Over the past two years, distressed investing has been, well, distressed.

Fewer opportunities have been available for distressed lenders outside of industries directly impacted by COVID, such as hospitality. New Federal Deposit Insurance Corporation (FDIC) rules have allowed banks more leeway to modify loans. Paycheck Protection Program (PPP) loans ($790 billion) and Economic Injury Disaster Loans (EIDL) ($351 billion) from the U.S. Small Business Administration (SBA) and Employee Retention Credits from the IRS were extended to more than 10 million companies. Historically low interest rates have made debt service more manageable.

While companies may continue to receive Employee Retention Credits through 2024, depending on when they submitted their applications, the PPP stopped accepting new applicants in May 2021, and EIDL applications were cut off in January 2022. Presumably, many companies have already spent those funds. Challenged businesses managed to get by over the past few years in most cases by receiving a “pass” by special asset officers. Preqin estimates the amount of dry powder focused on distressed debt investments increased 58% in 2021, as the demand for yields in distressed lending far exceeded the supply of opportunities. Banks planned for the worst in 2020 with oversized reserves for credit losses that did not materialize.

However, the tides are shifting; interest rates, labor, and material costs are rising, and nearly every business is affected.

Inflation is increasingly looking structural rather than transitory and may remain above the Fed-targeted
2% annual rate for longer than anticipated. In his recent newsletter, Howard Marks of Oaktree Capital Management noted that offshoring significantly influenced the low level of inflation in the United States over the last 40 years. Now, as the United States is forced to recognize its vulnerability and dependence on imported critical components, such as semiconductor chips, the reshoring trend is likely to continue, along with an uptick in associated costs. Added to all of this are whatever supply chain and price disruptions emerge as a result of the severe sanctions imposed on Russia over its invasion of Ukraine.

In an environment of increasing costs, supply chain disruption, and headlines increasingly warning of a recession, here are three considerations of which alternative lenders should be mindful:

• Costs and Ability to Maintain Margins. Companies that do not clearly understand their operating expenses are likely to find their margins eroded by increased costs. Worse, companies with fixed-price contracts may be stuck in customer agreements with negative or otherwise unsustainable margins. Ironically, these may be companies that in other contexts would appear to have strong customers and recurring revenue.

For example, over the last 90 days, companies with fixed-price government defense contracts and trash companies with municipal waste contracts have been forced to close or file bankruptcy in an attempt to renegotiate underwater pricing contracts. And businesses with customer concentration may fear that they’ll lose those customers if they increase prices. For example, companies with revenue dependence on large national retailers may be unable to immediately pass on increased raw material costs. How many suppliers in similar situations can absorb that hit to their bottom line—and for how long? It’s important that companies have their arms around their costs and be able to promptly increase the prices they charge their customers to preserve margins.

• Liquidity. As Warren Buffet famously remarked, “It’s only when the tide goes that you learn who has been swimming naked.” Operational losses can no longer be masked by the liquidity distributed to companies through the various government programs mentioned earlier. Business owners that lack the liquidity necessary to grapple with increased costs and potentially reduced margins will struggle and may have no choice but to look to their lenders as “equity partners.” Rising interest rates will compound problems for overleveraged businesses.
• Asset Coverage. Mergers and acquisition activity reached record levels in 2021, pushing price tags higher for businesses. Similarly, the market for used equipment has been particularly strong, as new equipment lead times have grown due to supply chain disruption and a dearth of closures and bankruptcies—which are at a 35-year low—that has translated into less used machinery hitting the market. Growing commodity and raw material prices mean companies require more working capital to purchase material and fill orders. While valuations are high, the market will eventually normalize and the elevated valuations do not apply to all asset classes, as some are still very negatively impacted by the supply chain disruption.

Calm Before the Storm?

As the cost of capital increases, the pain for overleveraged businesses will compound. This unavoidable effect will require banks to deal with these challenged credits. Unlike earlier in the pandemic when challenged credits passively benefitted from stimulus and PPP cash infusions, special asset officers now will likely have to take different actions to work through restructurings.

As the headlines reference inverting yield curves and Alan Greenspan warns of reduced sales of men’s underwear, the talking heads generally point to looming recession. Restructuring professionals certainly hope it’s the case, and the sentiment among lower middle market turnaround consultants and advisors is that the second half of 2022 will see an uptick in activity.

Historically, recessions have been great times for the distressed lending industry. Distressed debt funds generally outperformed private debt in 2000-2001 and 2007-2008. Would the next recession be different?

As noted earlier, there have been fewer opportunities for distressed lending firms over the past few years. Earlier this year Bank of America reported its lowest loss rate for loans in 50 years. Commercial Chapter 11 filings in 2021 were down nearly 50% from 2020, and in the first few months of 2022, the commercial Chapter 11 filings were nearly half of what they were in the same period last year. If this trend continues, it would be concerning for restructuring professionals and distressed lenders.

However, the turnaround community is anticipating an increase in bankruptcy filings. One national turnaround firm noted that it received more calls in the first quarter this year than it did for most of 2021. There is undeniably a lot of capital scouring the market for distressed lending opportunities. While the market will yield more opportunities as businesses struggle with the current challenges and the workout departments within banks receive more credits to manage, capital providers in the distressed lending space will be there to help banks exit nonperforming credits.