By Tom Stabile

Signs that the U.S. economy is kicking into a stronger, healthier gear have not deterred Oaktree Capital Management and Fortress Investment Group from hitting the market with new distressed investment funds this year. Oaktree is fundraising for a pair of distressed strategies that all told aim to raise $10 billion, while Fortress has a $5 billion fund in the market. Raising these funds now partly hinges on the premise that having capital to deploy at the moment the economy turns sour will be hugely beneficial. What’s not clear is whether institutional investors – many already questioning whether private equity in general is overheated – are ready to hedge on the economic recovery. Fundraising in the distressed market took a pause last year in North America, dipping to $19.6 billion in 2014, 31% lower than the $28.5 billion raised a year earlier, according to Preqin data. U.S. managers dominated the 2014 fundraising totals, led by Centerbridge Capital Partners, which closed its third distressed fund at $6 billion, and 3G Capital’s fourth special situations fund that closed at $5 billion. Distressed fundraising has stepped back largely because the last few years have seen stronger economic growth overall, says Elvire Perrin, a partner and executive director at Altius, a fund of funds and separate account manager that runs $27 billion. “Distressed has been harder to justify, and it’s pretty tough for managers active in these types of strategies,” she says. “They have been of less interest to limited partners – and U.S. limited partners specifically.” Still, it just might be time for LPs to look again at the sector, Perrin says. “Six years have passed without any distressed cycle, and the historic average is seven years,” she said. “Normally when you’re at these levels of debt in deals, a lot of U.S. LPs would expect a distressed cycle to take place in the next couple of years. My sense is that most of them would start thinking soon about how to position themselves for this next cycle.” The last few years have left distressed managers with fewer deal targets and in many cases lower returns. Distressed debt strategies at Oaktree last quarter again felt the impact of some of these factors, said Howard Marks, co-chairman at the firm, during its fourth quarter earnings call last month. “The relative lack of distressed opportunities of the last few years had caused portfolios to be relatively concentrated,” he said. One of Oaktree’s distressed funds currently in its investment period has lived through some of the market challenges of a good economy, Marks said. “[S]ince the environment during [Opportunity Fund IX’s] life has been non-distressed, that fund has done rifle-shotting [for deals] rather than a shotgun approach,” he said. The bright spots for distressed activity have been in cross-over deals with Oaktree’s real estate team and in the oil price-pressured energy sector, he said.
Marks said Oaktree is predicting a “substantial first close” for its new distressed debt funds, which it is raising in tandem – a $3 billion 10th fund to deploy in the near term and a $7 billion “10-b” fund that will act as a “standby”, ready to deploy when ample distressed opportunities arise. At Fortress, the firm’s fourth global opportunities fund, part of its distressed equity and debt product lineup, is on target, said CEO Randy Nardone, during the firm’s fourth-quarter earnings call last month. “We expect to raise exactly what we targeted: approximately $5 billion in new commitments,” he said.
Distressed managers see several promising sectors for investments, even amid a strong economy, says David Frank, CEO and managing partner at Stonehaven, a placement agent. “There are increased distressed opportunities in the fixed income markets as a result of disruptions to the energy complex, although this is already being pursued by many players,” he says. Displacement in the technology sector and emerging markets struggling with commodities prices are other areas drawing attention from distressed managers, he adds.
Not all distressed fund managers need a down cycle to execute deals for their strategies, Perrin says. But an economic dip is critical for some, such as Oaktree’s unique “A” and “B” fund approach, and for that reason LPs uncertain about when the next downturn is coming say they want to get into the second standby pool and avoid the current fund, she adds. If Oaktree succeeds in raising $10 billion for its pair of new distressed funds, it may end up with a considerable amount of uninvested capital in addition to about $10 billion it has in current funds, Marks said. Fortress, too, will have a big pot, if it adds the $5 billion it is raising to about $5 billion of uninvested capital it already has in its credit private equity funds.
Having such big amounts of capital to invest could pose tests of discipline for managers, Frank says. “While there is logic to raising capital before the next down cycle, way too many managers that have done this deploy capital too early,” he says. “The challenge is that a down cycle may end up being further into the future than anticipated, and then the [general partners] want to start deploying capital.”