US corporations are defaulting on bank loans and bonds at rates not seen since the 1991 recession. During the first nine months of 2002, roughly $480 billion¹ of debt defaulted or became distressed (that is, at serious risk of defaulting), and a McKinsey study estimates that at least an additional $410 billion will suffer a similar fate over the next nine months (Exhibit 1). This problem has a flip side, however. Investing in distressed debt,² either directly or, more likely, through specialized funds, has in years past given investors returns in the mid-teens, with little correlation to equity market returns. Institutional investors, long wary of the distressed-debt market, are now showing more interest in it, given its unprecedented size and the recent poor returns for equities. But they should choose their investments with caution. In this downturn, average recovery rates from distressed debt are likely to be much lower than they were last time.

The distressed-debt market has ballooned because record amounts of credit were extended to noninvestment-grade borrowers in the late 1990s. As lenders relaxed their usual standards for underwriting credit, high-yield bond issues and syndicated bank loans shot up, peaking at $145 billion (in 1998) and $320 billion (in 1999), respectively. But when the economy slowed, many companies—notably in the telecommunications and technology sectors—faced financial stress and began to default on their loans. Over the past year, for example, noninvestment-grade corporate borrowers have defaulted on 10 percent (and over the past three years they have cumulatively defaulted on more than 25 percent) of their outstanding bonds (Exhibit 2). The leap in distressed debt during the first three quarters of 2002 included $139 billion in defaulted bonds; WorldCom alone accounted for $23 billion.

Despite the attractions of distressed debt in the past, US institutional investors have channeled little money into it; in 2000, the top 200 defined-benefit pension plans, for example, had only 0.05 percent of their assets under management in this asset class. Many investors were deterred by the lengthy and complicated restructuring process, which reduces liquidity, and lacked the in-house legal expertise necessary for direct investment. Besides, equity markets were booming. But during 2001, as equities cratered and the distressed-debt market became too large to ignore, the top defined-benefit plans doubled their investment in distressed debt, to 0.1 percent of their assets under management, or more than $3 billion—ten times their allocation four years ago. Managers of public pension plans in California, Massachusetts, and Pennsylvania, among other states, have announced their intention to increase their holdings of distressed debt.

If such debt maintains its past returns and diversification benefits, investors that allocate more funds to it could considerably improve the battered risk-return profiles of their portfolios (Exhibit 3).³ But that is a big if. While there may be more than four times the volume of distressed debt in this cycle than there was in 1992, much of it will be of poorer quality and have lower recovery values as well as more varied rates of return. During the economic downturn of 1990 and 1991, companies at risk often had underlying businesses with positive cash flows or balance sheets full of tangible assets, such as real estate, but were burdened with too much debt—due, for example, to overly aggressive LBOs. As a result, financial restructuring (a debt-for-equity exchange, say) often sufficed to restore financial stability.

By contrast, in this cycle many troubled companies, particularly those in telecommunications and high technology, have unproven business models. A lot of these companies also have a high percentage of intangible assets on their balance sheets, and what tangible assets they have are often discounted, because of industry overcapacity, at a much higher rate than prevailed in 1990 and 1991. As a result, the value of their salvageable debt is likely to be lower than it was then. In past downturns, creditors could typically recover 40 cents or more on each dollar of distressed debt; during this one, average recovery rates are expected to range from 17 to 30 cents. Investors that purchased the distressed debt of telecom companies such as NorthPoint Communications, Teligent, and Winstar Communications—all of which had large investments in broadband infrastructure but paltry operating revenues—have already lost their money.

Once institutional investors understand the complex nature of the recent downturn, those still eager to participate in this market must decide between investing directly or through specialized distressed-debt firms. Most institutional investors, given their limited experience in this complex market and the high degree of expertise it requires, will probably choose the specialist route. A handful of firms do the lion’s share of direct investment, with ten of them (including Oaktree Capital Management, Cerberus Partners, and Angelo, Gordon) accounting for 61 percent of it in 2000. To create value from distressed debt, these leading players pursue one of two strategies: control or noncontrol.

The ultimate goal of control players is to buy enough of the debt of a company to own a controlling equity stake in the company; they salvage value by restructuring its operations and finances and, eventually, by selling their stake. Institutional investors should look for firms that can identify the class of indebtedness most likely to emerge as the residual claimant,⁴ have the legal and negotiating skills to maneuver through the restructuring process, and can add value to the management of the restructured firm. The more hands-off noncontrol players buy a minority interest in a company’s distressed debt and then try to resell the securities when they can generate the highest returns. For noncontrol players, the essentials are market experience, trading acumen, and strong research capabilities.

Institutional investors that allocate additional funds to today’s distressed-debt market may encounter more problems in the underlying businesses, lower recovery rates, and more disparate returns than they would have a decade ago. But those who persevere may well discover that talented vulture investors can still occupy a valuable niche in the business ecosystem.