Getting into the Zone with Stressed/Distressed Opportunities

Family Office Alpha Report

By Phoebe Outerbridge

November 27, 2018

There is a prevailing feeling among investors that we are late in the cycle, with overpricing a worry across markets, whether in public/private equity, or in real estate. Following a historically long bull market, people are also worried about market corrections and rising interest rates, among other concerns.

However, there are ample pockets of opportunity for those who are willing to look off the beaten path, all which can offer unique alpha to a portfolio. Investing in stressed or distressed assets and securities—through single-family-rental qualified opportunity zone funds, secondary market container ships, and stressed/distressed high-yield bonds to name a few examples—can be a timely way to capitalize on low prices as well as to reap tax benefits.

Enter the Land of OZ

The topic of Qualified Opportunity Zones has transformed from a relatively obscure element of the 2017 Tax Cuts and Jobs Act to a subject that has been widely shared and analyzed. The program’s intended goal is to spur economic growth in under-developed, economically depressed areas across the US—more than 8700 designated zones—through the catalyst of rolling over unrealized investment gains. Its tax benefits via capital gains deferral and basis adjustment rightfully have piqued many investors’ interest.

In short, an investor can take proceeds from long- or short-term capital gains, and (within 180 days) invest in a Qualified Opportunity Zone Fund (QOF) to defer taxes, the largest benefit going to those who make the longest investment (10 years) in a QOF.

Single-family-rental (SFR) QOFs offer the added benefit of addressing a documented shortage of and demand for moderately priced housing. SFR firms who are already on the ground in QOZs are able to acquire homes in scale, renovate and rent these starter homes. The investment provides returns to investors through rent yield and home price appreciation, not to mention the QOF tax benefit.

While there is sure to be a small stampede of not only investor interest but also of firms forming QOFs, those looking to take advantage of a QOF should perform appropriate diligence before jumping into “the zone.”

For starters, regulations state a firm need only self-certify through IRS Form 8996 to qualify: be sure you are partnering with a reputable operator who has experience working in the locations in which you’ll be investing. Given the short 180-day time window, you’ll also need to be sure the firm has the capability, technology, and expertise to execute from day one. Finally, ensure the areas in which you will be investing are actually viable: while the zones were designated for their growth potential, not all QOZs were created equal.

Distressed Securities: Stress on the Alpha

As equity markets climb higher and both public and private valuations worry investors, stressed/distressed credit securities—particularly high-yield bonds and loans—can be an attractive source of steady yield and portfolio diversification. While investors and advisors tend to focus on the equity markets given stocks can “move the needle” more (and are generally easier to understand), this asset class warrants attention.

Even in bull markets there are always opportunities to find companies who may be in trouble and whose bonds are trading under par. Event-driven situations like bankruptcies, refinancings, and reorganizations can create opportunities for smart investors to find mispriced assets. Another example is the downgrading of a bond to junk status: this can create forced sellers and a fresh opportunity to capture alpha.

While the opportunity in stressed/distressed bonds and loans can be vast, the landscape is not easy to evaluate; expertise in trade execution/timing and a thorough understanding of the risk parameters of companies and their balance sheets are all paramount.

This Ship Has Not Yet Sailed

When you consider that 90% of world trade is transported by seagoing vessels, it’s hard to fathom that shipping is an under-followed and under-invested market segment—at least in the US. But with an asymmetric risk-return profile that offers downside protection (asset-backed) and little correlation to equity and other markets, the upside potential of investing in secondary market ships can be tremendously attractive.

The current distress in the maritime markets makes for a ripe opportunity to exploit the low asset prices of secondhand container ships. The drop in levels of new ship building paired with an increase in scrapping old ships presents the classic supply/demand imbalance, boosting values of existing vessels. Before this current market cycle is over (in another 4-5 years), ship and charter rates may be more than double the current values—and this would only represent half the asset value levels seen at the last peak in 2006-2008.

European banks, who had largely been the holders of ship debt, are now looking to get the loans (and the vessels attached to those loans) off their balance sheets, and secondhand ships can be acquired at meaningful discounts to newbuild. Paired with an immediate cash yield from charter rates, this investment can provide low- to mid-teen unlevered returns.

In summary, there are plenty of opportunities that remain under-invested—many in distressed or stressed assets—that can offer an uncorrelated high-return to investors who are willing to take the time to find them.  In a recent interview with CNBC Host Brian Sullivan, Witherspoon Partners’ founder Keith Danko touched on two of these opportunities (see video). In a new climate where the bull market equity run is no longer a given, these unique distressed opportunities provide some creative ideas.