Distressed debt: is the fear of reputation risk warranted?

Sarah Miller

Vice President, Manager Research
(Monday, Oct, 11, 2021)
|   3 mins

Distressed debt funds (funds that predominantly invest in the heavily-discounted public and private debt of struggling companies, non-performing loan pools and stressed or distressed real assets) saw a record increase in dry powder in 2020, up 18% from 2019. We’re expecting an even bigger year on year increase in 2021. Why? Because stressed market conditions create investment opportunities for these strategies, which is one reason why distressed debt funds have historically been a diversifying asset class within a portfolio.

But the ability to generate value during market downturns comes at a cost – a highly volatile one. There’s also the reputational risk – with distressed debt funds often being tarnished with words like ‘aggressive’ or ‘asset striping’. And, in a world where institutional investors are placing an ever-increasing importance on ESG, reputational risk is a growing concern.

But it doesn’t have to be this way…

Whilst distressed debt funds have historically been associated with cut-throat restructuring, this isn’t always the case. And, increasingly, our research focuses on strategies that provide what we define as ‘constructive capital’; this means avoiding hostile operational reorganisations with a heavy social cost and instead sourcing opportunities where companies or situations require specialised expertise to recover and draw out unrealised value. Constructive capital can access the same attractive returns as the ‘cut-throat restructuring strategies’ without the headline risk.

Restructuring can create a positive ESG impact

As you can see in the illustration above, restructuring typically ends with the asset manager having control of or significant influence in the company. Couple this with the asset manager possessing the expertise required for recovery and you have a clear positive impact opportunity. Within our research we’ve found more and more examples of this type of ‘impact’ being driven by ESG factors, including: increased environmental disclosures, improved board diversity and other governance measures, implementation of ESG best practices and the employment of new people.

But how can we differentiate from traditional distressed debt funds and those that are providing constructive capital?

A good distressed debt fund, by all accounts, requires the ability to effectively source opportunities and quantify the potential value of a business when it’s in distress. What sets a more constructive fund apart is the expertise required to create positive impact, implement changes and turn a business around.

So what?

The universe of funds that fit the definition of distressed debt is large and has grown significantly since the pandemic. Our focus, however, remains on constructive capital, with managers able to identify where and how they can create a positive impact, particularly in governance procedures but also with respect to environmental and social practices. We believe the asset class as a whole can do a lot more when it comes to evidencing and reporting on this impact, and as part of our commitment to sustainable investing, we aim to continue to engage with these managers to help them evidence their impact.

To find our more or to discuss a potential manager selection exercise, please get in touch: sarah.miller@redington.co.uk

Unless indicated, these are the views of the author’s and may differ from those of the firm.

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