July 20, 2020
Making the distinction
It pays to know the history of an asset. This will allow you to see past the glossy marketing pitch for the latest ‘opportunity fund.’ Private equity companies will be happy to call it a distressed asset and let you think that they acquired it last month. If they dragged the company into this mess, what are the chances they’re going to be able to drag it out?
To understand the differences between stressed and distressed we can look at a few examples to crystalize the difference.
Example 1: Long-Term Capital Management, September 23rd, 1998.
The heads of the biggest investment banks on Wall Street – among them the CEOs of Goldman Sachs, Morgan Stanley, Lehman Brothers and Bear Stearns – gathered for a meeting at the Federal Reserve Bank in New York. The reason for their meeting was Long-Term Capital Management (LTCM), a hedge fund they all had a stake in.
Just months before, LTCM had been the envy of Wall Street. Now, it was on the brink of failure. It had racked up derivative contracts with exposure of almost one trillion dollars. LTCM had succumbed to what author George Lowenstein referred to as ‘picking up pennies in front of a steamroller.’ It had already turned to Warren Buffett for money. He refused – it was broke.
Example 2: Goldman Sachs, September 23rd, 2008.
A decade later to the day, Warren Buffett received a call from the chief of one of the same investment banks that had sat around the table at the Federal Reserve Bank. Unlike Bear Stearns and Lehman – who had also been at the table a decade before – Goldman Sachs wasn’t experiencing a crisis. It just needed a liquidity buffer.
For his part, Warren Buffett would receive preferred shares at a discount in one of Wall Street’s most venerable financial institutions. Goldman Sachs, on the other hand, would receive $5 billion in cash, which aside from liquidity, would send out a message to the world that it wasn’t going down the same route as Lehman Brothers and Bear Stearns.
It’s important to differentiate between stressed and distressed assets, as the universe for both is currently at a historical high, presenting a range of attractive (and not so attractive) opportunities. Making the distinction between them allows you to shed some light on whether what you’re buying into is an ‘LTCM’ or a ‘Goldman Sachs’.
Usually, the difference between stressed and distressed isn’t as black and white as LTCM and Goldman Sachs. And in 2020, thanks to the Coronavirus pandemic and its ongoing economic and financial impact, the line between what constitutes a stressed asset and what constitutes a distressed asset are being blurred even further.
Before making a commitment, investors would be wise to step back and decide whether an asset is actually stressed because of a temporary economic downturn brought on by the global pandemic, or whether the pandemic has merely exposed more fundamental problems in the company’s DNA.
Could it be that the pandemic just exacerbated the issues? Or, the corollary to this question: How responsible are some of the companies currently setting up distressed asset funds for the underlying distress? Has their constant emphasis on double digit growth coaxed them into taking on too much debt and making a stress situation a distress situation.
Private Equity as doctor and patient
This last point needs to be emphasized as it appears as though many private equity firms are deftly skipping between the roles of doctor and patient. A recent poll conducted by fund service firm Intertrust Group found that 92% of private equity professionals believe distressed fund deals are set to increase in the coming quarters.
It would seem a stretch to assume that none of these companies fall under the section in the venn diagram called ‘private equity.’ It’s just too unlikely. In June, Blackstone, the world’s largest asset manager by AUM, announced that it was skipping a payment on a $274 million loan it acquired on a hotel chain.
It bears repeating – the biggest world’s largest asset manager by AUM is skipping payments. If a cash machine like Blackstone has distressed assets in its portfolio that weren’t deemed to be distressed assets just a few months before, how many others are in the same boat? It’s not unreasonable to assume a sizable chunk of them.
The same Intertrust Group survey noted that 73% of respondents would spend the next 12 months ‘stabilizing’ their portfolios. Or put differently, 27% of the private equity sector believes that their portfolio is stable now. To anybody’s ears, that sounds like portfolios have deteriorated quite a lot in a short period of time.
So, in some cases, private equity may be playing the doctor and the patient. The scale of fundraising for distressed funds is unprecedented (Preqin estimated dry powder at $68 billion in June). Much of it is going straight into companies previously owned by private equity companies themselves…
‘Doctor, do I need more medication?’
‘I thought you’d never ask.’