Hedge Funds Aimed at Ailing Companies Will Do Well, Agecroft Says

Now is a great time for hedge funds specializing in distressed investing, according to a report by Don Steinbrugge, founder and CEO of consulting firm Agecroft Partners LLC. The Agecroft report argued that the prospect is rising that many bonds and other securities will sour as their issuers run into trouble and file for bankruptcy or restructure loans out of court.

Sectors such as commercial real estate, lodging and retail are suffering from high debts and slipping revenue, the report noted: “Higher interest rates, a weakening macro environment and a reduction of regional bank lending are putting pressure on many businesses, and cracks are beginning to surface.” Hedge funds that invest in distressed bonds, leveraged loans and preferred stock are good areas to put money into, the report recommended.

Distressed-oriented hedge funds have done well over time, although they—like hedge funds in general—have trailed stock and junk bonds lately. The HFRI Fund Weighted Composite Index is up just 2.3% this year, the same as the HFRI Distressed Debt Index, versus 16.6% for the S&P 500 and 13.7% for the Credit Suisse High-Yield Index. But since its inception in 1990, the distressed debt gauge has returned 9.7% annualized, beating stocks’ 8.2% and junk’s 7.8%.

The average yield on BB-rated high-yield debt, has jumped two percentage points in the last 12 months to 8.2% annually. Commercial bankruptcy filings and credit downgrades are increasing. Refinancing of debt is much costlier nowadays, given higher interest rates.

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As a result, investor interest in distressed investments is mounting. Almost two-thirds of investors surveyed by Preqin in 2023’s first half planned to increase their exposure to the asset class. “While it is true that the size of the distressed universe generally has an inverse relationship to the business cycle (peaking when the economy is at its worst), investors can miss out on significant opportunities by staying on the sidelines,” Steinbrugge wrote.

Navigating the world of bankruptcy filers and non-court restructurings is a difficult endeavor. But buying their securities at low prices produces huge upsides, he contended. From the financial crisis of 2008 through 2009 up until the 2020 pandemic onset, companies in their first year after emerging from bankruptcy, with less than $100 million market caps, averaged 8.6 percentage points better performance than the small-cap Russell 2000, he calculated.

While Steinbrugge did not name any hedge funds that stand out for their distressed investing prowess, he indicated that those aiming at middle-market companies had the best opportunities, rather than funds focused on large businesses. Middle-market companies “are more prone to labor shortages, supply chain issues, have less access to public markets and tend to pay higher interest rates regardless of the fundamental soundness of their business,” he declared.