Strategic Asset Allocation.

Private market debt investment is a type of investment that is usually linked with issuers and assets that are either sub-investment-grade or unrated. These types of investments often involve securities that come with restrictive covenants and contingencies such as callability or equity-like features. There are certain events, whether they are macroeconomic, industry-specific, or company-specific, that can create distressed circumstances for a subset of these investments, leading to idiosyncratic risks. However, these risks also present the potential for higher returns for investors who can fund these opportunities quickly if distress occurs. For instance, during the 2008 financial crisis, many investors found opportunities in distressed assets, such as mortgage-backed securities, which were undervalued due to the market conditions.

In recent times, private funds have increasingly initiated special situations funds to fund distressed firms while providing investors with acceptable risk-adjusted expected returns. These funds focus on distressed debt and are generally classified as a subset of private debt. The market for private special situations funds is expected to grow to roughly half of the private debt market by 2027. For example, during the COVID-19 pandemic, many special situations funds were created to invest in distressed industries such as travel and hospitality.

The Challenge of Allocation for Institutional Investors

Institutional investors, such as pension plans, face an allocation challenge in their private debt strategies. They must assess a manager’s ability to profit from the potentially higher risk associated with special situations funds as compared to other forms of private debt structure. The issuers targeted by special situations funds typically face either a cyclical downturn or a steady deterioration in performance in a declining phase of their life cycle. For instance, a pension plan might need to decide whether to allocate more funds to a special situations fund focusing on the retail industry, which has been facing a steady decline due to the rise of e-commerce.

Role of General Partners (GPs) and Associated Risk Factors

Fund General Partners (GPs) seek to navigate distressed situations to achieve returns from the following risk factors. The details of these risk factors are not provided in the text. However, it’s important to note that these risk factors could include things like the financial health of the distressed company, the overall economic environment, and the specific terms of the distressed debt.

Credit Risk

Managing credit risk is a critical aspect of the investment strategy for Fund GPs, similar to mutual or hedge fund managers, particularly when dealing with distressed assets. Here’s how they approach this task:

Expectation of Lower Losses: Fund GPs anticipate that their portfolio assets will yield lower expected losses than the purchase price suggests. This is based on an expected decrease in default rates or an increase in recovery rates through the restructuring process.

Purchasing at Discounted Prices: By acquiring distressed assets at a discount, GPs aim to recover more than what they paid. This could be through a reduction in the likelihood of default or an increase in recovery rates in the event of a default.

Special Situations Fund GPs: These managers specialize in identifying mispriced assets or situations where they can add value, similar to hedge fund managers who focus on unique investment opportunities. Adding value is often achieved by enhancing the recovery rates on distressed assets.

Strategy to Enhance Recovery Rates: The ability to pursue strategies that improve the recovery rates on distressed assets is key to managing credit risk. For example, identifying and assisting an undervalued company through temporary difficulties can increase the recovery rate on the distressed assets purchased.

Strategic Approach to Credit Risk: Fund GPs employ a strategic approach to identify opportunities for value addition and improvement in recovery rates on distressed assets. This approach is aimed at reducing expected losses on portfolio assets, thereby effectively managing credit risk.

Liquidity Risks in Special Situations Funds

Special situations funds, managed by GPs, focus on exploiting investment opportunities that arise from forced sales, similar to financial distress situations. Below are key points explaining their strategy and the associated risks, particularly liquidity risk:

Identifying Forced Sale Opportunities: GPs actively seek investment opportunities in forced sale situations, analogous to homeowners needing to sell their properties due to financial distress. This strategy involves scouting for assets being sold under pressure, offering a potential for purchase at below fair value.

Leveraging Asset Mispricing: By offering bids at prices below the calculated fair value of assets, GPs aim to capitalize on asset mispricing. This is akin to buying a house in a distressed sale for less than its market value, intending to sell it for a profit later.

