Wharton@Work

October 2023 | Finance

Advice for Those Seeking “Abnormally Positive Returns”

When “Big Short” investor Michael Burry bet more than $1.6 billion in August on a stock market crash, everyone from institutional money managers to individual investors went on high alert. Burry famously predicted and profited handsomely from the housing market collapse that contributed to the 2008 global financial crisis, and he is now set to cash in on the next crash if it materializes. The bet itself caused markets to move, and international news organizations continue to follow Burry’s moves.

For Wharton professor Kevin Kaiser, Burry’s bet highlights the need for investors to understand what would happen after a crash and be in a position to take advantage. “There are many indicators that point to a crash happening sooner rather than later. If it does, it will result in outstanding opportunities to invest in distressed assets. Given that there's a reasonable likelihood it's going to happen — even though it might not — investors have to position themselves now.”

The indicators Kaiser refers to include, among others:

• More than a decade of abundant liquidity provided by central banks at very low rates
• Aggressive borrowing by property developers followed by the technology- and pandemic-induced decline in need for commercial real estate
• Aggressive borrowing by PE to fund acquisitions at ever-higher multiples

These developments were followed by a sudden, sharp rise in interest rates, driven by central bank policy to curb inflation, which in turn was primarily due to by global supply shocks caused by the government policy response to the pandemic.

Kaiser says taking a wait-and-see approach won’t work because if and when a crash happens, it will be too late, as happened in 2008. “If you weren't in a position to take advantage in those first few days or weeks, you missed it. If it was a certainty, everyone would get prepared. But the uncertainty means there’s an opportunity for highly skilled investors.”

But the potential for recession along with a sharp market sell-off and consequent credit crunch isn’t the only reason investors need to prepare now. “There’s a real sense that interest rates are not going down anytime soon,” Kaiser notes, “which means companies are going to have increasing difficulty refinancing their debt. When they do refinance, it is going to be at higher rates. If they don’t make enough money to pay those rates, either they can't refinance, in which case they're already in distress, or they might be able to pay those rates in the short term, but end up in in distress months later. That’s the scenario if rates stay high, even if there's no collapse, which only adds to the urgent need to prepare.”

Investors Need Updated Knowledge

“The forces behind the rise in the amount of soon-to-be-distressed debt are relatively well understood,” says Kaiser. “What is much less well-understood is when the wave of defaults will start, how widespread it will be, and what impact it will have on the overall economy. It’s hard to understand because, as is the case with any system, the feedback loops are complex and chaotic. The need for even seasoned investors to learn, reflect, and act on these developments is very high.”

“We may hit a tipping point when the rise in defaults will trigger a sudden shift in investor willingness to refinance maturing debt, at which point the rise in defaults will become a flood and we will see a collapse in credit availability and bond and loan prices,” he continues. “The point at which this may be triggered is impossible to predict, but it is relatively easy to say that it is likely happen. Highly skilled investors will be wary of the arrival of the tipping point and will be prepared to invest after the sudden collapse. They will be able to identify the companies caught in the flood of defaults ‘unjustly,’ and position themselves to make abnormally positive returns by buying when everyone else is selling.”

But taking advantage of the opportunity takes new knowledge and skills, because many investors have no experience with a real distress situation. “It looked like COVID-19 might be one, but the market fell fast and then rebounded. Companies didn't actually experience distress because the government stepped in and helped them cover their costs and refinance,” says Kaiser. “The last global financial crisis was 12 years before that, so anybody who's come into the market in the past decade has never seen a wave of defaults. They have no experience with it.”

Investing in Distressed Asset Funds

In the Distressed Asset Investing and Corporate Restructuring program, Kaiser and fellow Wharton faculty explore the strategies and skills of distressed asset investors to help participants make informed decisions about where to put their money. “We talk about their skill sets in terms of fundamental analysis: how well can they differentiate the companies that are going to be sound and the companies that are going to be in trouble? Who is generating enough cash to make higher interest payments when they refinance their debt, how much they can support, and for how long?” Kaiser says. “For those unable to generate sufficient cash going forward, they will need to undertake a financial restructuring to reduce their debt burden and cash interest payments. This is what highly skilled investors are doing now: they're researching individual companies to make sure they know how far each one needs to fall to become a buying opportunity, and how to prepare for the restructuring.”

“The other aspect to consider is the asset managers themselves: some are better at owning the company than running the company,” Kaiser continues. “The return on the investment isn't just about identifying the companies that will rebound, but it's helping them to rebound. Distressed asset investors buy the debt of the company in order to end up in an ownership position so they can manage the success of the company going forward. It’s what’s known as ’loan to own.’ As a limited partner, you want to understand the different strategies and try to find distressed fund managers who have the skills and the track record to do this. In the program, I describe the different strategies and skills that they have, and how much time they devote to it, so that people will have a better understanding of the questions to ask when they're deciding which funds to invest in.”