Investors in distressed companies may find more opportunities in 2015. The number of covenant-lite or pure cash-flow loans are likely building the supply of distressed debt, says Tom Kim of Denver restructuring firm R2 LLC. A potential increase in interest rates would also increase the amount of distressed companies. Kim expects retail, health care and crude oil companies to be at risk.

Strategic Value Partners LLC, an investment firm that focuses on the distressed space, closed a $1.31 billion fund on Dec. 10 that will focus on distressed investments, especially in Europe. 

What trends did you see in distressed investing in 2014?

In 2014, we saw a decrease in the number of bankruptcies from the peak period in 2009 and 2010, but we’re not far off from the 20-year average. But the type of cases has changed a lot. There are a lot more sale transactions rather than reorganization plans. The perception is that sales are faster, cheaper and more certain than a plan. That has an impact on the professionals, because they don’t have a case that is going to last for a long time. All deal professionals are seeing that.

The other thing is a relatively low supply of distressed debt. That has an impact on the market because, whether it’s a bank or an entrepreneur owner of a company, it’s the distressed debt facility that starts the chain of a restructuring case. When supply is low, there are not as many deals getting pushed into the distressed pipeline. But the supply is building because of the number of covenant-lite or pure cash-flow loans that are being made right now, especially in the middle market.

What should investors of distressed companies expect in 2015?

The number of underperforming loans will increase in 2015. I have a skeptical view of what is going on in the underlying economy, and the leaders in certain industries are doing well, but the mid-range performers are having more trouble than is apparent. Some companies have been using capital-type transactions, such as refinancings, to mask problems that are going to become
undeniable.

Something we are seeing as an overall trend is the earlier detection of distressed indicators. People are using the euphemisms “liquidity management” or “performance improvement” to move advisers into matters earlier than when we used to classically enter, when there was an extreme crisis. Now professionals are moving in at the first negative inflection.

What constitutes the first negative inflection?

One sign of trouble could be decreased revenue. The top line starts to make a move down. Another, more meaningful, indicator is when gross margins start to decrease, or when cash starts to decrease. The other is overall balance sheet liquidity, when the ratio of assets to liabilities starts to shift and go negative. Those are the classic indicators of some kind of problem that is brewing. As you go higher in the middle market, you might hear about debt coverage ratios. When they decline, people get worried.

If professionals are moving in earlier, will there be fewer bankruptcy filings?

Earlier detection won’t necessarily affect the overall number of bankruptcies. A lot of cases are filed by smaller business, so there will not be a really big change in the numbers. But there will definitely be a decrease in the number of bigger, more sophisticated cases. A certain number of cases have to go through bankruptcy, no matter what.

Which sectors do you predict will undergo distress?

The vulnerable sectors include: retail, health care and crude oil. I also think we could see a shakeout in companies focused on natural resources.

How will an increase in interest rates affect investing in distressed companies?

Higher interest rates will increase the number of distressed deals. Any increase is going to have a negative impact, and if interest rates go up a whole point, that will have the most impact. There will be an increase in the number of transactions, and there will be refinancings. I think private equity firms that focus on investing in distressed companies, which are growing in number, are going to have more opportunities to take out these companies via a debt transaction, or a loan acquisition. Everyone is starting to get more interested in distressed investing. It’s mainly because of the value investment. Multiples on growing companies are so high right now. There is always risk in the distressed space of a bigger gap between the buyer and seller, and it’s easier to find an agreement with a seller when growth is high.

For Mergers & Acquisitions’ ongoing coverage of distressed companies, see our weekly Turnaround Tuesday column and Distressed Company Watch List.

 

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