With Little Distress to Feast On, Here's How Vulture Funds Cope

(Bloomberg) -- What’s a distressed-debt fund to do when the market just isn’t feeling the pain?

With so few companies on the verge of default, investors in the debt are finding other ways to keep busy, like turning to activism or joining banks in the loan market to try to fill the gap left by a shrinking pool of distressed bonds. They have a long way to go before they can spend $74 billion of cash they’re sitting on, according to a report this month by Preqin that cites Blackstone Group LP’s GSO Capital Partners and Oaktree Capital Management as having the biggest stockpiles.

Take Jason Mudrick. The founder of Mudrick Capital Management led returns among distressed funds in 2016, sweeping up debt of troubled energy companies. But these days he’s taking stakes in publicly traded companies such as Globalstar Inc. and Verso Corp. to push for management changes. He’s also raised $170 million for the Mudrick Distressed Senior Secured Fund, which he started this year to buy senior secured loans of distressed companies he doesn’t believe will be impaired during the restructuring.

“The next distressed cycle may be driven more by this interest-rate cycle rather than asset bubbles bursting, which could result in a longer cycle of higher defaults,” Mudrick said in an interview in New York. “It may just be a gradual slowdown rather than a ‘V’ shaped recession.”

Apocalypse Later

Turnaround firms, credit raters and distressed-debt specialists have been forecasting a default spike for the past two years, only to see the apocalypse repeatedly rescheduled. Banks have kicked the can down the road, extending lifelines to troubled companies in an effort to avoid default, while easy money and fearless investors have encouraged companies to make ever-riskier deals that may just be putting off the inevitable.

In response, David Tawil, president at New York-based Maglan Capital, has sold out almost completely of distressed debt -- except for some Puerto Rico general obligation bonds -- and remade the fund as an activist investor. That includes taking a substantial stake in FairPoint Communications Inc., revamping its operations and then steering the sale of the Charlotte, North Carolina-based carrier to Consolidated Communications Holdings Inc., he said.

“We first looked at FairPoint because there weren’t enough distressed opportunities,” he said. “The distressed investments have come and gone.”

Since the 2015-2016 cull of energy firms, defaults have grown more rare. A tally of distressed companies by S&P Global Ratings decreased to 184 as of April 24, reaching a 30-month low. Moody’s Investors Service expects the default rate for global speculative-grade bonds to fall to 1.5 percent by the end of 2018, before trending down to 1.2 percent in April 2019, down from 3 percent for the 12-month period ended in April.

It’s a frustrating situation, especially as distressed is the top-performing hedge-fund strategy this year, according to Eurekahedge.

Yet many are already preparing for the peak of the business cycle, the end of easy money and the impending pinch as companies struggle with heavy debt loads as growth stalls. The International Monetary Fund last month forecast global growth this year and next would continue on at 3.9 percent, then falter from 2020. According to FTI Consulting Inc., that’s the year the long-predicted spike in defaults will fully materialize.

Institutional investors in private debt “remain hungry for distressed-debt exposure” with more than half showing a preference for the strategy, according to Preqin.

“Many active players in both public and private markets foresee a potential correction on the horizon, after nearly a decade of economic expansion in the U.S.,” Preqin said in its report. “It follows suit that distressed-debt funds could flourish in the upcoming section of the debt cycle.”

©2018 Bloomberg L.P.

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