As distressed strategies experience an upswing in returns, Alt Credit Intelligence explores where the value lies and asks what the likelihood is of a distressed cycle hitting the US
By Chris Matthews | 9 August 2016
Over the past 10 years, the US economy has undergone a revolution in the production and consumption of energy.
“Increasing production of oil, natural gas, and renewable energy has contributed broadly to employment and gross domestic product (GDP) growth during the recovery from the Great Recession.”
The above quote comes directly from the White House. It is taken from a 2015 publication put out by the Obama administration dedicated to the “Energy Revolution” that had been sweeping the nation during the previous 10 years. It is fair to say the early part of this decade were boom years for the US energy industry.
Natural gas production sky-rocketed, nearly 2.4 million barrels of shale oil was produced a day in 2012 (around 600% more than in 2008), while crude oil topped 6 million daily drums in 2012. Oil-producing heartlands such as North
Dakota witnessed a modern day gold rush. The unearthing of the Parshall Oil Field in 2006 saw thousands pour in to the region looking for work in related industries; average incomes in Mountrail County more than doubled to 52,000 in the four years following the boom. Unemployment in the state dropped to 3.5% in late 2011, the lowest of any state in the whole country, while others speculate the boom created 2,000 millionaires every year until 2012 in North Dakota.
The country and investors were bullish. A Citigroup analyst said during the height of the boom that “North America is becoming the new Middle East”. Another industry participant talked of
the US being the world’s largest oil and gas producer by 2020 – “it’s the energy equivalent of the Berlin Wall coming down”.
A CNN report from January 2012 reported that foreign investors had ploughed more than $6bn into US oil and gas drilling companies in the previous few weeks. For a while the good times continued and created employment opportunities for many. But then came the fall.
Amid broader economic woes, the global commodities downturn late last year and into this year has drastically altered perceptions. Oil prices suffered the biggest price collapse in recent history, plummeting from $115 a barrel in mid-2014 to a meagre $27 in January.
Domestic production across the board has slumped and bankruptcies are engulfing scores of companies operating throughout the energy sector. According to Haynes and Boone, a legal practice working in the US energy space, the number of bankruptcies filed is up exponentially.
The number of companies working in oilfield services that filed for Chapter 11 in July 2016 was 83 – aggregated debt levels topped $13bn – contrasted to less than five filings made in February the year before. Linn Energy filed for bankruptcy in May with around $10bn in debts while other recent failures have included Vantage ($2.7bn), Paragon Offshore ($2.5bn) and Seventy Energy ($1.3bn).
“The down-leg of the current cycle feels most like the down-leg we experienced in the early 2000s, when too much capital came into a popular industry; that industry blew up; and the dislocation spread to other industries,” Rajath Shourie, co-portfolio manager at Oaktree Capital, said in a July company publication.
“In the early 2000s, telecom was the darling industry that went bust. Today it is energy. In the early 2000s, a majority of the high yield bonds issued by telecom companies defaulted, and unless oil prices make a major recovery, today’s exploration and production companies are likely to face a similar fate.”
In such a shifting energy environment and aligned to broader economic and political uncertainty in the US, credit opportunities could be on the rise.
As the prospects of a prolonged distressed cycle start to come into focus, are distressed investments proving more popular again and where do US managers see domestic debt value over the coming months?
According to recent data from HFR, distressed-centric strategies were up almost 2% for June and have posted 7.4% returns since the turn of the year.
There have been a string of high-profile fund launches, with 11 energy-focused launches recorded in Q2 according to data provider Preqin.
Among them are ex-Blackstone chief executive Chris Marich, who is setting-up Arrowhill Energy to focus on long-term gas and power financial deals, while Serengeti Asset Management is launching its first energy-centred vehicle later this year and ex-BP Capital Management portfolio manager Billy Bailey is launching an energy-focused manager called Saltstone Capital Management.
“The 2016 default rate for US high-yield bonds is projected to increase to between 5% and 6%. This compares to the 2015 default rate for US high-yield bonds of 2.8% and the 30-year average of 4%,” Oaktree’s investment chief Bruce Karsh noted in the July release.
“As you would likely guess, defaults this year already have been—and will be—heavily impacted by oil prices. I believe that easily two-thirds, or maybe even three-quarters, of the defaults this year will stem from energy- related issuers.”
The increasing number of bankruptcies occurring among energy companies and their MLPs has led to sustained interest in the space over recent months.
Los Angeles-headquartered Oaktree, which has $97bn in assets across a range of hedge fund and mutual fund vehicles, has been notably positive on energy investments. In April the firm announced it had acquired a 10% private placement in ailing natural gas company NGL Energy for $200m.
The UK’s vote to leave the EU saw NGL shares drop 10% immediately after the decision but they rallied 9.7% four days later as Oaktree snapped up more shares, taking its investment to $240m.
Meanwhile oil and natural gas producer Permian Resources has also been getting the attention of Oaktree and its peers in recent weeks.
The Texas-based firm is reportedly a target for Oaktree, Apollo Global Management and Ares Management among others who are potentially looking to strike a deal for the debt-ridden company, according to a July report.
July also saw activist hedge fund heavyweight Third Point reveal to investors that it is going to be committing more than $1bn to energy corporate credits going forward.
Dan Loeb’s $16bn firm, which saw its Offshore Fund post 4.6% in Q2 of this year, noted that its involvement in the energy space has been a significant reason for the positive performance.
“We came into the year with a short credit portfolio that we reversed sharply in February, getting long over $1bn in energy credit,” the firm said in its latest quarterly letter to clients. The commodities slump has impacted the many counterparties in the space. Investing in the related entities is an area which is also of significant interest to many funds in the current climate.
