HOME >Distressed cycles, energy, economy, and other unknowns
Macroeconomics is an inexact science and credit cycles are never the same. Therefore, how could one think about the future when the habitual assumption that tomorrow will be much like today seems (and is) more unreasonable than usual? This is a good moment to reflect on our thought framework for distressed cycles.
Distressed cycles
The way we see distressed cycles, with which some of our investors are familiar, is rather simple.
Discrete distressed opportunities can arise at any moment in connection to a specific economic performance or leverage of a company. Thus, being permanently in the game is a simple strategic decision. Then, there are times when these opportunities arise particularly abundantly. We think of distressed cycles, i.e. that part of the investing cycle which is systemically rich in distressed opportunities, as occurring in two broadly defined circumstances.
One of these is economic crises. Simply put, country specific, regional or global recessions create adverse business conditions for a wide range of companies (more so for cyclical industries but no one is safe). This wide range of companies becomes financially stressed and, potentially, bankrupt. Markets experience broad fear; correlations within each asset class and between at-risk asset classes go to 1. If there is a perceived safe asset class it will de-correlate, but often the sustainability of this safety-appeal is not clear as the value of every asset is ultimately linked to economic performance (yes, even gold…). Prices of securities – both debt and equities – imply a risk that tends to be generalized, as opposed to be nuanced e.g. from company to company or even country to country. Depending on the severity and contagiousness of the economic troubles, there can be a lot of pain. For investors there can be a lot of pain + a lot of value. Avoiding things that go to zero is important; however, there are not as many of them as it might seem and usually there are plenty of ultimately very rewarding things to do in everyone’s area of expertise. Because of this, staying in the financial and mental position to invest during the correction is the key. Although mediocre opportunities may linger for a while into recovery, the best ones (in terms or risk and reward) go away quickly. We could call this a counter-cyclical distressed cycle; for better or worse this is the most familiar scenario to many of us.
The second scenario is technological disruption. Like anything else, technological innovation can happen at any point in time during history, independent of the economic cycle. Probabilistically though, we think that disruption is more likely to occur during consolidated economic growth, when companies and governments can afford sustained R&D spending. Technological innovation creates irreversible changes. From a commercial perspective these can be additive, leading to the creation of new markets, industries and business models that thrive alongside the incumbent ones; for example biotechnology or space technology (so far!). Oftentimes though, these technological changes are not additive but rather disruptive. Their emergence attacks entire sectors directly at the heart. They may also affect many other sectors and companies, both negatively and positively, through avenues that are hard or even impossible to predict at the onset. The effect can ripple through the economy, and it takes a long time to propagate. Entire sectors need to adapt or die; in some cases no adaptation is possible. A distress cycle emerges. Although markets will react to both the disruption and the uncertainty of its effects through heightened volatility, the pro-cyclicality of such distress cycle makes the pain of getting into it much more bearable compared to the crisis case (barring no prior portfolio concentration in the disrupted sectors). Depending on the disrupted sector(s), the value for the deep distressed investor can be enormous, but so can the pitfalls be.
There are a lot of things that will go to zero: therefore in our view entry prices should be lower than in a crisis. Business conditions can be adverse for a long time for the impacted companies (as the change is structural, not cyclical): therefore investments should not be predicated on any rosy macro assumption. Liquidations – one of our favorite distressed situations – will be more numerous. Investment outcomes are influenced by broad economic conditions, be it global growth or slowdown, in a more limited way (which makes this type of distress cycle a gem for any portfolio). But the most important difference of all: there is not something to do in everyone’s area of expertise. This time staying in the financial and mental position to invest is not the key; many are ready, and eager. Avoiding things that go to zero, i.e. having real downturn sectorial investment experience and knowing what you don’t know, is the key.
Where does the current environment fit?
We believe that we are living a shocking conjuncture of three unrelated technological disruptions that happened to be contemporaneous.
Although energy steals the media show, we will start with the most mature of these disruptions: retail. E-commerce is the main culprit here, but various wireless/big data tools disrupt relentlessly this sector driving competition to unsustainable levels. It is a great global opportunity and a lot of the retail sector is already stressed. The availability of real expertise is good and pitfalls are quite limited.
The second disruption is happening in energy. The increased supply coming from the emergence of shale and oil sands technologies has changed the outlook for oil supply. In our view, this is coupled with more recent but steady advances in storing energy (thus making it available for transportation as a substitute for oil), technologies which now change the multi-decade outlook for oil demand. These two forces compound to change the incentives of the low-cost oil producers (Saudi Arabia, Iran, Iraq, Kuwait, maybe N Africa OPEC and UAE), who are now incentivized to maximize production, not margins[1]. The short term disruption is in high-cost producers, from Canada, Russia through Norway, China, Mexico and US shales, to sovereigns like Venezuela and Brazil (in order of estimated production costs, from higher to lower). Concurrently, advances in alternative energy only compound the problem by expanding it to both the broader energy space and to the materials sector. In the US, 51% of the bonds trading at stressed levels (over 1000bp spread) are in these two sectors, less so in Europe. However, the opportunity is global and far reaching. The true downturn/restructuring expertise is scarce, although many investors seem to think they possess it. It will be a fascinating opportunity.
The third disruption is very young. Not yet visible to the untrained eye, no investor talks about it. It will likely impact our lives much more than the previous two and is a very real disappear or thrive situation that every company in the TMT sector is aware of. It is called Internet of Things (IoT). Under a calm surface, companies from content providers, to media, telecom, computer or wireless are trying hard to navigate the early stages of a sea-change, which, in our view, will erase current business models and sector boundaries. What is different here is that there is no sure sectorial victim, nor a clear competitive advantage. To our minds, only the most agile of the existing TMT companies will survive and thrive. At the same time, potentially huge new markets will be born.
We cannot imagine the long term consequences of these disruptions, but we know that they are the premise for a likely unique distressed investment opportunity. This has already started. We do not know when it will accelerate, how it will evolve and how long it will last. What makes it so unusual is not only that there are multiple concurrent disruptions; it is the fact that, almost incredibly, all disrupted sectors are just perfect for distressed investing: asset rich and highly levered.
-Sorina Zahan, Ph.D.
January 2016
[1] The strength of the dollar drives their production costs down as a part of these costs are incurred in local currency, therefore not all of the price fall is a cut in margin.