With distress comes opportunity

  • Financial sponsors continue allocating funds to capitalize on possible distressed opportunities

  • Strategic buyers are on the lookout for distressed bolt-on deals to expand existing capabilities

Since the 2008 financial crisis, distressed investing has become an increasingly important part of global investment strategies. Even in today’s economic landscape, where interest rates remain historically low and the global economy is relatively strong, buyers can find distressed opportunities. Recent examples can be found in the retail sector where many brick-and-mortar retailers and consumer goods companies around the globe have slipped into the distressed bracket in recent years and savvy distressed investors were able to take advantage of quality assets being available at a reasonable price.

Uses for available capital

With financial sponsors sitting on an estimated US$2.5 trillion of “dry powder” waiting to be deployed, and strategic buyers often benefitting from high share prices and cash piles, the M&A market has recently been extremely competitive. Distressed M&A is one strategy to deploy capital more efficiently, allowing buyers to acquire attractive assets at a discount to their fundamental value.

Preparing for a potential downturn

While the investment community is not aligned on whether a recession will occur, the global economy is facing a potential downturn that could tip a number of previously secure companies into the distressed bracket and create investment opportunities.

Market commentators and investment professionals are increasingly looking at the approximately US$1.2 trillion leveraged loans market as a source of future distressed assets. Although default rates in the United States remain at record lows, the complex capital structures that some businesses have taken on through leveraged acquisitions may make them particularly vulnerable to an economic downturn.

Any downturn in a highly leveraged market will lead companies across a broad range of sectors, industries, and regions to face major financial difficulties.

Building distressed capabilities and strategies

Financial sponsors and strategic buyers alike are acutely aware of the opportunities that a downturn could bring and are preparing themselves accordingly.

For some time, many of the leading investment houses have raised distressed-focused equity and debt funds or allocated specific portions of their existing funds to targeting distressed assets. Their rationale remains the same – to take undervalued assets, guide them through the downturn, and sell at a profit once the market improves. However, the number of players in this area and the depth of fundraising for these purposes are significantly more robust than in the past, and suggest a concerted effort to take advantage of opportunities in times of distress.

Meanwhile, strategic investors are examining competitors, accessory businesses, and other industries that could prove synergistic or accretive to existing activities. Strategic buyers often view distressed assets as a way to build lines of business that are complementary or additive to their existing capabilities and are focused on long-term integration opportunities that can be absorbed into their overall business model.

Distressed assets will face a choice

With slight differences in focus, the approach taken by financial sponsors and strategic buyers will ultimately find them vying for many of the same target assets and businesses.

Strategic buyers may have a slight advantage, especially when it comes to valuations. Unlike their financial sponsor peers, strategic buyers are often willing to pay more, valuing the opportunity over a longer time horizon as a result of a longer term investment strategy, and with little or no pressure to sell the asset in the medium term. Strategic buyers are often able to inject capital swiftly and efficiently and on an accelerated timeline. As timing is of the essence in a distressed situation, this is often a key selling point to management and their advisers.

The flipside of this is what a strategic buyer will do with a business it acquires. Strategic buyers often look to integrate their acquisitions, absorbing them into their collective, leaving no standalone business when they are done. Financial sponsors often keep their targets intact, and maintain them as standalone businesses. This fundamental difference often plays a part in a management team’s interest in working with one kind of buyer versus another.

Faced with the possibility of a pervasive economic downturn, those investors who can act quickly and strategically likely will acquire the best assets to see them through to the next period of prosperity.

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