Interest coverage ratios are coming off of historically strong metrics as interest costs rise quickly. This signals increasing difficulty for businesses to pay their debts.
Interest coverage ratios measure the amount of profits available to pay for (or cover) interest on debt. They are a common barometer of business financial health.
In 2020 and 2021 high interest coverage metrics made good marketing for credit funds. The unusually low level of interest rates showed a distorted picture of credit quality health.
The return of interest rates to normal levels has sent average interest coverage ratios from 5 times payments to about 2 times for many floating rate borrowers. Many junk bonds are just a refinancing away from a similar degradation in coverage.
Company profits have held up in the aggregate, but for many businesses they will not be strong enough to maintain their current debt load.
When good businesses have bad balance sheets, they need to reorganize through creditor negotiations and bankruptcy. Reorganization allows the value of good businesses to carry on with new owners and lenders. This is the world of distressed investing.
Distressed investing requires unusual capital. Markets go through long “dry spells” with little distressed opportunities. Then the tide can turn unexpectedly. When that happens urgent high risk, high reward capital must be raised at a time when money is tight and fear is high. Attracting capital can be especially difficult because distressed opportunities are viewed as complex and often in industries with negative press.
A distressed team often must bring together tax, credit, and legal experts above and beyond the typical stock investing team. This need for expertise further limits the pool of available distressed investors.
The limited pool of capital for distressed funds make for attractive returns.
Some distressed fund operators expect the size of the distressed market to increase by 5 to 10 times without a serious deterioration in the economic or capital markets outlook. Should interest rates continue to move higher, the supply of distressed opportunities could balloon further.
Even without further increases in interest rates, the market looks likely to become as attractive as the dotcom bust or 2008 financial crisis. The dotcom bust provided some of the best vintages of distressed funds this century and 2008 saw a 15.2% net IRR median fund return according to Preqin, an alternative asset data company.
However, it’s important to remember that we live in a regime where interest rates are no more predictable than the government committee that sets them. If rates were to fall, the supply of distressed opportunities and expected returns would also fall.
Fortunately for Qualified Purchasers, there are time-tested private equity funds that rotate carveout, buyout, and distressed investing strategies. These strategies are natural complements as distressed opportunities proliferate when attractive buyout opportunities dry up.
A fund with a proven track records, persistent culture, and repeatable processes is well positioned to take advantage of distressed market opportunities should they materialize, but thrive even if they don’t.