The coronavirus pandemic has resulted in some economic turbulence which has businesses of all sizes under a certain amount of pressure. Many businesses, from those adversely affected to those experiencing growth in the current climate, are looking to access capital in the short term or are looking for longer term partnerships.
The pandemic provides unique opportunities for private equity, venture capital, private debt managers and other alternative assets managers while providing the commercial ecosystems in which they operate much needed relief by way of access to capital.
We have compiled the following series of frequently asked questions regarding setting up fund structures in this environment:
What are distressed asset funds, opportunistic asset or special situations funds?
During times of economic strain and uncertainty, investment opportunities for asset managers often come in the form of investments in "distressed assets" or "opportunistic investments". Distressed assets are generally assets that are experiencing some form of adverse financial pressure or strain, including credit default, insolvency or bankruptcy.
Broadly, the strategy employed by these funds falls within a few categories:1
(a) Distressed Debt Trading - where the fund purchases debt that trades at a considerable discount to fair value and sells it when the price rises;
(b) Distressed Debt (Non-Control) - where the fund purchases debt that trades at a considerable discount to fair value but seeks to influence the restructuring or insolvency process to heighten the value of the purchased debt;
(c) Distressed Debt (Control) - where the fund purchases debt that will be converted to equity post-restructuring and that will provide the fund with a controlling stake in the restructured portfolio company;
(d) Turnaround - where the fund purchases equity in the portfolio company prior to its restructuring and influences the restructuring process to maximize the value of the portfolio company;
(e) Special Situations / Opportunistic - where the fund takes advantage of an opportunity that arises during a special situation (positive or negative) including insolvency, bankruptcy, litigation, shareholder activism, stock buybacks or other events that may influence an asset or portfolio company's short-term prospects.
The current pandemic and the response from governments, institutional investors and public markets creates a turbulent economic environment where otherwise performing assets can face short-term pressure. Like previous periods of economic uncertainty, savvy asset managers and investors alike are undoubtedly going to look for opportunities created by this economic turbulence.
Have investors shown interest in investing in distressed / opportunistic funds?
The Financial Post recently reported the chairman and chief executive office of Onex Corp., Gerry Schwartz, as stating that new opportunities in private equity are likely to come in more distressed situations.2 Similarly, Brookfield Asset Management's CEO, Bruce Flatt, mentioned on the company's first-quarter earnings call on May 14, 2020, that we were in "one of the great environments, possibly, to buy distressed debts that may have ever been in existence".3
The current market is buzzing with high net worth and institutional investors looking for investments in distressed or opportunistic funds across different asset classes (debt, private equity, real estate). According to the data provided by Preqin, in 2008, firms raised US$44.7bn in capital to take advantage of the financial crisis.4
For example, Probitas Partners, a US-based placement agent, has reported an influx of investors looking to invest in distressed debt or special situation funds. In a turnaround to normal practice, Probitas reported that in March, institutional investors have been reaching out to Probitas looking for distressed/opportunistic funds rather than the other way around.5
Barron's reports that many of the large US asset managers are seeking to or have raised significant amounts of capital in the last few months.6
While slower in its response than their US counterparts, Canadian asset managers and institutional investors have been active in trying try and take advantage of the opportunities created by the Covid crisis.
What is the principal difference between distressed / opportunistic funds and their "regular" counterparts?
In comparison to their non-distressed counterparts, funds with distressed or opportunistic strategies are required to respond rapidly to opportunities and provide to investors higher risk and reward.
As these strategies can expose investors to higher risks than their traditional counterparts, it will be important for the fund documents to accurately describe the investment strategy (including providing a clear description of the type of opportunities the fund will be looking at) and adequately describe the risks.
When considering the fund's strategy, asset managers may also seek additional flexibility when it comes to the type of assets it can invest in (corporate debt vs. equity) and how much control the fund will seek when investing in specific portfolio companies (buyout vs. minority stakes). The purpose of the added flexibility is to provide the asset manager with access to as many tools as possible to respond to the opportunities.
Depending on the asset class, the asset manager may also seek to reduce the drawdown notice period in order to allow the fund to respond more rapidly to opportunities.
Other terms which asset managers often consider in the context of opportunistic funds include the shortening of the fundraising period, the investment period and life of the fund.
The amount of work required to manage distressed assets can be significant - are the management fees higher in a distressed fund?
Many asset managers have inquired whether distressed/opportunistic funds warrant higher management fees due to the increased complexity of managing distressed assets. Indeed managing distressed assets may call upon a wider range of skills from the asset management team including expertise in the areas of corporate restructuring, debt financing (and restructuring) and insolvency.
Asset managers will ultimately need to make the case with their investors but if the funds established during the 2008 financial crisis are any guide, the fees will probably remain within the range of their traditional counterparts.
To what extent can a manager use an existing fund to take advantage of distressed opportunities?
Some asset managers with existing funds have shifted from a traditional strategy to one taking advantage of distressed assets. On a recent earning call, Apollo Global Management, a leading global alternative asset manager, said they expected to switch the strategy of the firm's US$24.7bn flagship fund from traditional private equity to a more distress-for-control private equity.7
An asset manager wishing to use an existing fund to invest in distressed assets should carefully review the fund's governing documents to ensure notably that the investments it wishes to make fall within the investment objective of the fund and are not prohibited by the investment restrictions or parameters of the fund. Investment restrictions that could limit a manager's ability to invest in distressed assets include limitations regarding the industry, concentration limits and limitations follow-on investments.
Even if the investment strategy is wide enough to allow for opportunistic investments, we would recommend discussing the shift with the fund's limited partners or the fund's advisory committee. As distressed and opportunistic investments may increase the risk profile of the fund, such discussions would ensure that the investors are onboard with the shift in strategies. This is especially true if statements have been made in any disclosure or marketing document (e.g. offering document, private placement memorandum) which would be inconsistent with the making of distressed / opportunistic investments.
If the investment strategy or investment prohibitions are too prohibitive to adequately effect the distressed or opportunistic strategy, amendments could be proposed to permit the asset manager to make such investments. Such amendments would normally require at least a majority in interest of the limited partner to agree with the proposal.
Of course, the asset manager will need to ensure that the fund (i) is still in its investment period (i.e. is able to deploy capital) and (ii) has sufficient capital commitments to fund the investments in distressed assets (and potential follow-on investments).
What are the principal things a manager of an existing fund should consider prior to launching a distressed / opportunistic fund?
The first item to consider prior to establishing a distressed / opportunistic fund is whether the asset manager is restricted by a covenant from establishing "competing funds". Normally, fund documents will restrict the asset manager from establishing funds with similar strategies during the investment period until most of its committed capital (75% or more) has been deployed.
Even if the asset manager is not subject to such restrictions, it should remain cautious as the establishment of a new fund while an existing fund is not fully deployed may cause investment allocation and conflict of interest issues as some investments may (or may be perceived by investors) be eligible for investment in both funds.
Another restriction to pay close attention to the existing fund's key person provisions. Specifically, key persons subject to such obligations will want to ensure that they are not breaching their obligations to devote a certain amount of time by providing a competing time commitment to another fund.
Our team would be happy to discuss this topic further with you. Do not hesitate to reach out to us if you have any other questions that you would wish us to address or any opportunity that you would like to talk over with us.
7 Louche W. op. cit. note 2.
Originally published 1 June 2020
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.