With company default rates at historical lows, pickings have been thin on the ground for the much-maligned distressed debt banker. But lenient lending policies to troubled firms in recent years may mean a bonanza is on its way, says Karina Robinson.

“If there is an economic blow-out it would be like having a dump of fresh snow,” says an investment banker in distressed debt who, like many in this stigmatised industry, asked not to be quoted.

There has been a dearth of fresh powder in the sector since the glory days of the big bankruptcies of US companies Enron and WorldCom, when there was about $350bn of distressed debt to trade and restructure, say bankers, with a hint of nostalgia. Now, according to financial data provider DebtWire, there is £74.2bn ($140bn). Meanwhile, about $600bn of high-yield debt has been issued between 2002 and 2006, a potential future supply.

Avalanche watching

Many distressed debt specialists have got their skis on in preparation, despite being unsure about when the snowstorm will break. Similarly, economic commentators are uncertain about when the cycle will turn – with forecasts ranging from the end of this year to 2009 – and what will be the catalyst – interest rate rises or perhaps a terrorist attack.

It certainly has not yet begun: 2006 saw the lowest default rate for companies in almost a decade, both for speculative grade and investment grade, according to Standard & Poor’s. However, this understates what is happening to companies. David Staples, a managing director at rival rating agency Moody’s, says that there is a universe of transactions that could go through distress and not come under the radar of a rating agency as the substantial liquidity around and the demand for those assets from yield-hungry investors means many do not need to go through the public markets to refinance. Additionally, he points out, weaker covenants in Europe mean a rated company with debt in the public domain can renegotiate its distressed debt without having to disclose this, unlike in the US, he says, as long as there is no actual default.

Participants involved in the industry for many years say several indicators point to the future snowstorm.

The principle indicator is that there are new participants. As more hedge funds have been piling into the distressed debt space it has become awash with liquidity. The more traditional banks involved in the business, and the private equity funds that have also waded in, can hold cash and wait for a good opportunity, although hedge funds have to invest faster because they have shorter lock-up periods, say sources, potentially leading to a closer embrace of riskier propositions.

In reality, though, every participant is searching for yield and, bankers say, many have been willing to take on more risk for less reward. From July 2006 to January 2007, buyers of better quality high yield debt are making 1 percentage point less in interest, with yields down from 300 to 200 basis points over Libor, yet more evidence of a hot credit market.

Another indicator of the excess liquidity is that distressed debt, which historically trades well under par at 100, is now trading in the low 90s to 101.5, while the current default rate on high yield debt is at a record low of only 1%.

Meanwhile, Ed Altman, a professor at New York University’s Stern Business School, notes debt-to-cashflow ratios have risen to above six in some refinancing or merger activities, so it “could be laying the groundwork for potential defaults unless leverage lessens within two years”. This ratio, according to bankers, rises to an average of nine times for private equity deals.

Many of these factors apply to the bond markets in general. The difference, say participants, is that troubled companies that should have gone through a restructuring, due to fundamental problems with their business plans and/or excess leverage, have managed to avoid it because lenders are too lenient to apply strict criteria. They also say covenants are looking very loose.

Restructuring boon

The attractions of the sector are clear. Distressed debt investors who get involved in restructuring a company, rather than simply trading distressed debt, on average make between two and a half to three times their money on investments that last, on average, three and a half years, say participants.

Firms such as MatlinPatterson, for instance, a boutique specialising in distressed debt, became involved in the restructuring of telecommunications giant WorldCom, which went bust in 2002, in one of the US’s largest corporate bankruptcies. It became the company’s largest creditor, helped it emerge from bankruptcy in 2004 and converted the debt it held into shares.

MatlinPatterson was spun-out of Credit Suisse First Boston in 2002 and now has 20 investment professionals and $3.9bn invested through a couple of funds.

For banks, there are other synergies. Once they have turned a company around, it could well become a banking client, while mergers and acquisitions bankers can become involved at different stages.

To prepare for the snowstorm, hedge funds and others have been building up their capabilities, says Dee Symons, a headhunter at Russell Reynolds. Some market participants, however, say this is overstated. They assert that much movement has occurred in the market – distressed debt bankers in investment banks have moved to the buy-side or to hedge funds – and those spaces have had to be filled.

Deutsche Bank is a major player in this market, having set up its specialised unit in 1993. The Frankfurt-headquartered bank trades distressed debt and restructures companies in distress and has, acknowledged by competitors, a market share of more than 50% in Europe, in excess of 20% in the US and about 35% in Asia. In the past year it raised its headcount almost 30% to 132.

Martin Dent, head of global distressed products at Deutsche Bank, is wary of predicting any imminent increase in distressed debt.

“I don’t see any specific problems being created, or a specific industry sector that looks unviable. The credit markets, in particular the European high-yield market, are much more sophisticated, disciplined and, thanks to credit derivatives, more diverse than in the last credit boom,” he says.

“But with much higher absolute debt levels and with a low margin for error, history tells you this degree of leverage is a recipe for more defaults,” he adds.

Currently, half of the Deutsche distressed debt unit’s revenues reportedly come from restructuring, the rest from trading, but this balance will change in the event of a downturn – and how the derivatives and structured products relationship with the bond markets will fit into the equation is something market participants are wary of predicting.

But in many ways, the existence of structured products and a liquid-booming market has given a boost to financial institutions taking on more risk. However, a credit crunch could change this situation.

Market strength

Viral Acharya, visiting professor of finance at Stanford University’s Graduate School of Business, says: “The period of 2001-2002, when global defaults were at historic highs, has shown that mechanisms for credit-risk transfer such as CDSs [credit default swaps] and CDOs [collateralised debt obligations] have made modern-day financial systems highly resilient.

“Thus, the real question is: are there likely to be failures in risk management at some large institutions that might lead to concentrated exposures on some trading books and result in disorderly liquidations upon an economy-wide shock? Clearly, the concern applies to the entire spectrum of financial institutions, ranging from pension funds to banks to hedge funds.”

Given the relatively limited amount of distressed debt and the level of excess liquidity, lead financiers in any group formed to restructure a company now insist that every participant bring something other than liquidity to the table. This ranges from having a good network of possible chief executives in a sector, to being sector experts.

Of course there might be a new paradigm and no snowstorm. But Mr Altman says it is more likely that at some point the hot money will recede, moving to other asset classes such as real estate and alternative energy stocks, and more normal default rates will emerge. That will provide a bonanza.

Meanwhile, the image problem will not go away, which is why investment bank Goldman Sachs, one of the stronger banks in this field, refused to participate in this article. A spokesperson said it is “an area of the business we don’t seek to publicise”.

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