Risk of Misjudging Asset Value: A critical risk in this strategy is the possibility of incorrect assessment of the asset’s fair value and its mispricing. An erroneous valuation could result in purchasing assets at inflated prices or selling them at a loss, mirroring the risk of overpaying for a house or selling it below market value.

Understanding Liquidity Risk: The liquidity of the market for these assets is a significant concern. A lack of liquidity can make it challenging for GPs to sell the assets at desired prices or times, potentially leading to financial losses. This scenario is similar to a homeowner struggling to sell their property in a slow real estate market.

While special situations funds offer the potential for significant returns by capitalizing on distressed sales, they also carry substantial risks, particularly regarding asset valuation and liquidity.

Legal Risks in Special Situations Investments

Managing legal risks is a critical component for Fund GPs in special situations investments, which are often distinguished by their unique challenges and opportunities. Below are key aspects of how legal risks are navigated and the potential benefits of effective risk management:

Expertise in Bankruptcy and Negotiations: GPs with the requisite expertise and experience in navigating bankruptcy processes and negotiating recoveries can manage legal risks effectively. This capability can lead to significant price appreciation on their investments, differentiating it from the primary sources of returns in traditional private debt investments, which typically focus on interest income and principal return.

Diversification Potential: Special situations investments, often categorized under private debt, offer diversification benefits compared to traditional private and public debt allocations. They are less impacted by inflation risk and interest rate risk, which can significantly affect returns on more conventional debt investments.

Flexibility in Investment Mandate: Some private debt funds have a broad investment mandate, allowing them to switch between distressed and non-distressed debt investments based on industry and economic conditions. This flexibility is particularly beneficial for investors with smaller allocations to private debt and special situations, enhancing their ability to capitalize on market dislocations.

Due Diligence Process: The investor due diligence process for special situations fund managers not only shares commonalities with that of private debt fund managers in terms of requiring superior credit analysis and debt management skills but also necessitates additional expertise. Special situations fund managers need to manage the legal and procedural aspects of restructuring, bankruptcy, and liquidation processes, essential for dealing with issuers in financial distress.

Practice Questions

Question 1: Private market debt investment is often associated with sub-investment-grade or unrated issuers and assets. These investments can involve securities with restrictive covenants and contingencies such as callability or equity-like features. Given this, which of the following statements is true about the risks and returns associated with private market debt investment?

1. Private market debt investments are risk-free and guarantee high returns.
2. Private market debt investments carry idiosyncratic risks and offer the potential for higher returns.
3. Private market debt investments do not involve any risks and offer low returns.

Answer: Choice B is correct.

Private market debt investments carry idiosyncratic risks and offer the potential for higher returns. Private market debt investments are often associated with sub-investment-grade or unrated issuers and assets, which inherently carry higher risks. These risks are idiosyncratic in nature, meaning they are unique to the specific investment or issuer and cannot be eliminated through diversification. These investments can involve securities with restrictive covenants and contingencies such as callability or equity-like features, which can add to the complexity and risk of the investment. However, in return for taking on these higher risks, investors in private market debt can potentially achieve higher returns. This is because the issuers of these securities must offer higher yields to compensate investors for the additional risk they are taking on. Therefore, while private market debt investments can be risky, they also offer the potential for higher returns, making them an attractive option for certain investors.

Choice A is incorrect. Private market debt investments are not risk-free and do not guarantee high returns. As mentioned above, these investments are often associated with sub-investment-grade or unrated issuers and assets, which inherently carry higher risks. Furthermore, the returns on these investments are not guaranteed and can vary widely depending on a variety of factors, including the performance of the issuer and the overall market conditions.

Choice C is incorrect. Private market debt investments do involve risks and do not necessarily offer low returns. As discussed above, these investments carry idiosyncratic risks that are unique to the specific investment or issuer. In return for taking on these risks, investors can potentially achieve higher returns. Therefore, it is incorrect to say that private market debt investments do not involve any risks and offer low returns.