Himanshu Gulati, head of Man GLG’s US special situations unit, says: “We really like the mid-stream space. We are spending a lot of time on the energy companies that have suffered bankruptcy, we thought there was asymmetric downside for E&P on the upstream side.
“From our standpoint, we have been very involved this year. We really think it is a differentiator because it is clearly tied to energy but a lot of these companies don’t take significant commodity risk. It is a really unique area to invest capital, we feel it is one of the better places to be involved.”
Others exploiting the area include Pimco, which has seen its $116m MLP Energy Infrastructure Fund post more than 12% returns so far this year, while Goldman Sachs’ MLP vehicle, which has a 46% leaning toward pipeline and terminal firms, is up 7% as of 1 August.
Wexford Capital, the $2.7bn Connecticut- based manager, is also reaping distressed dividends with its Credit Opportunities Fund up 3.4% through June and more than 11% YTD, according to BarclayHedge data.
Mark Zand, a co-portfolio manager on the fund, says the strong performance has been driven by a concentration in distressed energy debt, and particularly in E&P MLPs. He explains: “Several of these companies have a diverse group of assets that are not well understood by the market, and in some cases they have assets that have substantial market value even though they currently produce little or no cash flow.
The MLPs are somewhat earlier in the restructuring cycle than C Corps because they generally had strong hedges and the flexibility to cut their distributions… this has enabled them to hold out a little longer than many of the C Corps.” “BreitBurn Energy is one of the MLPs in which we are involved. We believe there is substantial value to be realised from their assets, and that this will be a key component of their restructuring.”
Trey Parker, head of credit at Highland Capital believes that while distressed energy opportunities are out there, more appealing deals may not start to appear until the New Year.
“While we have seen heightened levels of energy defaults in both the high-yield and the bank loan markets, at current commodity price level expectations, we believe more significant defaults are yet to occur,” he says. “I would contend that the spread levels in energy credit today do not appropriately price in the risk of future default loss, particularly in the unsecured bond markets.
“We do think it is still going to take another 12 months or so to see a normalisation of supply and demand and a correction in inventory balances in the US.”
Although Highland is cautious on certain distressed opportunities, he says the firm has been actively involved in the CLO market. Issuance of new US CLOs picked up in the second quarter according to Fitch Ratings with 39 US CLOs and 11 European CLOs
priced, while new issue stated spreads increased in the US and dropped in the European market during Q2.
“We have exposure to some CLO mezzanine, which is a fundamentally attractive market right now,” Parker adds. “CLO mezzanine has not experienced the rally that we have seen in other credit assets over the last fourth months, and even considering historical volatility and liquidity spread premiums in CLO debt versus bank loans, we still see this as very attractive on a relative value basis.”
Another area where Highland, which manages around $19bn in assets, is looking to actively expand its distressed net is technology. With certain legacy technology companies losing market share to new, often cloud-based innovations, Parker believes there could be a splintering in the market leading to several distressed situations occurring.
“Technology is another area that is probably going to be a focus for us for the next few years. I think a lot of highly leveraged software companies got financed in the last three or four years, and I think many of them too aggressively so,” he says.
“We are spending time thinking about appropriate discounted entry points, as investors pause and often misunderstand the fundamental dynamics for software companies transitioning from on-premise to cloud business models.” Software and services provider Avaya, whose debts top $6bn, is garnering particular interest from distressed dealers.
Blackstone’s GSO Capital is leading a group of creditors – also among them are Davidson Kempner and Guggenheim Partners – who own $4.6bn of Avaya’s first-lien loans and bonds, to restructure the firm’s debt.
“While the company could likely limp along if all maturities were pushed out to 2020, the current capital structure is impractical and at worst, prevents some customers from choosing Avaya,” Moody’s said of the firm recently.
Opportunities on the horizon
According to recent BarclayHedge data provided to Alt Credit Intelligence, istressed-orientated funds were among the best performers for June. Of the top 20 yielding credit managers, three of
the top five operate in distressed markets. Wexford Capital’s Opportunity Fund is fifth, while Armoury Securities’ similarly named vehicle is top with 35.7% returns YTD and JLP’s credit opportunity fund is up 17.1% for the year.
There has also been a flurry of broader distressed fund launches in recent months, perhaps an indicator that some see more value on the horizon.
Notable launches include TCW Distressed, a venture from ex-Davidson Kempner executive Sara Tirschwell and the asset management giant TCW, which is set to launch in the coming weeks. While Marble Ridge Capital, formed by ex-Paulson & Co partner Dan Kamensky, has posted 11% returns for the year since launching in January.
Although there has been some standout performance and an uptick in YTD returns, many are in fact cautious on distressed opportunities in the immediate future.
Pinpointing the domestic distressed investments offering value has been a tricky took for many and certain managers are looking further afield to emerging markets and European debt for deals.
Parker says: “With the US elections, monetary policy action, Europe – and we don’t think the noise of Brexit is fully over yet even though the markets took it quite easily – and geopolitical issues around the world, all of those topics are likely to add more and more uncertainty to the markets,”
“In the current climate I think we will remain quite cautious and are fading the rally in trading opportunities that have worked well for us YTD.”
Man GLG’s Gulati agrees and says that while his team has been active in certain energy areas, broader domestic distressed plays may not show up for a little while yet.
“I think we are going to see some difficulties in getting trades down and we are also starting to see hung loans in banks and for us that is the tell-tale sign of when the credit is starting to crack… we haven’t seen that since 2007,” he says.
“We think credit can remain in a range over the next six months and I think going into 2017 that is where distressed opportunities will become far, far more interesting.”
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