Wharton@Work

April 2022 | Finance

The Brave New World of Distressed Asset Investing

There’s a perfect storm coming for distressed asset investing. The market will be flooded with opportunities, and investors are ready to move on them. But the asset class has changed, and knowing how and what today’s market requires is a key to seeing returns. Kevin Kaiser, senior director of Wharton’s Harris Family Alternative Investments Program, says many on both sides — investors as well as CFOs and other senior business leaders — aren’t prepared for what’s coming.

“Funds available for investing have skyrocketed, and investors seem poised to deploy it soon. Companies that made it (barely) through the pandemic need to know what to expect when those investors turn their attention to them,” says Kaiser. “On the other side, investors need to understand recent changes in distressed asset investing — it’s not about the relatively quick operational improvements that were once required. If you are an institutional or family office investor, you can give money directly to asset management firms, but you should know more about distressed asset investing before you do. Learn the kinds of questions you should ask before you invest. Understand why the returns on distressed asset funds have been so much higher than those on flagship hedge funds, and whether those returns are sustainable.”

A Reckoning Is Coming

Kaiser says he expects “massive” investment opportunities in the near future. “I was expecting defaults to rise in 2020. It looked like we were poised for a once-in-a-lifetime opportunity to buy distressed assets. Typical default rates for high-yield debt are about three to four percent. In a recession, they typically spike to 10 percent. But as COVID-19 played out, central banks made money available to markets and consumers, and interest rates fell to near zero. Companies that should have defaulted didn’t.”

Instead, over the past two years default rates have been among the lowest on record. Kaiser says whether you have celebrated or criticized the move to keep businesses funded, it has led to large numbers of what he calls “zombie” companies — the walking dead who are alive but shouldn’t be. “We can disagree about how many,” he says, “but as soon as interest rates start to rise — and the Federal Reserve has indicated that will happen soon — they will all be exposed.” It’s a situation Warren Buffet famously described: “Only when the tide goes out do you discover who's been swimming naked.”

Add to rising interest rates the economic uncertainties due to global political events and supply chain disruptions, and it is clear that companies with debt are in jeopardy. “If you’re a senior executive at a company that struggled through COVID-19 and took on more debt, now is the time to be prepared. We’re not talking ambiguously about ‘what-ifs.’ You need to understand what’s coming, and plan for what’s next,” says Kaiser.

Investors Are Hovering

A significant part of what’s next are moves by the large funds that are ready to do distressed investing. After realizing great returns on early COVID-19 investing, they haven’t deployed much capital in the past 12 to 18 months. “They have the money, and they need to put it to work in the near future,” says Kaiser. “Right now, they are just hovering.”

What about sanctions that have created a buying opportunity in Russia? Although it’s “business as usual” for Wall Street to take advantage — J. P. Morgan said it traded about $200 million of Russian and Ukrainian corporate debt a week after the invasion of Ukraine — not everyone is getting in. “These investments have a strong potential for reputational damage,” says Kaiser. “But what this activity shows me is they have money they need to put to work. As soon as American companies stumble, they will jump in. For the leaders of those companies, there are clear dangers. Arm yourself with knowledge and confidence when evaluating your alternatives, on both the operating and financing sides of your business, and hone your understanding of the potential benefits and consequences of the restructuring alternatives available to the company.”

Investing: Three Requirements

Investors getting ready to deploy capital must also hone their understanding of today’s distressed asset market. “A fundamental difference between distressed asset investing a few years ago versus today is the amount of money required,” says Kaiser. “Arbitrage is no longer profitable because there are so many money-chasing opportunities, and markets have become too efficient. You can’t just replace a management team or fix minor problems to realize a return. Now you need to bring in new money to support the company in strategic efforts, which may include mergers and acquisitions.”

In addition to costing more, investing in strategic efforts requires patience. “When distressed asset investing was about simply making operational improvements, you weren’t buying into very troubled companies,” says Kaiser. “When companies are more troubled, you have to stay operationally and financially supportive, and that takes more time. If you’re not patient, you might not want to make the investment, or you could pull out too quickly, before realizing the potential returns.”

Kaiser says the third requirement is expertise. “Providing operational support isn’t just expensive and time consuming. Investors need to possess strategic capabilities, going in knowing how to grow the business.” The complexity, time, and cost of these investments mean they are riskier. “Many times, the efforts don’t work as expected,” he says, “Strategic enhancement takes more money and more time, so you need a better return to justify the investment. But you have to expect that it won’t work out.”

For business leaders and investors seeking a deeper understanding of the current distressed asset market, Kaiser co-directs the Distressed Asset Investing and Corporate Restructuring program, which runs next from June 6–10 on Wharton’s Philadelphia campus. He has been teaching a version of the program to Wharton MBA students since 1992, and says today many investors aren’t aware of the changes that have made the asset both riskier and more complex.