Distressed debt investors may be carping about the high prices in the market, but a number are also confident there will be ample opportunities over the next 18 months thanks to amateurish due diligence on the part of some hedge funds, increasing leverage and rising interest rates. "The distressed market is going to start getting interesting again," said Bob Hockett, principal at DDJ Capital Management, speaking at The Strategic Research Institute's 6th Annual Distressed Debt Investing Forum held last week at The Venetian Hotel in Las Vegas.
One potential source of optimism for the industry is that hedge funds have pushed prices too high and this could come back to bite them. "My sense is that we may see entire hedge funds becoming distressed as a result of some of them overpaying for property," noted Robert Lass, managing director of Radius Equity Partners. "We've seen hedge funds come in off very little due diligence and offer eight times projected EBITDA on a distressed company. At these prices I don't think they are going to hold out," he noted.
"In the next three years a lot of companies bought by hedge funds will be back in the market at lower multiples and lower prices." Hedge funds will have to take their losses, Lass commented, adding that he doesn't believe acquiring distressed businesses is necessarily a good hedge strategy. "It takes far more operational expertise than some hedge funds are willing to exhibit," he said. This will not be applicable to all funds, but to the ones that are just buying and warehousing businesses, he said.
Investors also see opportunities on the distressed horizon as the number of companies refinancing their way out of financial difficulty accumulates. "Leverage will hit the wall," said Mitchell Harwood, managing director at Encore Partners, who argued that companies have refinanced out of financial difficulties without actually solving them.
DDJ's Hockett explained that 2005-2007 has been set up for increasing default rates given the low quality of recent deals with triple-C issuance comprising 25% of the market. "Lower quality issuance has increased significantly over the last few years." He noted around 20% of junk credits generally default within two-to-four years. In the meantime, there is rolling industry default created by raw material price mismatches from companies having difficulties passing on costs to customers. "There is always a base level of distressed product," he added.
Another factor in the mix is rising interest rates. Ronald Beck, managing director at Oaktree Capital Management, said he expects rates to have a sharp upturn in the next 18 months through an either internal or external shock in the system. Harwood recommended being ready for a new cycle, "Good investors are always early in setting up positions and always early in taking profits."
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