on part of banks to free their balance sheet of such assets and huge funding available through private equity, SWF funds and several other routes, the industry is certainly expected to reflect strong growth opportunities. However, given the slow legal and regulatory decision making at country level, the pace of this growth will depend on the ability and willingness of the government to push through these policies and make it an investor friendly environment.
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( This is part of the "VCCircle Classroom" section in alliance with the Indian School of Hyderabad.)
