Distressed debt guide: LP perspective

Réal Desrochers, the former head of alternatives at CalSTRS examines the role of distressed debt and restructuring funds in an institutional portfolio.

The use of debt-related strategies and distressed debt in a private equity portfolio, while providing good risk-adjusted returns, has additional benefits such as smoothing volatility, mitigating the J-curve and providing early liquidity. These factors can be beneficial to a number of investors, such as funds of funds, insurance companies, pension funds, endowments and family offices.

Normally, a private equity portfolio is a component of a larger portfolio, where diversification can be gained through sub-asset class allocations, timing of commitments, geography and manager selection. Given its risk profile, the private equity portfolio should have a benchmark targeting equity-like returns. It will have limited liquidity during the first few years of inception but if well constructed and well executed in a prudent and disciplined manner, excellent returns can be achieved.

Distressed debt investments, perhaps comprising 5 to 15 percent of a total private equity portfolio, can offer a countercyclical element to the portfolio. Distressed debt investment strategies where private equity investors take control of a company are most dependent on highly specialised investment expertise and provide the opportunity to create real value in the portfolio. Timing the exposure within the economic cycle is important to the success of this strategy.

Investors are likely to have debt components in other areas of their overall investment portfolio depending on their asset mix. Some portfolio managers place these debt components in their fixed income portfolio, others within special situations and the rest in their absolute return strategies. The point here is to make sure that one analyses not only effects of holding these assets within the private equity portfolio, but also understands the place these strategies have within the entire portfolio.

Private equity portfolio design and construction must be done with discipline, diligence and prudence, while taking into consideration the riskiness of all the sub-asset classes that will be a part of that portfolio.

The major sub-asset classes of private equity are:

• Venture capital: Made up of investments in young, emerging growth companies in various stages of development. These stages include seed (entrepreneurs seeking capital to conduct research or to complete a business plan), early (company in product development phase and seeking capital to commence manufacturing) and late (profitable or near profitable, high growth company seeking further expansion capital). There is a heavy focus in the venture capital sub-asset class on technology, telecommunication, life science and clean technology industries.

• Growth equity or expansion capital: Similar to late-stage venture capital, except that equity expansion investments target companies that are generally larger and are often less technology-driven. These small and medium-size companies have grown from the start-up stage to profitability and are poised for continued rapid growth. The aim is to realise substantial profits on investments in this sub-asset class through the sale of the company to a larger corporation that is looking for growth opportunities or the listing of the company on the public market. The sector also is less reliant on those industries that drive venture capital. Investment is more likely to take the form of a minority rather than a control position.

• Leverage buyouts (acquisitions or LBO): Acquisitions involve the purchase of all or part of a company’s stock or assets with a significant amount of borrowed capital and a relatively small portion of equity. Borrowed capital will typically consist of some combination of senior and subordinated debt. The company may be privately- or publicly- owned, or be a subsidiary or a division of a company. Acquisitions are generally made of companies with stable cash flows, have dominant or large market share, generate high profit margins and sell low- or non-technology products in industries that are not subject to wide profitability swings. The ultimate aim is to acquire an asset that is undervalued or underutilised and to restructure and revitalise it in order to sell it or take it public at a substantial premium to its pre-buyout value. Investors often divide the LBO sector in two: large and mega-buyout funds targeting large, often multinational companies, and middle-market funds focusing on smaller companies. However, there is no clear agreement amongst investors as to where exactly the line is drawn between these two sectors.

• Special situations: Special situations represent a ‘catch-all’ category for investments that do not fit in traditional groupings. These include minority but often control positions in public companies, ‘white knight’ efforts to support management, restructuring funds and other special situation profit opportunities. Generally, a hostile business takeover is not the intention. Over the last decade, dedicated strategies in specific industry sectors such as energy or media have also been classified in this category.

• Debt-related investment strategies: Debt-related investments include subordinated debt and distressed debt investment strategies. Subordinated debt is often used to help finance leveraged buyouts or similar transactions. It typically takes the form of mezzanine securities, junk bonds, convertible preferred stock and other high yield debtoriented securities. Although considered debt-oriented, securities at the subordinated debt and mezzanine levels typically possess equity-upside features through equity rights and warrants that provide additional return beyond current coupons and issuance or redemption fees. Subordinated debt is senior to common equity of the company.

Distressed debt investments are a form of recovery investing that focus on the debt of a distressed or bankrupt company.

Debt-related investment strategies are described in greater detail in the latter section of this chapter, along with a more detailed analysis of the role distressed debt plays within the private equity portfolio. Restructuring funds, which are included in the special situations allocation, will not be covered in detail as the cash flow dynamics of these funds are very similar to buyout funds.

Portfolio modelling

It is customary for the private equity portfolio manager to use a portfolio simulation model that will forecast the behaviour of the portfolio over a given period of time in order to help set overall and sub-asset class allocations. The basic assumption for this discussion is that the portfolio will be built using an indirect investment approach, which means investments will be made through private equity fund managers who in turn use their expertise to make direct investments in the various sub-sectors.

The first step in modelling is defining the investment strategy, if it has not already been set, in terms of key items such as risk/return profile and long-term target returns. From this exercise, the tactical plan will be derived. Typically, it will consist of determining allocations to the various sub-asset classes, taking into consideration geography and the fund’s vintage year. Within the model, assumptions must be made for each of the main sub-asset classes, as well as for the overall portfolio, on expected rates of return, correlations, draw-downs and distributions of capital and finally portfolio realisations. The result of this analysis, combined with the portfolio manager’s perspective on the market going forward, will be to underweight or overweight allocations and future commitments. Crucial to every aspect of the investment management process is portfolio benchmarking.

Private equity portfolio benchmarking remains a subject of debate amongst industry professionals as benchmarks can significantly differ due to the market’s long-term investment horizon, variety of pursuable strategies and lack of liquidity compared to public market comparables. Benchmarks for private equity portfolios have to be equity-like given the riskiness of the asset class and the fact that the portfolio is competing with other asset classes at the overall portfolio level.

This partial chapter is one of 15 in The Definitive Guide to Distressed Debt and Turnaround Investing: A comprehensive resource for making, managing and exiting investments in distressed companies and their securities, a new book from PEI Media.

Edited by Probitas Partners, this guide provides investors and fund managers with valuable tools and practical guides, as well as case studies and best practices.