Aftershocks and Opportunities: Distressed Funds Find The Way Forward

The economic turmoil in which we find ourselves has made us all curious to see what will happen in the special situation and distressed investing markets.

In keeping with our recent articles, we decided to go out and ask for feedback from a handful of private credit and distressed asset investors—the most active managers in private equity right now—about what they’re seeing, doing and thinking in this new environment. While their timelines and strategies vary, there are some common threads in their sentiments about what lies ahead.

What We Learned

Fundraising and LP Outlook

Our survey respondents expect an extended period of market volatility and “aftershocks” that will spur investment opportunity for firms managing private credit and distressed asset funds.

With that said, firms are either in the market or have plans to raise capital (in one instance, “hold capital”) to be well-positioned for investing when the time is right. This pairs well with a generally positive sentiment among LPs—although they’re doubling down on investing in their existing relationships. (There is an interesting parallel here because banks in the PE space are also doubling down on their existing clients.)

LPs are requesting more transparency, frequency of communication and access to pipeline information so they can make better-informed decisions—and firms are delivering in this regard. LPs are focusing more attention on managers’ business continuity plans and completing operational due diligence. This crisis has made most a bit more methodical and added new concerns to the diligence checklist.

Evaluating Investments

It appears firms are underwriting new investments under “draconian” assumptions. This aligns with their philosophical view that the market disruption will be going for an extended period, and we will be in choppy waters—at best—for the time being. Firms are focused on investing in sectors that have a realistic chance at rebounding within a reasonable time.

Communication and Technology

All firms are ramping up their use of technology, and a few mentioned using software that allows subscription agreements to be completed online.

While working from home appears to be going well enough for everyone in a practical sense, the tech resources we have are not a full replacement of human to human contact, the interactions paramount for relationship building with third parties and internal teams. I agree with this 100%—although I must say, I never thought I’d have the chance to miss going to meetings! This crisis really makes you appreciate everyday life.

Bold Predictions

At our prodding, a few respondents ventured to make bold predictions. One mentioned this could be a banner year for credit/distressed managers. The other predicts a trend of GP consolidation. 

We’ve included a selection of the more interesting quotes from their responses to help you get a sense of what’s on the mind of our industry peers:

1.    What is your firm’s investment strategy?

Our survey respondents cover a wide range of strategies such as alternative credit and debt funds, CLO issuance, private investing; bridge loans, mezzanine loans, preferred equity and structured equity investments and acquisitions; portfolios of distressed loans, securities, special situations in municipal market and public purpose assets.

2.    How have your firm’s 2020 fundraising/investing plans shifted in light of the market disruption?

“There will almost certainly be continued financial aftershocks from the pandemic, which will drive volatility across the global credit markets. Our firm continues to hold some capital to lean into these dislocation opportunities as they occur, positioning the Funds for what we believe will be the best upside potential.”

“While we never could have anticipated the pronounced global market disruption that has in fact occurred, our consistent adherence to a disciplined underwriting approach, focusing on essential service verticals and protection of principle above all, has served our investors well. While the global pandemic has already resulted in substantial market turbulence, and its long-term impact on the broader economy has yet to fully take shape, some important themes are emerging. Most significantly, we expect to see an increase in stressed and distressed opportunities.”

“In terms of fundraising efforts, although the market disruption has undoubtedly presented challenges for investors, we are invigorated by the support that we have received from our existing limited partners and strategic prospective investors.”

“Since our strategy is defensive in nature and provides a strong current return, our LP base has expressed interest in our next Fund, and we are currently targeting a first close in Q420.”

“The crisis has created a dislocation in certain of our target assets that we’re seeking to take advantage of, but we estimate that the greatest supply of our target assets won’t become available for sale for 6 – 12 months. In addition to moving up the target date to launch our next fundraise, we’re also exploring raising co-invest capital to fully take advantage of some of the larger opportunities we expect to come to market.”

3.    The financial crisis of 2008 is very different than the COVID-19 crisis. How is this impacting the decisions your firm is making from an investing perspective?

“The biggest differences that we have seen between the two crises are (i) the velocity of the recent disruption was greater than what was witnessed in 2008; granted distress and investing opportunities in our universe are still unfolding as private assets have a longer fuse (mostly due to illiquidity) than say public securities, and (ii) with the firm working from home, we have had to adapt in order to maintain communication and efficiency of execution.”

“We’re modeling all acquisitions under extremely draconian assumptions that assume any performance/value degradation is permanent. Should there be another leg-down in the economy we want to be well prepared; essentially making sure that anything we purchase today can withstand a drop in value.”

“We are conservative by nature and not at all a volume shop. Since this is a crisis of movement, not liquidity as in 2008, we expect opportunities to come as restrictions lift, and states and regions have confidence in moving ahead.”

4.    What is the sentiment from the LP community on committing new or more of their capital to the asset class?

“We’ve raised +$1bn in 2020 to invest in dislocated markets and have therefore already seen traction.”

