The pandemic-induced economic crisis is expected to be deeper and longer than any seen in our lifetimes. The scale of this crisis has put “Distressed Credit”, “Special Situations”, “Distressed-for-Control” and “Opportunistic” funds at the front and centre of the investment world. These distressed strategies aim to take advantage of market dislocations caused by the pandemic to offer double-digit returns.

However, distressed investors face several risks, many of which have become acute in this current political, social and economic climate. Some risks, such as those related to the role and intervention of governments, have been amplified by this crisis. Other risks are new but are also leading indicators, notably the increasing importance of environment, social and governance (ESG) criteria. And some ever-present risks, such as fraud and misrepresentation by borrowers, come with new ‘COVID-19 challenges’.

In this crisis, the political risks associated with distressed investing are higher than ever before. Government intervention – through state-backed investment, job support, and individual and corporate subsidies – has softened the impact of the crisis. Yet government-imposed lockdowns and restrictions (though arguably necessary) have also hurt many businesses.

Government support is often highly politicised. The UK government’s recent decision to extend loans to private equity-backed companies has attracted criticism, and similar schemes in the US have come under the spotlight. In the past, distressed investors in Asia have suffered from political scrutiny: Lonestar is still fighting a claim with the South Korean government as result of its 2003 distressed investment in Korea Exchange Bank. Distressed investors are involved in making tough and unpleasant decisions to restructure businesses and to lay off employees: if they do this while receiving government financial support, they are likely to face heightened political scrutiny and potential opposition.

Likewise, investors in distressed sectors, such as travel and entertainment, will be lobbying for lockdown-related restrictions to be lifted. However, if this comes as the expense of public safety, or even the perception of a hit to public safety, these investors could face political opposition or intervention.

Identifying key political and government stakeholders, potential political risk scenarios, and their appropriate mitigation is key to managing these risks.

The pandemic has also prompted investors to question the notion that corporations should simply focus on profit and highlighted the issue of their broader social role. The question surrounding an investor’s role becomes even more sensitive in distressed situations, when – even in the best of times – hard decisions need to be made regarding shutting down businesses, making employees redundant, or foreclosing on assets. In today’s environment, investors in a distressed fund may start to question the social impact of their investment. Stakeholder concerns will become more pronounced if the restructured companies start to cut back on environmental (and even biological) protections.

As a May 2020 article in an ESG investment magazine put it, “The practice of making distressed loans to such borrowers with the intent to take control and radically change their business in an effort to capture the equity upside does not embody the type of governance or social responsibility that anyone in the general partner or limited partner community should feel good about.”

While the provision of capital to support fundamentally sound but temporarily ‘solvency challenged’ businesses is a key element of the financial system, the radical restructuring that distressed investment requires may be more than employees, politicians and other stakeholders are prepared to tolerate. The “social” in ESG may come into conflict with the sometimes-brutal financial imperatives of distressed investment. Understanding the impact of business changes and the relationships underlying the business  to ensure that ESG obligations are being adhered to is a key ‘information gap’ that distressed investors need to fill as part of their decision-making.

While political and ESG issues have risen to the forefront of the COVID-19 world, the old challenges of operating in highly opaque information environments in which borrowers have a strong incentive to misrepresent remain. As Akihito Watanabe of Pierfront Capital said at the Asia Legal Business Cross-border Debt Restructuring Forum in September 2020, “The creditor relies on the trust in the management and that the management acts in good faith and that the levers are being used in good faith.” But as one of his co-panellists declared, “The difficulty is getting good information – even the financial advisers don’t have all the information.”

COVID-19 has exacerbated these information gaps in a number of ways.

First, it is often unclear how a company came to be in a position of distress. Some borrowers are fully transparent about how and why the company is unable to service its debts or meet its contractual obligations, and so needs to be restructured or take on new capital. Other borrowers are less competent or honest, deliberately hollowing out assets from a going concern, and trying to mislead creditors about their financial standing. COVID-19 has not only put a strain on key relationships with suppliers, customers and partners, but also created a new ‘excuse’ for failure for a borrower or counterparty that wishes to misrepresent themselves.

Meanwhile, the ‘true’ performance of a business has become less clear. With travel for due diligence often restricted, investors may now find it harder to determine the real status of a borrower’s business: are sales growing, has production resumed, are supply chains reviving, or are costs rising? Even harder to assess are possible hidden liabilities and off-book lending, such as cross guarantees, related-party transactions and undeclared encumbrances on assets. If it is a contentious situation, then investors in the distressed space need this insight now more than ever to inform recovery strategies and to leverage negotiations.

Once investors have provided new capital, they sometimes struggle to determine how the company is spending the money. Creditors want to know where their money is going, and if it is being used in a manner that is aligned to their interests.

Finally, not all distressed investment results in a positive outcome. In some situations, creditors want to determine if borrowers are being fully transparent about their interests. Often, they fail to disclose their commercial, political and social relationships. At a minimum, understanding these relationships can help determine true value, and conducting sufficient diligence to, at best, recover assets stolen by the management is key to securing returns for distressed investors.

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