- Ares’s Bennett Rosenthal, Apollo’s Josh Harris bullish on distressed debt
- Markets “ready and expecting some sort of downturn,” says Rosenthal
- “Our flow of distressed-for-control investments has increased,” says Harris
Ares Management and Apollo Global Management expect to deploy their new private equity funds in distressed for control deals, a departure from the traditional buyouts that dominated their pipelines for much of the last half decade.
“This feels like one of those markets we see every seven years,” said Ares co-founder Bennett Rosenthal in a keynote address at the Wharton Private Equity & Venture Capital 2016 Conference on January 29.“We’re not going to be able to make money relying on auction flow and doing traditional buyouts.”
Ares’ private equity strategy typically pursues leveraged buyouts and distressed-for-control deals, which gives the firm the ability to invest across market cycles, Rosenthal said. The firm is currently marketing its fifth flagship fund with a $6.5 billion target.
Buyouts represented the bulk of its private equity platform’s business in the years following the recession, which included its $6 billion acquisition of retailer Neiman Marcus alongside the Canada Pension Plan Investment Board in 2013. Strong public market growth, ready access to debt and expanding multiples made for a “very benign and accommodating environment” over the last several years, Rosenthal said, but those days appear to be drawing to a close.
Economic uncertainty in China, Russia’s incursion of the Ukraine, instability in Greece and basement-level oil prices made for volatile public markets, which in turn gave rise to larger distressed ratios, Rosenthal said.
The impact of lower oil and gas prices has been particularly noteworthy. The energy sector accounts for “a big part” of the growing number of distressed companies, said Rosenthal. “We’ve made several toehold distressed investments, some of which are in energy.”
While Rosenthal stopped short of saying these are signs of a coming recession, “we’re starting to see signs of cracks,” he said. Commenting on the leveraged finance markets: “It feels like the markets are ready and expecting some sort of downturn.”
Like Rosenthal, Josh Harris, co-founder of Apollo Global Management, sees a big opportunity to purchase distressed debt in companies — sometimes as a prelude to an acquisition, sometimes as a bet on the value of the debt itself. But he seemed more optimistic than Rosenthal that the United States would avoid a recession.
Investing out of an $18.4 billion fund, its eighth in a series of private equity pools, Apollo saw a dramatic shift in opportunity toward the end of the year, Harris said while delivering the afternoon keynote at the Wharton conference.
Going into the holidays the credit markets that finance large buyouts largely shut down and didn’t re-open after bankers returned from their vacations. That meant Apollo, to maintain return expectations on deals in progress, needed to go to sellers to try to negotiate a better price. Neither side blinked. “Our entire private equity pipeline dried up,” said Harris.
Meantime, investors rattled by plummeting oil prices, among other things, ran away from investments in high-yield debt. That led to big discounts in the market as yields, which go in the opposite direction to prices, spiked some 500 basis points from 5 percent to 10 percent. Said Harris: “For the first time in a long time our flow of distressed-for-control investments has increased.”
From virtually a standing start, Apollo, which manages $162 billion in third-party funds, accumulated positions in about a dozen companies whose debt is trading at distressed levels. In fact, Harris said, the percentage of money from Fund VIII invested in distressed opportunities jumped to 10 percent from 5 percent over the last quarter. By comparison, distressed opportunities accounted for 59 percent of the money invested by the $14.7 billion predecessor fund, vintage 2008.
The strategy has its risks. Even if investors turn out to be overreacting, falling equity and debt prices can create a “self-fulfilling prophesy” that ends up damaging the economy, said Harris. Consumers get scared and stop spending; businesses get scared and stop investing. There’s also the risk of buying too early. During the financial crisis Apollo began buying debt in chemicals company LyondellBasell at 80 cents on the dollar only to see the price fall to 15 cents on the dollar (at which point Apollo continued to buy, eventually leading to a $10 billion profit).
“For us, we do think there is a buying opportunity here,” said Harris. “But we’re going to be cautious about how we leg into it, because there is so much volatility right now in the market that it could create problems economically. But I do not believe it has yet.”
Indeed, Harris suggested many of the worries keeping investors up at night have been overblown. The collapse in oil prices? Apollo sees oil prices, which Harris called “over-corrected,” rebounding back above $60 per barrel within one to three years. Part of his reasoning: It’s uneconomic to drill oil in most of the United States right now, which eventually will lead to falling supply. “Nothing fixes low prices like low prices,” said Harris.
A slowdown in China’s economy? Harris points out that China is still growing quickly relative to other large countries, and that the government has plenty of tools on hand to manage deceleration while avoiding the dreaded “hard landing.” The slowdown has caused a “massive recession” for commodities such as oil, gas, aluminum, cotton, nickel and others. But, he added, “that’s actually a positive for the U.S. economy and somewhat neutral for the world economy.”
Summed up Harris: “There’s been this huge shift in sentiment without an underlying change in fundamentals.”
David Toll and Sam Sutton co-wrote this report.
Photo: Joshua Harris, co-founder of Apollo Global Management, speaks to the media while he attends an NHL hockey news conference announcing the new owners of the New Jersey Devils at Prudential center in Newark, New Jersey August 15, 2013. REUTERS/Eduardo Munoz