Promising opportunities for distressed debt investors?

High interest rates and low consumer spending have tipped the business landscape. December saw a wave of multi-million-dollar US companies going bankrupt. And US corporate credit defaults soared by 80% last year, compared to 2022. Likewise in the UK, the final months of 2023 ended in recession, with an increase in corporate insolvencies. 

During the pandemic, corporations - including 74% of small business owners - found themselves forced into debt, and trapped by 2023’s escalating interest rates. At the time of writing, US companies bear under a record $13.7 trillion in outstanding loans.

The prognosis for corporate growth looks bleak. “We expect consumer-facing segments to lead defaults again in 2024”, predicts S&P Global. “Because of higher interest rates, we also expect mounting pressure on issuers with higher debt burdens”. 

The silver lining of a struggling market 

Struggling businesses aren’t bad news for everyone, however. For specialised distressed debt investors, lucrative opportunities could await. “For more than a decade, it wasn’t a great time to be a lender”, legendary investor Howard Marks commented to the Financial Times last year, following the hikes. “Now it’s a much better time”. 

Investors like Marks are highly specialised at buying bad debt at discounted prices, with significant downside protection. If the company goes bankrupt, distressed debt investors should be the first to get paid-out, often by selling valuable assets or by taking control of the company. For this reason, investment firms like Marks’ Oaktree Capital Management will only buy debt for businesses with “strong underlying assets”. 

Distressed debt investors are not usually looking to bankrupt their holding, however. Their strategy is normally to gain a controlling share and steer the business into profitability. A sound business model is therefore vital. “We look for good companies with bad balance sheets”, is one of Oaktree Capital Management’s most enduring mottos. 

Magnified risk and reward potential 

Distressed debt investment has roots in both venture capital and high yield bond strategies. Investors purchase struggling companies with good business models and try to push them back into the black. With this elevated risk comes the potential for enhanced returns. 

Oaktree Capital Managementis a pioneer of distressed debt investing. The firm has been following this core strategy since the late 80s, and annualised returns for investors have averaged between 7% and 47%. Notably, this group has never delivered a negative return, indicating how lucrative this niche investment style can be for seasoned professionals. 

The upcoming twelve months could have all the elements – high interest rates, high default rates and low liquidity - for this investment strategy to thrive, not guaranteed. 

Broadening opportunities

The number of firms reaching the threshold for distressed debt provides investors with additional opportunities for sector diversification. 

“This year, the opportunity set has increased significantly”, elaborated Robert Dafforn, CIO of Opportunistic Credit at Polus Capital Management, speaking to Private Debt Investor. “We’d expect inflationary pressures and higher rates environment to drive broader distressed activity across a wide range of industries”.

With banks retreating, the supply of lenders is expected to be weak too. This may create a favourable market for alternative lenders, offering more opportunities for price negotiation.

For first movers, the rewards could be compelling. As the Oracle of Omaha, Warren Buffett, himself says, “Be fearful when others are greedy, be greedy when others are fearful”. 

Market opportunities for professional investors 

However, a word of caution. Even in the most fertile ground and with the lowest competition, capturing a lucrative distressed investment is like finding a needle in a haystack. It’s not for the faint-hearted or those short of time.

Investors who venture down this route need to be specialists. They must be well-versed in local bankruptcy laws, have a keen eye for balance sheets, be able to command and control a sinking ship of a company... and restore it to profitability. All while stomaching long periods of illiquidity. If the debt does not pay off, it’s not just money that’s been lost, but also time, energy, and opportunity. 

This is why many experienced investors prefer to get exposure to this asset class through funds managed by specialists. 

For experienced professional investors, we believe distressed debt could offer an attractive risk and reward balance. If you are interested and wish to see any distressed debt opportunities available through Wealth Club, please complete our short questionnaire and declaration to see if you qualify as an elective professional client – this is required to access this type of fund.