“Broadly speaking, LPs remain optimistic on our opportunity set, particularly given our focus on special situations in essential service verticals. With travel restrictions in place, we are seeing that many have been able to adapt their processes accordingly (e.g., substituting on-site visits with video conferences). Additionally, many LPs have cited that trusted relationships with existing managers are more important than ever in their decision-making process.”

“Lack of clarity of the depth and duration of COVID-19 and its impact on global markets is complicating allocation decision, particularly as LPs confront challenges associated with depressed portfolio valuations, increased liquidity needs, and concentration risk, among others.”

“Our LPs are opportunistic, and we are in lockstep with them in that we are looking for opportunities from the dislocation, but we are not going to look at deploying capital into retail, hospitality or student housing for the foreseeable future.”

5.    Have there been or do you foresee any changes in partnership agreement terms? Any other key takeaways from conversations you’re having with LPs?

“New capital is on the same or similar terms to existing funds so far.”

“Based on conversations with LPs, we don’t foresee any drastic changes to the terms of our partnership agreement. That said, some investors are pushing for management fees based on invested capital versus committed capital.”

“We have not made any changes to our partnership agreement terms. They seem more concerned with shoring up capital needs and protecting downside than hitting the proverbial home run, however, they understand the need to be invested in the current (and sustained) low interest rate environment.”

6.    How is your team managing (or plan to manage) the fundraising process with all of the stay at home orders and travel restrictions?

“Our fundraising process is long-dated and ongoing, and plan to engage existing relationships and what we have in the pipeline.”

“Alternative forms of communication/interaction are becoming increasingly important. We have been proactively reaching out to our current and prospective investors and connecting over webinars, video, and conference calls. We have also increased our focus on existing investors and prospects who know our firm and our investment strategy well.”

“Transitioning to a remote-work construct in mid-March has enabled us to successfully engage with LPs. We have conducted investor due diligence sessions remotely, sharing slides, excel models and other data over screens. We have a robust online data room where they can review offering documents, marketing materials, and due diligence materials. We have partnered with a third-party provider that allows subscription documents to be completed online. We plan to host a virtual annual meeting by webinar later in the year.”

“We are having regular/daily zoom calls internally and monthly update calls with our LPs. We believe it is critical to be transparent and accessible. That approach has been well received by our LPs.”

7.    The general view is we don’t know when we return to “normal” and what normal is expected to look like. With that in mind, how is this impacting your capital deployment strategy?

“We’re pacing our capital deployment and asset class allocation, attempting to leave enough dry powder for 6-12 months from now, when we anticipate a large supply of our target assets.”

“Since the crisis first emerged, we have shifted focus from defensively positioning our portfolio to playing more offense, albeit at a measured pace with a high degree of selectivity.”

8.    Given the lag in private portfolio valuations and the uncertainty in the market, how are you pricing new investment opportunities (i.e. % discounts to 3/31 NAV, using public market comp data, any other metrics?)

“From an underwriting perspective, valuation is largely based on expected cash flows from underlying assets. In many cases, we are haircutting near term (18-24 month) cash flow expectations in many asset classes, particularly where shelter-in-place orders and school closures have effectively shut down activity.”

“While we don’t expect these impacts on our existing portfolio, we’re pricing all asset acquisitions assuming rather draconian assumptions including immediate degradation in performance and value.”

9.    What is one positive and one negative key takeaway from your firm working at home full time?

“Positive: no efficiency has been lost. Negative: no in-person interactions.”

“Team members have stepped up to meet the challenge of functioning remotely. With the support of a strong technology infrastructure, and enhanced processes and communication, we have been able to successfully adapt and continue our full-scale operations during this unique moment in time. Negative: While we have been able to settle into new routines and adopt new habits, there is no substitute for face-to-face interaction.”

“The absence of travel has improved efficiency across our firm, but we miss the camaraderie of being together in the office.”

“It has been great to be around my kids. I don’t take that for granted at all. But being efficient and as connected with my team from being in the office is a challenge.”

10. What is your private market bold prediction for the remainder of 2020?

“There will almost certainly be continued financial aftershocks from the pandemic, which will drive volatility across the global credit markets.”

“Consolidation among asset managers.”

“We believe 2020 will be a banner year in terms of capital raising for stressed and distressed opportunities with direct lending (i.e. private credit), which was one of the hotter segments leading up to this year, being one of the biggest laggards.”

And one smart soul said, “I’m not good at predictions…sorry!”

We also inquired if there were any questions that we didn’t ask that we should be since we’re not at the virtual table during their Partners meetings? We’d love to hear your responses to these additional questions! Let us know on LinkedIn.

• Do you plan to launch a co-investment vehicle or expand your investment mandate?
• Have you revised fund return targets in light of the market dislocation?
• When do you anticipate returning to your offices, and what changes will you make to the office in response to COVID-19?