As the economic cycle progresses, the next recession draws inexorably closer, bringing with it the next downturn in the credit cycle. Recognising this, institutional investors are increasingly considering allocations to distressed debt managers.
While lumping all distressed managers into one group is tempting, different managers have meaningfully different approaches that are not captured by considerations like geographical or vintage year diversification. Further, investors’ traditional way of thinking about distressed debt managers makes timing paramount.
The Probability Tree Approach
One way to consider differences among distressed managers is to use an old tool from option pricing: the probability tree. A probability tree can be used to price convertible bonds, options, or any other financial asset with a value that depends on a range of possible paths (i.e., path dependent assets). These paths usually refer to price changes and their attendant probabilities. The value of an asset priced in this way is the sum of the products of the outcomes and their attendant probabilities (discounted back to today at the appropriate rate and time).
Probability trees can also be used to chart other outcomes—the accumulation of a blocking position in a debt tranche, the accumulation of outright control of a debt tranche, the private equity owner’s commitment to fund an upcoming commitment, the forbearance (or not) by senior lender of its creditor rights, etc. Distressed debt investors face these and many other potential outcomes when purchasing distressed securities. The succession or concomitance of these outcomes can influence the ultimate value of a security, and hence the returns generated.
Running Through the Trees
By viewing distressed investing as a path along a complex probability tree, investors can differentiate among managers based on their appetite for path length and complexity. Some managers have a limited appetite for length and complexity and seek opportunities that offer quick exits, mainly through refinancing at par. Others are happy to ride the probability tree to ownership of post-reorganisation equity. The vast majority fall somewhere in between.
Grouping managers allows investors to determine whether their skills match their strategy in much the same way coaches and trainers can determine whether an athlete has the build, stamina, and pace to sprint, run a mile, or complete a marathon. Moreover, differentiating among managers facilitates portfolio construction in the same manner that identifying skills helps a trainer build a track and field team.
1) SPRINTERS: limited appetite for length and complexity
Sprinters seek a quick path to exit. They are not interested in engaging in protracted litigation, enforcement of creditor rights, consensus building around other lenders, or company engagement. They do not care to own conversion securities and are even more averse to assuming ownership of a borrower. Instead, they wish to exit through a refinancing, or a “pull-to-par” adequate to drive returns. While sprinters may benefit from broader market (“beta”) forces, they can also find investments in buoyant markets where borrowers suffer from temporary financial difficulties.
2) MARATHONERS: willing to run to the very end
Marathoners are in for the long run and have the appetite to see restructuring through to the conversion of their debt security into post-reorganisation equity ownership. Distressed-for-control managers tend to be marathoners. They recognise that the extended probability tree is a means to an end: control of the borrower to effectuate a turnaround of a struggling company into a profitable gem of a business. Marathoners will advertise their intentions to institutional investors and will showcase private equity–like management capabilities deployable at assumption of control.
3) MIDDLE DISTANCE/MILERS: those in between
Milers represent the largest category of distressed debt investor. They exhibit not just powerful financial analysis capabilities, but also considerable legal prowess. They embrace enforcement of creditors’ rights as a real option and know how to influence, persuade, threaten, and cajole stakeholders. Like the middle-distance athletes that can run an 800 meter race or as far as 5,000 meters, these managers can execute a quick exit or manage an extended process all the way through bankruptcy, as the circumstances dictate. The best managers will lead processes, much like how the best milers set the pace that others follow.
4) THE ASSET/LIABILITY REMIX
Within these groupings, distressed managers can be further described based on their focus on either assets or liabilities. While they have vastly different appetites for path length and complexity, sprinters and marathoners share a focus on the asset side of a borrower’s balance sheet – they make the same bet on the resilience of the borrower’s underlying enterprise value.Milers focus more on the liabilities. They must be aware of assets and enterprise value as well, but they thrive in the complexity of byzantine legal structures and overlapping documentation. Naturally, not every investment has all of these paths to exit, but building a portfolio of investments with one, some, or all of these possible exits require a greater focus on creditor rights.
Allocating Through the Cycle
Sprinters, milers, and marathoners prosecute these different strategies in pursuit of the same target returns of more than 12%. Investing across different types of distressed managers allows investors to allocate capital in a manner that diversifies strategy and offers opportunities across the credit cycle.
For example, allocating to marathoners, who wish to own equity, might be wiser when capital markets are less accommodative and access to capital is more constrained, two phenomena that make it difficult for struggling companies to ignore financial woes. Market participants currently cite today’s capital markets as providing ample liquidity to even marginal borrowers. Nevertheless, the best marathoners can find good investments even under these conditions.
Early to late in an expansion cycle, sprinters may be the better choice as they seek to exit investments quickly, when refinancing opportunities are more abundant. They are therefore less likely to be caught holding deteriorating assets when the cycle turns. And today’s capital markets are wide open, accommodating the refinancings that frequently support sprinters’ exits. However, for how long will that continue?
Middle distance runners are also not without risks. While they may map out certain paths along the probability tree, markets can change quickly, causing them to abandon those paths in favour of new ones.
This differentiation does not mean to suggest that all sprint strategies will outperform all marathon strategies early in the cycle or, as the cycle progresses, every middle-distance manager will outperform every sprint manager. Rather, identifying and categorising strategies as sprinters, milers, or marathoners helps investors differentiate, analyse, and set expectations for each manager.