O#4 NOVEMBER The share price of Kier Group, a struggling British builder, fell nearly 10% on reports that banks were trying to offload its debt at a steep discount. The rumor remains unconfirmed – sources close to the company and one of its biggest lenders dispute that claim – but investors may still have felt a sense of deja vu. After the sudden collapse of Carillion and Interserve, Kier is the third British construction giant to face a battle for survival in less than two years. And each time the fortunes of the groups deteriorated, hedge funds eager to buy back their debt at bargain prices began to turn in circles.
Funds that buy “distressed” debt, which typically fetch ten or more percentage points over Treasuries, are becoming familiar villains. They pounced on Thomas Cook, a tour group, and PG&E, a California utility, shortly before it went bankrupt this year. They tend to revolve around struggling oil companies and stores disrupted by e-commerce, notes Christine Farquhar of Cambridge Associates, an investment firm. And they are raiding portfolios of failed loans from banks. If their target eventually recovers, they pocket big profits. If not, they often win regardless, as they are usually first in line for liquidation proceeds.
Still, distressed specialists are frustrated. Convinced that a recession was approaching, they have raised $136 billion since 2017, more than they did in the four years following the financial crisis, according to Private Debt Investor, a financial information provider. But they struggled to deploy the money. Troubled debt funds currently hold $62 billion in ‘dry powder’, nearly double what they had in 2008 and near the peak of $75 billion reached a year ago, estimates Preqin, a data company.
Two things make their life difficult. First, despite turbulent markets and a slump in commodities, the global economic expansion is ten years old and continues. And just when funds think a downturn is finally coming, interest rates are slashed, allowing weak borrowers to limp on longer. Meanwhile, the abundance of cash has led to a weakening of covenants – covenants that require borrowers to keep overall debt levels under control – making it harder for funds to force struggling companies to bankruptcy.
Difficult offers are therefore rare. And when they do show up, the competition is fierce. This drives up prices, which hurts returns. Weaker contractual protections make matters worse: creditors often recover less from restructurings, says Fraser Lundie of Hermes Investment Management. Distressed debt is also becoming less liquid and harder to trade, as passive funds that track bond indices focus on larger, safer companies. After outperforming private equity for years, the asset class has lagged every quarter since 2016, according to data firm eFront. Internal rates of return are just 8.5%, net of fees, compared to 12% two years ago.
The famine “wiped out an entire generation of professionals in distress”, notes a credit fund manager. Trading desks lost staff; flagship funds retreated. Nick Kraemer of s&P Global, a ratings agency, says default rates on speculative-grade debt in America could top 10% by mid-2020, up from 2.4% in June 2019, giving reason for hope. But further easing by the Federal Reserve could thwart that. And structural factors, such as weak covenants and low liquidity, are likely to persist. UK builders may be floundering, but corporate debt appears to be on firmer footing.■