The possibilities and pitfalls of investing in distressed debt

November, 2011 Print



Andrew Swan (AS): Paul, can we first establish what you would say is the definition of distressed debt?

Paul Taylor (PT): Absolutely. There are plenty of different terms in the market, but in general it’s debt that has fallen in price to the point that it pays a “credit spread” of 10% above equivalent government bond yields or cash rates, meaning that the borrower may struggle to refinance themselves affordably, and may even be at risk of defaulting due to their financial under-performance.

AS: Do we see distressed debt in all the fixed income asset classes?

PT: Yes, for us the distressed debt “universe” includes senior loans, mezzanine loans, public bonds, real estate debt, subordinated real estate and CMBS (Commercial Mortgage- Backed Securities). We tend to see plenty of opportunities, from time to time, across each of the fixed income asset classes.

“…unlike many others, we do not see ‘distressed debt’ as an asset class in itself.”

AS: Is it not counter-intuitive for prudent investors to specifically target distressed securities to invest in?

PT: I think that’s a really good question. The best way of beginning to understand what we do is to realise that unlike many others, we do not see “distressed debt” as an asset class in itself. That means that we’re not about building a portfolio of distressed securities from scratch.

It’s worth explaining that M&G is one of the leading credit investors in Europe, and so we will sometimes come across assets that slip into the “distressed” category. When that happens, my team does a great deal of financial and legal analysis to find out if it’s worth owning that security. Sometimes we do not think it is – and so we may decide to sell it – but in other cases we’ll discover that it appears to offer a great deal of value, and that it’s therefore worth persisting with, even if a debt restructuring were to take place. In those cases, the asset in question may be an intriguing investment opportunity in its own right.

AS: Can you outline the stages of analysis you go through once you are faced with a distressed issue in one of M&G’s existing funds?

PT: The first thing we always do is assess the robustness of both the business and the asset – initially  ignoring factors such as the business’ leverage. In most cases, there can be a positive story surrounding the company. Our job is to analyse the finer details of that story with the help of M&G’s large team of credit analysts.

Having said that, understanding the financial situation is only part of the job, there’s the whole legal side which you need to analyse too. The legal documentation is ultimately what we debt-holders rely on for our claims against the business. We have highly experienced legal restructuring specialists on our team, and so we are well resourced for this.

Once we’ve decided that the business is suitably robust and the legal position is strong enough, we then figure out the various scenarios that could play out over the next few years, and how we would fare as one of the business’ debtholders in each one. Once we have done that we can then make an informed decision about just how valuable the security is.

“What we’re certainly not looking to do is take risky bets on marginal businesses.”

AS: How important is breadth of legal resource to you?

PT: We are privileged to have the level of resource and experience that we do. On the private debt side for example, where you get access to the full suite of legal documents, we crucially have a full-time legal team who are able to trawl through them. There aren’t many teams who have that resource on hand full-time.

During the height of the credit boom in 2006 to 2007, a lot of legal documentation became quite lax, and so it’s important to be able to pinpoint where the strengths and weaknesses of these contracts lie. When we do come across weak covenants, it will lessen the value of the security to us.

“There is a ‘wall’ of maturities over the next few years in the high-yield space.”

Fixed income investing – how bonds are creating new challenges for local authoritiesAS: Do you see a lot of opportunities arriving in the near future?

PT: Inevitably, yes. There is a “wall” of maturities arriving over the next few years in the high-yield space. Refinancing will prove tricky partly because the main buyers of high-yield debt in the past were the banks and CLOs (Collateralised Loan Obligations), and both now have less appetite for the debt due to various regulatory and other reasons. The commercial real estate market is also facing a maturity wall of nearly £500 billion in the coming years. These “walls” will cause a mismatch between supply and demand and several opportunities will stem from that.

AS: How will you look to take advantage of those opportunities? 

PT: Our process will remain the same in each case. We will pinpoint decent, though potentially overleveraged, businesses whose securities are trading at distressed prices due to the supply/demand mismatch. What we’re certainly not looking to do is take risky bets on marginal businesses.

“We don’t take big picture views on the entire market; our only views are on the underlying quality of specific individual businesses…”

AS: What should investors be wary of? What are the potential pitfalls?

PT: I think you need to be able to understand each individual situation really well. As I said, you need a financial view and a legal view on that situation. If you have dozens of analysts across the floor, as we do, analysing the issuers day-to-day – whether they are distressed or not, then that’s an excellent starting point, as is having an experienced legal team. I think a major pitfall lies in looking at “distressed debt” as an asset class of its own.

Over the coming years, we expect people to buy up distressed securities on the basis that they are technically cheap compared to historical levels. This is an approach that assumes the overall picture in the market and the economy will improve and things will start to look rosier again. Our approach is completely different. We don’t take big picture views on the entire market; our only views are on the underlying quality of specific individual businesses, on an entirely case-by-case basis.

AS: One thing we haven’t mentioned is influence. How important is it to be influential as a debt holder during a restructuring process?

PT: It’s absolutely crucial to be able to wield influence. I think this has been proved over the past two to three years. If you’re not willing or able to be influential (for example, by getting on the bondholder steering committees in the event of restructuring) then you’ll usually end up with a disappointing restructuring outcome. It’s all well and good identifying a decent borrower that’s over-leveraged, and undergoing the stages of analysis that I outlined, but unless you’re happy to then shape the strategy that allows that business to recover, your returns will be entirely uncertain.

AS: Thank you Paul.

This article reflects M&G’s present opinions reflecting current market conditions; are subject to change without notice; and involve a number of assumptions which may not prove valid. This is not an offer of any particular security, strategy or investment product. It has been written for informational/educational purposes only and should not be considered as investment advice or as a recommendation of any particular security, strategy or investment product. Information given in this document has been obtained from, or based upon, sources believed by us to be reliable and accurate although M&G does not accept liability for the accuracy of the contents.


Fixed income investing – how bonds are creating new challenges for local authorities

Paul Taylor
Head of Fixed Income Restructuring
M&G Fixed Income

Paul joined M&G in 2005 as a restructuring specialist in the fixed income team. Paul is responsible for the workout of problem credits across the wider fixed income team as well as private investments.

Prior to joining M&G, Paul was a senior manager at KPMG within their Corporate Restructuring team advising both debtors and creditors in turnaround situations, including facility negotiation, covenant setting, de-leveraging transactions and fallback planning.

Fixed income investing – how bonds are creating new challenges for local authorities

Andrew Swan
Director of Fixed Income
M&G Fixed Income

Andrew joined M&G in 2005, as a Director of Fixed Income in the institutional fixed income team. His primary focus is developing M&G’s institutional bond business in the UK.

Prior to joining M&G, Andrew was a client relationship manager for Banquo Credit Management, responsible for developing relationships with institutional clients in the UK and Europe. Previously, Andrew worked for Merrill Lynch, Deutsche Bank and Goldman Sachs, within fixed income trading and sales roles.

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