‘Distressed investing’: Outsized returns with positive social benefits
Picture this scenario. It’s 16:55, the day before payday. As chief financial officer, you log onto the company’s online banking platform for the umpteenth time today and the outlook remains as distressing as previously.
The overdraft is maxed, your lenders have reached internal limits and are unable to extend additional funding, all company assets are encumbered and the directors stand as guarantors.
Where to next? Placing the company in business rescue might buy a few months’ grace from disgruntled creditors. Unfortunately, without access to working capital, referred to as post-commencement finance, and a turnaround plan, the formal process will most likely end in a structured winddown or liquidation – a desperate outcome for all but the secured creditors.
The unfortunate situation in South Africa is the limited pool of capital actively seeking opportunities in such distressed situations. This is despite ‘distressed investing’ being a mainstream investment strategy internationally, pursued by private equity firms, hedge funds and investment banks.
The attractiveness of the strategy is the counter-cyclical nature of this asset class, whose opportunity set improves as the economy slows. Target investee companies tend to be late-cycle, highly geared acquisitions, with limited margin of safety to meet debt repayments should economic tides change course.
In such instances, the ‘new money’ (distressed investor) will typically acquire debt from existing bond holders at attractive discounts, making sure there is collateral to underpin their exposure. The new money will then direct the restructuring, likely to be operational (reorganisation of operations) and financial (rightsizing the balance sheet to expected earnings).
A successful turnaround should result in the emergence of a resilient entity, a preferential outcome for creditors compared to liquidation, and it includes job savings. The state treasury benefits through the continued payment of taxes. Ancillary benefits include the creation of a secondary debt market, providing an exit route for lenders and the avoidance of a costly legal process.
Lastly, the financial returns to the new money can be significant, with upside attributable to the discount at entry, operational restructure and a return to profitability, and the exit multiple applied to future earnings.
There are positive signs in South Africa that capital dedicated to turnaround-and-restructuring activities is being mobilised. An example is Africa Special Opportunities Capital (Asoc), which, in 2016, raised the Asoc Fund I and is fully invested. Asoc’s value proposition is to bring together financial capital and operational restructuring muscle to a deal.
Our alternative strategies team recognised the opportunity set and subscribed to Asoc Fund I as anchor investor through the Momentum Investments Special Opportunities Fund. The outcome at December 2020 was an estimated internal rate of return of 17% and a net job saving of 1 700. These social benefits are part of our responsible investing philosophy, which forms part of our core belief. Sustainable and responsible investment practices are a material factor underpinning our long-term success.
Our view is that more institutional capital is required for turnaround-and-restructuring investing in South Africa and that every effort should be made to educate asset consultants, pension fund trustees and other institutional gatekeepers of the benefits of investing in distressed companies.
Responsible investing practices resonate with our outcome-based investing philosophy and the alignment of our clients’ long-term goals to positively influence the world they will retire to. Investing in distressed companies and the consequent social benefits help to create investments that are good for clients and society at large.