As Distressed Gets Hot, Some Get Cold Shoulder

While distressed companies are garnering a lot of attention from investors, with many planning to up their distressed exposure this year, those investments are going to be aimed at specific high-performing sectors. As such, many companies that need the money the most will likely be left out in the cold.

In a recent survey by Bingham McCutchen, FTI Consulting, Macquarie Capital, and Debtwire, two-thirds of respondents said they plan to invest more money in distressed debt this year. Thirty-seven percent of respondents said they plan to invest in financial services companies, and 34% said they will invest in auto manufacturers and suppliers (see chart page 8). But these companies combined make up only roughly 10% of distressed issuers, according to Standard & Poor's estimates.

On the flip side, only 10% of survey respondents said they would invest in media companies, and only 3% said they would invest in telecommunications and technology companies. Media companies account for 21% of all distressed issuers, and telecommunications and technology companies make up 11%.

"[The funds] that are looking to invest are being very choosy," said Samuel Star, senior managing director in corporate finance for FTI Consulting, Inc. "They want to be sure that what ever they pick will have a meaningful return on investment. As their investors have been burned from previous deals, they want to improve their track record; hence the caution."

Several companies have recently boosted their exposure to distressed debt. Mark Devonshire, a former co-head of the proprietary trading desk at Merrill Lynch who left to start mCapital, has reportedly set his sights on 30 to 40 companies, with plans to invest between $25 million and $50 million in each. mCapital is set to launch in February. John Paulson, who runs the $36 billion hedge fund Paulson & Co., has reportedly said he is looking to buy distressed mortgages and distressed debt.

The amount of distressed debt has grown substantially over the past four years. In mid-2005, there was around $251 billion outstanding. Now there is more than $1.3 trillion. The number of distressed companies has more than doubled in that time to reach almost 400.

The survey, which polled 100 hedge fund mangers, proprietary trading desks and asset managers, found that 20% of respondents plan on allocating between 80% and 100% of their assets to distressed companies in 2009. Only 7% of the respondents said they allocated the same amount last year.

The second quarter will see a wave of distressed activity, according to the survey, which shows that 46% of respondents will start making distressed debt purchases in the second quarter. Sixteen percent said they will start purchasing in the third quarter, and 5% said the fourth quarter is when they will jump in.

So where did all of this opportunity come from? One needn't look further than the leveraged buyout boom between 2005 and 2007. The total amount of outstanding leveraged loans reached nearly $600 billion by the end of 2007. Now approximately 80% of the loan market qualifies as distressed. Distressed debt is defined as debt trading with a spread of Libor plus 1,000 bps or more.

Meanwhile, S&P forecasts the U.S. speculative-grade default rate to climb to 13.9% by the end of 2009, significantly higher than the long-term average of 4.3%.

While the survey shows a growing opportunity for distressed investors, it also speaks volumes about their confidence in a few ailing sectors. Almost one-third of respondents said they plan to invest in distressed automotive companies, a sector that makes up 5% of all distressed issuers, according to S&P's estimates. Nearly 30% of investors named the energy and chemical sectors as areas of interest. Those two sectors make up approximately 14% of all distressed issuers.

The investment vehicles investors drive into distressed territory will be fairly straightforward, with 78% of survey respondents saying first-lien secured bank loans are the way to go. Common shares and subordinated bonds, on the other hand, are not. Approximately 50% of respondents said both investment vehicles will be unattractive in 2009.

"I hope we've learned our lessons," said Star. "We need to keep [investments] simple and towards the top of the capital structure. The simpler, the better. Other opportunities for straight equity, subordinated financing, preferred equity, are going to have less bells and whistles than it had previously because you want pieces of paper that can be monetized. And the simpler it is, the easier it is to monetize."

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