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Distressed debt funds have slipped in performance in recent years, with slim pickings for attractive distressed assets. But GPs expect to increase capital deployment in 2024 and beyond with expectations for more troubled companies and distressed debt.

Higher for longer interest rates are expected to create more stressed and distressed situations among over-leveraged borrowers with maturing debt, which should result in more deals, improve fund returns and propel capital-raising efforts again.
   
Distressed debt funds posted double-digit one-year rolling IRR throughout 2021 and in the first quarter of 2022, but the party didn't last. The asset class ended the year with a 3.7% one-year rolling IRR in Q4 2022, according to PitchBook's H1 2023 Global Private Debt Report.

Preliminary data for Q1 2023 shows that fund returns slid to near zero. In contrast, direct lending rose to 6.4%, also outperforming mezzanine financing and venture debt. In the realm of private debt, distressed and special-situation funds typically outperform direct lending funds during economic downturns, the report noted. However, the trend reversed itself in recent quarters, even as credit conditions tightened and defaults and insolvencies rose. Brief window of opportunity Distressed debt funds had some shining moments in 2020 and early 2021. Following the initial outbreak of the COVID-19 pandemic, the market benefited from increased corporate stress driven by debt payment defaults.

"Around the second quarter of 2020, many LPs allocated to distressed debt strategies," said Robert Molina, managing director and head of origination at Briarcliffe Credit Partners, a placement agent.

But the window of opportunity narrowed in the US and Europe following massive government stimulus and the waning of the pandemic, and the prices of many distressed assets soon returned to healthy levels.  

Accordingly, distressed debt fund managers slowed investment to hold significant undeployed capital, which caused their funds to deliver lackluster returns and, in turn, stifled LP interest in the asset class, according to Molina.
   
Fundraising for distressed debt fell off a cliff this year. Only seven funds closed, collecting a total of $9.9 billion as of Friday, according to PitchBook data. That compares to $32.2 billion last year and $36.6 billion in 2021.

"Direct lending is intrinsically more of an evergreen opportunity," said Bill Sacher, a partner and head of private credit for Adams Street Partners. "Distressed debt and, to some degree, mezzanine tend to be more cyclical. There are just not great distressed investments all the time."

For much of the last decade, "there really hasn't been a prolonged, distressed cycle," he said, adding that the market does, however, appear to be entering a period where distressed debt opportunities will reemerge.

Some GPs have altered their investment mandates. Instead of pursuing a pure-play distressed debt strategy, they might pitch investors on opportunistic credit funds, which have a more flexible mandate and rely less on a default cycle, Molina said. Expectations for 2024 Looking ahead, some managers anticipate a more favorable investing environment for distressed debt in 2024 and beyond, which will renew the appeal of this strategy.

"Interest rates are putting real pressure on companies' ability to service their debt and meet their fixed charges," Sacher said. "That's especially true for highly leveraged companies, which could ultimately lead to a distress cycle. It just takes time and hasn't happened yet."

Davidson Kempner Capital Management, a multistrategy hedge fund that invests in distressed debt, believes investors will soon experience a prolonged distressed debt cycle starting next year, thanks to a daunting maturity wall, higher base rates and more highly geared assets, according to a white paper it published in October.

The firm expects the length of the upcoming investment period to be similar to historic distressed cycles before 2013. High wall to vault in 2025 The looming maturity wall will act as a trigger for the new investment cycle. An estimated $351 billion of high-yield bonds and leveraged loans will reach maturity in 2025 in the US, tenfold this year's $35 billion, Davidson Kempner expects, citing data from JP Morgan. That figure will increase to $806 billion in 2028, further highlighting the growing pressure in the US corporate credit market.

Furthermore, the percentage of upcoming maturities from borrowers who in general have the hardest time refinancing—or borrowers rated "B" or below—will also spike.

Some of these troubled borrowers could have sustainable business models but suffer from unstable capital structures. Those will be ideal targets for distressed investors, according to the white paper.

Several credit managers skilled in trading troubled credits raised fresh capital this year that will allow them to pounce on the potential opportunity set. Fortress Investment Group is raising a $8 billion fund to target investments including distressed debt and structured credit, Bloomberg reported.

Connecticut-based manager Strategic Value Partners reportedly held a first close on $1.5 billion in March for its distressed debt vehicle, Strategic Value Capital Solutions Fund II.

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This article originally appeared on PitchBook News