Question 2: Special situations funds are increasingly being initiated by private funds to finance distressed firms while providing investors with acceptable risk-adjusted expected returns. These funds are generally classified as a subset of private debt. What is the expected trend for the market of private special situations funds in the future?

1. The market for private special situations funds is expected to shrink by 2027.
2. The market for private special situations funds is expected to remain the same by 2027.
3. The market for private special situations funds is expected to grow to roughly half of the private debt market by 2027.

Answer: Choice C is correct.

The market for private special situations funds is expected to grow to roughly half of the private debt market by 2027. Special situations funds are a subset of private debt that focus on providing financing to distressed firms. These funds are typically initiated by private funds and aim to provide investors with acceptable risk-adjusted expected returns. The market for these funds has been growing steadily over the past few years, and this trend is expected to continue into the future. The growth in this market is driven by a number of factors, including the increasing number of distressed firms in need of financing, the attractive risk-adjusted returns offered by these funds, and the growing interest from investors in alternative investment strategies. By 2027, it is expected that the market for private special situations funds will grow to roughly half of the overall private debt market, reflecting the increasing importance of these funds in the broader investment landscape.

Choice A is incorrect. The market for private special situations funds is not expected to shrink by 2027. On the contrary, the market is expected to grow significantly over the next few years, driven by the factors mentioned above. The assertion that the market will shrink is not supported by current trends or market dynamics.

Choice B is incorrect. The market for private special situations funds is not expected to remain the same by 2027. As mentioned above, the market is expected to grow significantly over the next few years, driven by the increasing number of distressed firms in need of financing, the attractive risk-adjusted returns offered by these funds, and the growing interest from investors in alternative investment strategies. The assertion that the market will remain the same is not supported by current trends or market dynamics.

Glossary:

• Credit Risk: The risk of loss due to a debtor’s non-payment of a loan or other line of credit.
• Fund General Partners (GPs): Individuals or entities that manage the assets of a fund.
• Default: The failure to repay a debt including interest or principal on a loan or security.
• Recovery Rate: The extent to which principal and accrued interest on defaulted debt can be recovered, expressed as a percentage of the face value of the debt.
• Distressed Assets: Assets that are under a threat of default.
• Special Situations Fund: A specialized type of fund that invests in securities of companies facing special situations such as mergers, restructurings, or bankruptcies.
• Liquidity Risks: The risk that an asset or security cannot be traded quickly enough in the market to prevent a loss (or make the required profit).
• Special Situations Funds: A type of investment fund that invests in securities of companies or physical assets that are in distress or bankruptcy.
• Forced Sale: A sale of property or assets that occurs without the owner’s consent.
• Asset Mispricing: A situation where the price of an asset does not reflect its intrinsic value.
• Private Market Debt Investment: An investment associated with sub-investment-grade or unrated issuers and assets.
• Special Situations Funds: Private funds initiated to fund distressed firms while providing investors with acceptable risk-adjusted expected returns.
• Institutional Investors: Entities such as pension plans that invest large amounts of money.
• General Partners (GPs): Individuals or firms that manage investment funds.
• Idiosyncratic Risks: Risks that are specific to a particular company or industry.
• Distressed Debt: Debt of companies that are under financial stress and may be near or in bankruptcy.
• Legal risks: The potential for financial loss due to legal proceedings, regulatory action, or changes in laws.
• Distressed environment: A situation where a company or economy is struggling financially and is in danger of bankruptcy.
• Special situations: An unusual event that can affect a company’s stock, such as a merger, spin-off, or restructuring.
• Private debt: Debt that is not issued or traded in the public market.
• Inflation risk: The risk that the value of assets or income will decrease as inflation shrinks the purchasing power of a currency.
• Interest rate risk: The risk that an investment’s value will change due to a change in the absolute level of interest rates.
• Due diligence: An investigation or audit of a potential investment or product to confirm all facts.

Private Markets Pathway Volume 2: Learning Module 5: Private Special Situations;LOS 5(e): Discuss the risk and return among special situations and compared to other forms of private debt as part of a strategic asset allocation