Some of them look back fondly on the bursting of the dotcom bubble; others feel nostalgic about the 1990s recession. Distressed-debt traders, who buy bonds no one else will touch, and turnaround specialists, who pull companies back from the brink, operate in a topsy-turvy world, where bad times are good and corporate wreckage yields rich rewards.
The pickings have been slimmer for vultures over the past three years, however. Corporate profits have proved annoyingly robust and plentiful credit has made refinancing sickeningly easy. Except for the odd scrap of rotting meat (mainly among car-parts makers and airlines) they have had little to sink their talons into. This has led to “category creep”. Traditional distress funds have drifted reluctantly into risky, but still solvent, junk bonds and high-yield loans to keep business ticking along. Now thanks to the subprime-mortgage woes, hopes are rising that trouble is finally on its way, bringing with it outsized returns for those who trade in corporate casualties.
Investment banks, readying themselves for the expected downturn, have been strengthening their distressed-securities groups. Goldman Sachs is on the lookout for subprime bargains and recently lured a lieutenant of Carl Icahn, an ageing raider, to its “special situations” group. The investment bank, wary of the “vulture” tag, says it merely wants to ensure it can make money at every stage of the business cycle. Barclays has poached an entire team from Oaktree Capital Management, which manages distressed-securities funds. Oaktree itself is raising a new $3 billion fund.
The skills required to resurrect a fallen firm are also in fresh demand. One indication of this is the membership roll of America’s Turnaround Management Association, which has swollen by some 1,000 since 2004.
Behind this cyclical burst of activity is a deeper trend. Distress, once the preserve of specialists, is now attracting the mainstream. Edward Altman, a finance professor, counts 170 institutions that invest primarily in distress, more than ever before, with an estimated $300 billion at their disposal. The field has benefited from growing interest in “alternative” investing (which also includes hedge funds, private equity and commodities). Punting on clapped-out securities is now on many a hedge fund’s list of favoured strategies.
Vultures hope that feast will follow the recent famine. They believe the very lack of distress lately will mean the carrion is more plentiful when times eventually change. More junk bonds are being issued than ever before, more risky loans are being offered. And remarkably, this lending free-for-all continues despite a sharp drop in credit ratings, says Martin Fridson, editor of the indispensable Distressed Debt Investor. No one seems bothered that 17 percent of senior, unsecured junk-bond issues are on the lowest possible rung, compared with 2 percent in 1990.
Mr Altman, who has spent many years tracking financial junk, says he has never seen anything like today’s market. His diagnosis: “almost insane”. The “glut” will surely end dramatically, he says. Mr Fridson reckons a recession could cause defaults to jump to unprecedented levels.
That is when vultures come into their own. When sentiment turns after a long bull run, the market usually overreacts. It loses all sense of distinction between basket cases and risky but viable firms. The distress can also trigger forced sales of potentially valuable assets. Those gutsy enough to swoop can enjoy rich pickings. For example, buyers of some troubled American power companies have seen triple-digit gains as shares have recovered, boosted by mergers. Some investors in struggling cable firms have also done superbly — though others, who bought well before prices hit bottom, have lost money.
New, and Sometimes Nasty
The next wave of distress will be unlike the last in two respects. First, commercial banks no longer dominate the process. According to Standard & Poor’s, a rating agency, non-banks such as hedge funds now make roughly half of all high-yielding leveraged loans and hold the lion’s share of the secondary market.
Indeed for many distressed borrowers, hedge funds have become the last, best hope of salvation. Accredited, a troubled subprime lender, was recently propped up by a $200m loan from San Francisco-based Farallon after banks withdrew support. The hedge fund charged a credit-card-like rate of interest. It also secured the right for ten years to buy over 3m Accredited shares for $10 each, a deal that will bring it huge returns if the lender pulls through. This is a variation on the “loan-to-own” strategy now popular among hedge funds: credit is extended in the hope that it can be converted to equity when the company fails to recover, allowing the lender-turned-owner to restructure the firm thoroughly.
Though hedge funds offer quicker, more creative solutions than banks did in the past, their tactics can upset other creditors. They have also ruffled the feathers of the private-equity firms that sponsor leveraged takeovers. Fearful that activist funds will make trouble in a downturn, the buy-out shops have started asking their banks to insert legal clauses that prevent their debt from being sold into such hands.
The second change is likely to cause conflict too. Borrowers’ capital structures — the various layers of debt and equity, each with different rights in the event of default — are now more complex. It is less clear than it was who is entitled to what.
That is largely thanks to the explosion of “second-lien” lending. These loans are secured against a company’s assets, but with fewer rights than more senior loans. Trouble is, these rights are not always clear. Second-lien lenders, who provided 75 percent more money in 2006 than the year before, have begun to exploit this fuzziness to challenge those above them in the pecking order. “We could see some almighty bust-ups when the market turns and everyone’s less understanding,” says Mo Meghji, who runs a restructuring boutique.
Vexing as they may be, these extra layers of debt may provide golden opportunities for bottom-fishers once credit markets tighten and refinancing becomes harder. Daniel Arbess of Xerion Capital Partners thinks loan-laden American manufacturers look particularly vulnerable. If interest rates rise, they will only be able to refinance their debt when it falls due if they secure ratings upgrades by making fundamental improvements in their business. But the opposite is more likely, he argues, as such firms continue to feel the full force of competition from low-cost countries.
Which leaves just one question: what might trigger the next crunch? Nobody knows, but Mr Arbess suggests it may arrive disguised as good news. The turning point of the last cycle, he believes, was the merger of AOL and Time Warner. That deal exposed the kind of faulty logic that allows a money-losing internet firm to get the better of a profitable media giant. So don’t hope for a $100 billion leveraged buy-out — unless you’re a vulture.