Successful investment in a distressed market calls for a carefully planned strategy and there are lessons to learn from history, says Oleg Pavlov, chief executive of international private equity investment firm Quadrum
How do you successfully invest in a distressed market? The key indicator we look for is on a macro level. Put simply, it is the cost of debt capital available to a developer or investor versus the normal rate of growth in the market. Because when cost of capital is high relative to growth rates, this usually means asset prices need to go down to reflect the new reality. This looks to be the case at the moment in a number of emerging markets and peripheral European economies.
The best time to invest in a market is after a major systemic event, such as a sovereign default, when all lenders turn away en masse. For example, we have been very active in the US in the wake of the 2008 debt crisis. We made our first acquisition back in 2009.
What you need to avoid are assets that look cheap because they are cheap for a reason. Here is a simple example: suppose you see an empty office in the middle of nowhere that somebody built with a lot of debt during the previous bubble. It may be very cheap, well below replacement cost, but this does not mean it is attractive. Perhaps it should have never been built in the first place.
Instead, when looking for distressed opportunities, we always identify solid assets in good locations that are mispriced because of their ownership. Sometimes owners have to sell assets in a hurry for internal reasons or simply because they lack the human or financial resources to add any further value. We call these “orphan assets”.
Value in volatility?
We were previously very active in emerging markets of the former Soviet Union and South East Asia. At the moment, we are not convinced that emerging markets are necessarily a good place to be. Many of them are suffering from systemic issues, such as large private sector debt and slowing growth.
When you look at specific economies, you find difficult realities, such as decreasing productivity gains (China), poor governance (Brazil), or falling commodity prices (Russia and the Middle East). For these reasons, we feel emerging market asset prices and currency values may fall further as investor capital flows out of risky assets.
One can never draw exact parallels, but in some ways we see the world entering a period similar to the one it experienced between 1995 and 1999. Then, the Anglo Saxon economies were recovering from the recession of 1987-1992. By the mid-1990s, Western economies were growing steadily, with little private debt and rising productivity gains brought on by the first internet revolution.
This was positive for real estate, technology and other developed-world assets. At the same time, many emerging markets were suffering from structural problems, resulting in economic “accidents” and outright defaults.
In 1994, just as I began my career as an investment analyst, Mexico experienced a major currency devaluation, known as the “tequila crisis”. In 2014, Russia had a major rouble devaluation. I have yet to see anyone refer to it as the “vodka crisis”, but the hangover is just as painful for the locals.
In 1995, several Latin American countries, such as Argentina and Brazil, flirted with sovereign default. This year saw the onslaught of the Greek debt crisis, Ukraine officially went into sovereign debt restructuring, and Puerto Rico will most likely follow soon.
In 1996, the Turkish lira appeared in the Guinness Book of Records as “the world’s cheapest currency”. Compare this with the emerging market currency drops seen this summer.
In 1997, we saw the Asian crisis that was set off by Thailand’s default and culminated in a full-blown Russian crisis in 1998. We have not seen any formal sovereign defaults in this cycle, but we wouldn’t rule this out going forward and we certainly expect more debt haircuts and rising volatility in the next couple of years. Structural problems and weak balance sheets will be further exposed by the strong dollar and the inexorable interest rates lift-off.
In short, now may not be the best time to invest in emerging markets and risky assets in general.
Protection plan
But what if you have already invested? What can be done to protect existing assets in falling markets and how do you work out whether your funds are tied up in a good or a bad asset in a distressed market?
There is no universal answer. A lot depends on liquidity and cash flow. An overseas open-ended opportunistic fund will have liquidity constraints and decision-making processes that are very different from a local industrial family that is committed to the market and may take a multi-generational view.
I often say that everything begins with strategy and ends with management. First, you must decide whether the market or the asset is strategic to your mandate and if you are prepared to go the distance. If the answer is yes, then you must focus on your team. The stronger your local management team is, the better it will be able to protect value in a difficult market and later identify attractive new opportunities when everyone else is running for exits.
However, if the asset is not strategic, it may be better to wind up the portfolio quickly and focus elsewhere. Run an auction, sell to the best available bidder and move on. The worst decision is to adopt a half-hearted “wait-and-see” approach in a falling market without a strong team in place.
