Institutional Investor's Alpha Magazine - March 2009 - (Page 22) DISTRESSED DEBT INVESTING “We need two things: bargains and a recovery. I think we have bargains – and we may have greater bargains – and I think we’ll have a recovery.” Howard Marks Oaktree Capital Mgt because in 2008 many distressed funds were liquidated, bank lending dried up and “leverage” became a dirty word. Loan and bond prices have dropped dramatically at a time when there are few buyers and companies are locked in the struggle of their lives to refinance. Funds that do venture into the market can even buy senior secured debt that offers equity-like returns (see p. 6). “There’s been such a massive dislocation in the credit markets. Never in its history have you seen so many assets deemed illiquid or untradable that in previous years would have been highly liquid and yielding double-digit returns,” says Karl D’Cunha, senior managing director at Houlihan Smith & Co., an investment bank known for its capital restructuring and bankruptcy services. Assessing the opportunity The current market offers a huge opportunity for distressed funds that have cash to spend. What’s needed to make money in this distressed cycle is pretty simple, says Howard Marks, chairman of Oaktree Capital Management, which has $16.7 billion in assets under management dedicated to distressed-debt investing. “We need two things: bargains and a recovery. I think we have bargains — and we may have greater bargains — and I think we’ll have a recovery.” However, there are qualifiers to this formula. The argument that there are bargains out there is pretty much undisputed, but when the recovery will come is another matter. Without a recovery in liquidity, the return of leverage and renewed market confidence that enables companies to refinance, the price of distressed debt isn’t going to go up. In fact, current indicators suggest valuations will keep falling, particularly as collateralized debt and loan obligations continue to be unwound. And corporate default rates likely will continue to rise. Leveraged loans alone in default already total more than $22 billion, and Standard & Poor’s predicts the default rate will reach 9 percent in 2009. Some analysts suggest the rate could reach double digits. With no recovery in sight, potential exit strategies, such as debtor-in-possession financings, are extremely hard to come by, particularly as banks are not lending in this market now. Indeed, 54 percent of respondents to the Debtwire survey thought refinancing would be more difficult in 2009 than in 2008. Many fund managers are reluctant to invest when they don’t know when the market will reach the bottom or when the situation will start to turn around. “Some funds are investing, but many are saying, ‘Maybe it’s three months, six months or 12 months before I start deploying my capital’,” says John Ashmead, a partner in Seward & Kissel’s Bankruptcy and Reorganization and Business Transactions groups. The firm’s multidisciplinary alternative investment practice advises hedge fund clients on distressed-debt and bankruptcy situations, among other things. Ashmead explains that the situation creates a vicious circle: If banks can’t invest in overleveraged Top Distressed Investment Sectors in 2008 Energy/Chemical Healthcare Industrial Consumer Products Financial Services Airlines/Transportation Auto Manufacturers/Suppliers Retail Media Construction Telecom Paper/Packaging Technology Gaming 0 5 10 15 20 25 30 Percentage of Responses 2 • Alpha Sponsored Report • March 2009 Source: North American Distressed Debt Market Outlook 2009
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