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October 10, 2017

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Distressed Asset Investing Strategy

July 7, 2017

 One of the alternative investing strategies that is becoming popular among portfolios of wealthy families is distressed asset investing. It is a relatively new investing concept, and can be described as the situation when negative sentiment prevails and leads to unusual opportunities for signing deals at bargain prices. A distressed situation may be present for an individual company, asset class or whole sector. But from a macro view, a distressed opportunity appears when unrealistic – or more elegantly put, overly optimistic – asset valuations and loose credit standards lead to sharp market disruptions.

 

In more recent years following the 2008 crisis, financial institutions had many illiquid securities to sell. In addition, due to certain portfolio limitations, institutional investors were forced to sell non-investment grade assets. Following this, banks started repossessing business and property interests. Corporate balance sheets were stressed and credit conditions were tightened. This is quite the opposite from what we are observing now, but we are in the latter part of the cycle, so experienced opportunistic traders might be taking positions before high volatility returns to the market. Some further words of precaution: distressed investing is an opportunistic strategy that is less liquid and reflects contrarian views. It often involves counter-intuitive position-taking, and as stated above, can be highly volatile. It is even regarded as vulture investing, where the aim is to buy assets at a significantly lower price and then realize gains through a flip deal, or eventually seize the underlying asset in the case of a bankruptcy.

 

In 2013, roughly during the middle of the current economic cycle, funds such as Pictet recommended allocations for this strategy at 2.5%, with average expected returns in the range of 5-6%. Citi Private Bank noted that commitments gradually increased after the 2008 crisis, and that clients were expecting to tie up their money for 3-5 years and receive a total return for the period of 15-25%. But will this early positioning for high-volatility investing turn wrong, as the ongoing expansion that started in mid-2009 has already run for so long (96 months)? At present, such a strategy may not represent the best opportunity due to the spreads tightening. On the other hand, one of the late cycle effects is greater variability of performance among corporations; therefore, this could be a good time for long/short credit strategies.

 

When looking for ways to invest in distressed securities – even for large institutions investing in the stocks of hedge funds – buying shares of a private fund is sometimes preferred over direct asset picking. The reason is that there is high unsystematic risk – for example, investors might easily pick the wrong bonds and may get nothing in return in future bankruptcy proceedings. This is in stark contrast to the typical hedge fund specializing in distressed opportunities, which often has a pipeline of around 100 companies going through or close to bankruptcy.

 

Some of the larger players in the market are Oaktree Capital Group, Apollo Global Management and Avenue Capital Group. Their objective is to achieve attractive risk-adjusted returns by investing in distressed and other value-oriented investments, also in emerging markets. Oaktree Capital Group (NYSE: OAK) specializes in distressed debt is and has US$ 101 billion of assets under management (AUM) as of December 31, 2016. They have a long history in investing in the debt of financially distressed companies, with substantial gains achieved by restructuring and returning companies to financial viability. Their strategy favors large, fundamentally sound companies that are overleveraged, and avoids losses through emphasis on secured or senior debt.

 

A subset of distressed asset investing focuses on opportunities in emerging markets. This might be an interesting strategy to consider for those who follow the global markets closely. Even after Brexit, the West European distressed market does not seem so promising (formerly represented mostly by Spain and Ireland), but opportunities for purchasing non-performing loan portfolios at a low cost can be presently found in China – NPLs at Chinese banks hit an 11-year high in March 2017 and competition among asset management firms is growing. More opportunistic investors, in search for yield out of the US markets, should also look at Central Eastern Europe, where banks continue to clean balance sheets in order to comply with stricter capital adequacy ratios.

 

To wrap things up, as investing in distressed assets is a strategy exploiting market inefficiencies, timing is key. This strategy offers opportunities for substantial gains, but only with proper risk controls in place.

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