Valuation, due diligence concerns crimp distressed deals

Distressed asset specialists are increasingly looking to pick up companies or their debts at discounted valuations amid the ongoing Covid-19 pandemic. China is particularly drawing their attention, with its economy having broadly exited lockdown measures to combat the virus.  

But would-be buyers will need to surmount many hurdles to conclude deals, including wildly varying valuation estimates, the difficulties of conducting due diligence, and the scepticism of the asset class among asset owners. 

The early months of the pandemic has led to a collapse in private equity deals, as the economic prospects of many companies fell and would-be buyers reassessed their interest. One example took place in May, when private equity firm Carlyle Group and co-investor partner GIC of Singapore were sued for reneging on a plan to purchase a 20% stake in American Express Global Business Travel. 

But many companies need to raise emergency funds or enter bankruptcy, and that prospect is causing would-be buyers and sellers to slowly return to the negotiation table. Companies that were highly leveraged before the pandemic struck are also among the most likely to end up on the block.

“We are starting to see some of that recognition now among sellers, and those who are seeking capital that their distressed time is here and it's now time to come to the table and have negotiations,” said Hong Kong-based counsel Spencer Park at Dechert. 

Close to a third of 143 private equity fund managers across Europe, North America and Asia polled in April by Intertrust indicated their interest to diversify into private debt over the next 12 to 24 months.  

The degree of valuation discrepancy varies from sectors to sectors. However, retail, travel, leisure and entertainment industries are among the most likely to have been adversely affected by the pandemic, and thus the valuation gap between distressed asset buyers and sellers in these areas tends to be wider.

In addition, traditional debt valuation approaches such as yield analyses using contractual cash flows may not be appropriate for distressed debt, said Houlihan Lokey.

CHINA APPEAL

In Asia, China has become a particular centre for distressed asset discussions. The country has largely overcome the original outbreak of Covid-19 and opened up once more.

It also offers a lot of potential deals. Benjamin Fanger, Guangzhou-based managing partner and founder of ShoreVest Partners, estimated that the country’s legacy non-performing loans amount to between $1.5 trillion and more than $3 trillion. The private investment firm specialises in Chinese distressed debt and special situation debt. 

“China distress is of particular interest because it opened up a lot sooner than other markets and investing in distressed assets requires a significant amount of due diligence,” said James Donnan, managing director for Hong Kong at fund administration specialist Intertrust.

He noted that the country's relatively accessible economy has led investors and fund managers to start the early stages of due diligence on distressed debt transactions.  

Warburg Pincus, for example, agreed in April to acquire a 17.11% stake in Chinese car rental business China Auto Rental (CAR), whose share price dropped following a scandal at Luckin Coffee, which is backed by CAR's founder.

While China may be drawing distressed investor eyeballs, it does not guarantee a lot of business will follow. A private market specialist at a Hong Kong-based asset owner noted that the process of due diligence will remain difficult, especially for smaller scale investors. 

Small family offices, for example, usually lack the resources to conduct due diligence on assets in China. In contrast, it has been easier for bigger investors and fund managers with a local presence can more easily overcome such difficulties. As a result, larger general partners and co-investors are the most likely to initially benefit from emerging distressed asset opportunities in China.

“We have been setting up some funds in China for this [distressed company] segment and on the non-performing loan sector as well, which is also seeing a lot of interest,” said Donnan. 

DISTRESSED DIFFICULTIES

Another limiting factor will be the ability of reluctant sellers and eager buyers to find mutually acceptable valuations.

Mingchen Xia, co-head of Asia investments at Hamilton Lane, said it had become “very difficult” to negotiate private equity investments in Covid times.

“The buy-side might expect a significant drop in asset price but sometimes the sell-side might think that the situation is not that bad and that they didn't want to take a big discount,” he told AsianInvestor.

Park added that valuation discrepencies likely crop up around distressed assets because buyers and sellers have very different pricing expectations and usually offer contrasting perspectives about the likelihood of an economic recovery.

“Investors are convinced that the doom and gloom is here and that it'll take longer before recovery will happen and sellers don't share that same view or have a more optimistic view,” he said. 

Indeed, there appears to be a diverse array of perceptions among asset owners for distressed debt investing. A study by Invesco published on July 20 found that only 13% of the sovereign investors that it polled considered distressed debt to be the most attractive over the next three years. Some asset owners, including Korea’s Public Officials Benefit Association, have previously expressed concerns over the risks of investing in the asset class in general.

It also proved to be the least popular investment option when measured against other fixed income options such as emerging market debt and high yield corporate debt. Instead, they beleived that the best opportunities were to be found in infrastructure and real estate.