This backdrop would have created a good opportunity for investing in distressed debt and special situations and that was very much reflected by the number of asset managers launching funds in this space. However, the massive spike in defaults that the market initially anticipated failed to materialise. This was largely a result of the immediate central bank action and further government stimulus, which stabilised markets and kept many of the so called “zombie” companies afloat.

Fast forward 18 months. We’re now getting closer and closer to the withdrawal of accommodative policy, not least because of global inflationary pressures. With higher rates and less support for businesses, many companies will struggle to stay in business or will need much more flexible private financing solutions. The initial expectation for that spike in defaults has now turned into a longer (maybe multi-year?) and flatter default curve. And with these expectations, the optimism for distressed credit and special situations have been revived.

Why exactly are we seeing these opportunities now? All the support that was handed to businesses was mainly used for short-term purposes i.e. balancing losses and fixed costs as well as making up for a year of lost revenues. As the pandemic (hopefully) eases, many businesses will have lower revenues and higher debt and, as the economy begins to normalise, they will have to start thinking about de-leveraging.

Companies that were reasonably de-levered with strong balance sheets prior to the pandemic should be well positioned going forward. This may create idiosyncratic, stressed credit opportunities on the back of price dislocations.

Lower rated companies that weren’t well positioned to start off with will likely experience covenant breaches and liquidity shortages, suggesting defaults are on the horizon. This will also create stressed credit opportunities and short-term, alternative (gap, bridge or rescue) financing in exchange for high rates of return.

But what you also get with these companies is a greater likelihood of defaults, which is when the distressed opportunities kick in. With distressed debt, there are two routes investors can go down. They can either take distressed for control positions or non-control positions. Distressed for control involves a default which will require a restructuring or workout situation. In this instance, the businesses that default compensate investors with a majority equity stake. With this, the manager can then aim to enhance value, similarly to private equity, to generate significant returns. In the case of a non-control distressed situation, the investor simply invests in the debt of a business at a lower price than what they expect to get back in the event of a bankruptcy and subsequent liquidation of its assets.

From a regional perspective, it’s probably the US that has been and is expected to be more active. Given that US businesses are generally more leveraged than their European counterparts and the fact that the US Fed seems to be further along in its path to policy normalisation than the ECB, greater opportunities are likely to be seen in the US. Further, there is a relatively larger proportion of US companies in the energy and hospitality sectors. These sectors had been hit harder by the pandemic, which means they are more likely to go through some form of stress or distress, resulting in more opportunities. Though, over the cycle of a distressed debt fund, there should be more of a balance in terms of opportunities and activity in this space.

One of the obvious issues with distressed debt and special situations is the amount of dry powder, with asset managers having raised and looking to deploy significant capital since last year. One of the key points here, though, is that this is dominated by the biggest players who are raising billions of dollars for their mega-funds. Where there will arguably be the greatest opportunity set and the most scope to generate alpha is in the small or middle market space. Here, there is less competition and less dry powder because it is impractical for the mega-funds to allocate here.

To conclude, with current expectations of the removal of accommodative policy and government support, many businesses globally will struggle, and they will need some form of financing for various purposes. This will create numerous stressed and alternative (gap, bridge or rescue) financing opportunities and those companies that are in a much worse state will result in a number of distressed opportunities. And because this default cycle is expected to be longer than initially expected, this should be a multi-year opportunity for distressed debt and special situations.

P.S. Admittedly, this was initially written before the news of the Omicron variant came to light, but it doesn’t change the view. Yes, there is a reasonable chance of further restrictions and lockdowns, but it seems unlikely that there will be as much support as there was over the last 18 months. Governments and central banks simply cannot afford it, more so because it would escalate the risks of inflation. With no or minimal support, alongside more restrictions, an even greater number of opportunities than initially expected may present themselves.