The coronavirus pandemic and resulting economic conditions have presented a “once-in-a-decade” opportunity for distressed debt investors, according to SVPGlobal.
The high yield, leveraged loan, and direct lending markets in the United States are worth $4.5 trillion, according to a new paper from the distressed debt and private equity firm. With a projected 10 percent default rate for 2020, distressed investors will have many options to choose from.
“If you use the default rate as a proxy, we think that for us and people who do what we do, we are going to be feasting for the next two or three years,” said Victor Khosla, SVPGlobal’s founder and chief investment officer, by phone.
Khosla’s $9.8 billion SVPGlobal, previously known as Strategic Value Partners, has the dry powder available to do it: the firm closed a $1.7 billion distressed debt fund in late October, Institutional Investor previously reported.
When the pandemic came stateside in March, a wave of debt holders unloaded their now-distressed investments following downgrades.
“In almost all markets, the first 60 days of the pandemic were bedlam,” Khosla said. Then, the Federal Reserve stepped in with an open market buying program that injected liquidity into the debt markets, slowing the sale of debt.
This is one of the largest differences between the 2020 market decline and that of 2008: During the Great Financial Crisis, liquidity dried up. Unlike today, the financial system itself was a problem, prompting bankruptcies at large companies like Lehman Brothers and General Motors.
“Prices fell and they fell fast,” Khosla said of 2008. He added that in 2008, leveraged loans were trading at 60 cents on the dollar after the market dropped. In the 2020 downturn, by comparison, leveraged loans fell to 78 cents on average before bouncing back.
Still, distressed debt markets were virtually untouched by the Federal Reserve’s open markets program, as the Fed is unable to invest in high-yield debt and other riskier asset classes, the paper said. In other words, the Federal Reserve has chosen “winners” and “losers,” the paper said. Now, those losers are defaulting, presenting another wave of distressed debt up for grabs.
As of October 31, the default rate was 6.3 percent, data included in the paper show. If defaults reach 10 percent, they will be at their highest since 2009. In 2021, Khosla said, default rates will likely sit between five and seven percent.
[II Deep Dive: ‘Creditor-on-Creditor Violence’ Lands Big Managers in Court]
The losers in this scenario are middle-market companies, according to SVPGlobal. The firm expects that companies with less than $5 billion in debt to present investment opportunities.
When these companies restructure, companies like SVPGlobal can buy debt — usually senior secured issues — at prices below par and convert it into equity. This debt ideally will be sold above both the purchase price and par value, according to the paper.
“These are companies in good businesses but have bad capital structures — in other words, they potentially offer much better value,” the paper said.