How May Distressed-Debt Investors Benefit from Market Slumps?
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While the equity market often gets the easy attention of the media coverage, the debt market, far larger than the equity market in the value outstanding, really deserves its fair credit. Contrary to the so-called leading-indicator theory, the equity market sometimes can actually be reactive to economic and financial conditions, more specifically, to what’s going on in the debt market. Companies often use equity, a permanent capital, for underlying business investments. But to stay afloat with ongoing operations, most resort to temporary credit to carry themselves forward from one business cycle to the next. Any disruptions in the debt market from spikes in debt defaults may cause a ripple effect through the financial system, leading to a credit freeze for businesses and financial losses for credit providers. A modern economy as we know it depends on the continual movement of money and credit, and a stress in the financial system may threaten to alter the normal business progress for all parties.
Distressed-debt investors buy non-performing debt holdings from original credit providers or trade troubled debt investments on the secondary market. The ability to unload bad debt through debt sales by business entities, especially banks and other institutional debt holders, allows them to obtain the needed cash flow for meeting their own financial obligations. However, distressed-debt transactions often are heavily discounted from the recorded book value in favor of distressed-debt investors who stand ready to provide liquidity while no one else will.
There are companies that specialize in distressed-debt purchases from money managers such as Oaktree Capital (NYSE: OAK) and Blackrock Inc. (NYSE: BLK) to equity firms that have extended into operating in the debt market, for example, Apollo Global Management (NYSE: APO) and Carlyle Group (NASDAQ: CG). These are all publicly traded companies, giving individual investors the chance to hold a stake in the otherwise inaccessible distressed-debt market, previously open to only accredited and institutional investors who can make large amount of capital commitments to a distressed-debt fund sponsored and managed by an investment company.
Distressed-debt investments are an especially fitting theme in the face of the ongoing debt crisis in Europe. There, governments and businesses alike continue to have financial difficulties to meet their debt obligations, and many debt holders are forced to shed their lending assets at bargain prices to meet their own cash needs. Oaktree Capital, the world’s largest distressed-debt investor, has been raising money for opening more distressed-debt funds to better position itself and take advantage of the prolonged European debt crisis.
As long as political solutions for financial rescues by the EU governments stop short of delivering sustained improvements to their overall liquidity conditions, there will be increased demand for private credit facilities like those provided by distressed-debt investors through discount-debt purchases. With financial backing from either the government or private debt investors, a debt nearing default or having already defaulted can always be restructured to refinance or extend the payment date. Distressed investors not only benefit from such transactions in the end, but also in the process help prevent sudden breakdowns in the normal functioning of the credit market.
Private equity firms that operate on a global basis are increasingly turning to the debt market to make up the lack of equity deals in today’s slumping business environment. Apollo Global Management, for example, recently raised about 2 billion euros for a distressed-debt fund that will purchase loans from cash-strapped European banks. Some of us may not realize that private equity firms actually are also debt experts, and don’t let the much-publicized name private equity confine you into having a narrow interpretation of their complex business. While equity investments are at the core of what private equity firms do, they carry out equity deals often with the backing of leveraged loans to maximize returns for fund investors. Now debt investments by private equity firm are just the flip side of the borrowing that they have always used well. Knowledgeable about the nuts and bolts of how the debt market works, private equity firms seem to be all set for playing another active role in the distressed-debt market.
For investors who wish to play both the up and down market, investing in distressed debt offers them a viable investment alternative to counter the current slumping market. And thanks to the increasing number of investment companies going public, interested investors now have an easy way to be part of the non-traditional money moves.
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