The Covid-19 pandemic has put many companies globally under financial strain, accelerating the growth of the distressed debt asset class. That is drawing interest from some asset owners – but not all of them.
Jang Dong-hun, chief investment officer of Korea’s Public Officials Benefit Association (Poba), said the biggest concern for his W14.3 trillion ($11.6 billion) pension fund over allocating to distressed debts is the risk of losing its principal investment.
Lee Soo-Cheon, co-founder and chief investment officer of credit specialist SC Lowy, shared similar thoughts, “At the end of the day, what's important when you deal with high risks, high returns investments [is that] you may lose your returns but you can't lose your capital.”
The lack of a stable cash flow from distressed asset investments can also be an issue for pension funds like Poba.
“Stable annual cash flow is very important to our company [in order for us] to pay liabilities. However, since illiquid distressed debts are not making any stable cash flow during investment period, that is one trait we do not like about distressed debt,” Jang told AsianInvestor.
The pension fund is no stranger to alternative assets; it had 30% of its assets under management in them at the end of 2019 and wants to raise this to 35.8%. However, Jang noted that while Poba wants to earn decent investment returns that alternative assets can offer, it also intends to secure its investment principal and to generate stable cashflows.
Distressed debt isn’t a perfect fit for such goals. Lee noted that the illiquid nature of distressed debt is often overlooked by investors and managers. It often takes a lot of time for a distressed company to become profitable again.
The need for Poba to raise assets in a brisk but sustainable manner is understandable, given Korea’s aging population. Around 73% of the country’s population are expected to be 65 or older by 2050, which would leave Korea on track to become the second country globally with the highest old-age dependency ratios after Japan, according to Allianz’s Global Pension Report 2020 released on Friday (May 29). That means the liabilities of Korea’s pension funds will rapidly surge.
PROCEED WITH CAUTION
Poba boasts a high cash ratio (it stood at 10% at the end of last year), so asset liquidity is not currently a major problem. But Jang said the illiquidity of distressed debt assets means that his fund would be cautious over allocating to them. The fund has never done so before.
Instead, his investment team is looking to identify and invest in discounted assets, which will allow the company to take advantage of the asset’s appreciation in value when the economy normalises.
Jang noted that were Poba to decide to invest some of its assets into distressed debt, something it has not decided to do, it would be very selective in terms of where the exposure will be, and whom the fund will be investing with. In particular, the fund will likely stick to developed markets.
“We are public pension company, it would be difficult for us to invest in risky emerging company, we are mostly investing in developed OECD countries,” Jang said.
Jang added that Poba might consider allocating were it to come across good opportunities with very low risk, but he said he would do so "limitedly and selectively," with a "very cautious attitide".
Hea added that were the pension fund to do so, it would look for distressed debt fund experts with good track records, with a secondary priority being whether or not the manager had experience managing such assets in the last global financial crisis of 2008 to 2009.
While the experience of the last major financial crisis offers some level of comfort, it’s not a given that those with experience from that time will be equally capable in turning distressed companies around in 2020. For a start, many traditional corporates may no longer be relevant or have been made obsolete in the current digital era.
For example, American rental-car giant Hertz recently filed for bankruptcy after struggling with as much as $19 billion of debt burden as of May this year as its business model struggled in part from emerging competition from the likes of ride-hailing company Uber.
According to S&P Global reports, over 30% of debt from US companies was trading at distressed level as of April 10, with sectors spanning oil and gas, as well as retail and automotive.
“Is there no need for car rental companies to exist in the future? I don't think so,” Lee said, “Ride-hailing companies may change some of the dynamics but I think there are ways for some of these companies to survive because it's a different model and that's the thing we need to figure out.”
That said, Lee noted that distressed debt fund managers who survived the global financial crisis will be more mature and less likely to panic during tumultuous times.
Josh Jeon contributed to the story.