By Pamela Lawrence
Today’s distressed market is very similar to that of the late 1980’s and early 1990’s when macro-driven systemic issues created distressed opportunities. In the 1980s, easy money led to the creation of the high-yield bond market and a real estate bubble. Banks and other financial institutions took excessive risk and purchased highly levered products. By the end of the decade, the real estate market collapsed, the credit bubble burst and many banks had failed. To stabilize the market, the government established the Resolution Trust Company to buy assets, including high-yield bonds and real estate, from the banks. Insider trading scandals led to the bankruptcy of Drexel Burnham, a prominent broker/dealer, in February 1990 putting Wall Street’s credibility in question. All these events were followed by a consumer recession in 1990-91.
Today’s market conditions have many similarities to that time. In the past decade, easy credit fueled a residential and commercial real estate bubble and a significant increase in leverage. There was little concern for the consequences of risk. The high yield and leveraged loan markets expanded to $2.6 trillion by the end of 2008 versus $200 billion in high yield with a non-existent leveraged loan market in 1989. Financial firms purchased these and other levered products and real estate. As in the 1980’s, the government supported the banks and other financial institutions as the markets experienced the downturn and uncertainty prevailed. Lehman suffered the same fate as Drexel Burnham, other forced acquisitions in the banking sector occurred, and Wall Street was chastised by main street and the government.
However, there are differences between today’s market and the 1980’s. One, the magnitude of the market is unprecedented. Four of the largest bankruptcies in history, Lehman, General Motors, Washington Mutual and CIT, occurred within the past 18 months. Second, the severity of the economic and structural issues is more pronounced. Derivatives, while financially innovative, have amplified problems and their existence complicates market dynamics. Finally, the decline in the housing and equity markets resulted in a destruction of wealth for the consumer. The consumer has responded by
deleveraging, saving more and spending less.
As violent as the collapse was in 2008, the market’s rebound in 2009 was almost as pronounced. Government stimulus fueled the beginnings of an economic recovery and created positive sentiment in the markets. In 2009, the S&P generated 26.5% returns after losing 37% in 2008, for a two year decline of 20.3%. As the yield on U.S. Treasuries and money market funds reached historic lows, investors’ desire for income fueled inflows into high-yield mutual funds at an annual amount of $32.7 billion. This created a supply/demand imbalance which fueled returns of 54.2% for the high-yield market and 44.9% for the leveraged loan market. This compared to record underperformance in 2008 of -26.8% in high yield and -29.1% in leveraged loans.
The supply/demand imbalance also resulted in record high-yield bond issuance. Abundant market liquidity enabled better quality companies to fix their balance sheets by issuing new debt and extending debt maturities. Approximately 77% of new issuance in 2009 was used to refinance existing debt. The institutional loan market focused on loan amendments that extended maturities and provided covenant relief. Investor demand also contributed to rescuing other highly levered balance sheets by exchanging debt for new debt with longer maturities.
There is $855 billion of high-yield and leveraged loans outstanding which will mature in the next four years. Much of this debt was issued in 2006 and 2007, the peak of poor quality debt issuance, with excessive leverage and few covenants. In addition, while distressed exchanges were a popular way for high-yield companies to extend maturities, a study by Professor Edward Altman at NYU, concluded that 49% of these companies eventually file for bankruptcy protection. The dynamics of 2009 did not fix the balance sheets or the operational issues of these companies.
Despite the liquidity, many companies were unable to refinance and the default rate increased to 11% in the high yield and 14% in the leveraged loan markets. While the defaults of larger companies (General Motors, Chrysler, CIT Financial) were widely reported, more than 85% of the 191 companies that filed for bankruptcy protection (as of September 30, 2009) were companies with less than $2 billion in liabilities. Typically, small to midsize companies have less access to the capital markets, and default more often, which was the case last year. This has occurred repeatedly in the past and the future should be no different.
It wasn’t until 1994, more than five years after the 1980s bubble burst, that the credit market fully recovered. We anticipate it could take even longer this time. All these market dynamics will create many distressed opportunities. While the better quality companies may be able to generate cash flow to support their capital structures and/or have the ability to refinance their debt, it is likely not all companies will succeed and many companies will default and ultimately restructure. In particular, small to midsized companies face more challenges when accessing the capital markets. It will be companies in this space that will create future long and short investment opportunities. It will also be a time when bottom-up fundamental analysis will be important to successful investing. If the past cycles were sprints, this is a marathon.
Pamela M. Lawrence is Co-Founder and Managing Principal at Restoration Capital Management LLC, a distressed debt hedge fund based in Greenwich, CT. She is responsible for directing the Firm’s investment strategy. Prior to founding the Firm in 2001, Ms. Lawrence worked as a Portfolio Manager concentrating on distressed investing with several firms, including Tribeca Investments LLC, and Whippoorwill Associates, Inc.
Performance data for Restoration Capital Management.