Distress Can Yield Returns in Wake of U.S. Financial Crisis

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The first half of 2008 was the most successful in private equity fundraising history. Turbulence in global credit markets is driving investor capital from buyout funds to distressed equity, according to alternative investment research firm Private Equity Intelligence, Ltd. (Preqin). Interest in the sector hasn’t waned; it has just changed.

Private equity funds raised $324.4 billion in the first half of 2008, Preqin reports, barely surpassing the previous half-year fundraising record of $323.8 billion set in the first half of 2007. Though the credit crunch rages on in the background, investors continue to commit resources to private equity.

Traditionally, buyout has been the largest and fastest growing sector in this asset class. This is where the implications of the credit crisis are evident, as inflows to buyout funds are down 18 per cent year-over-year, according to Preqin’s research. Distressed debt funds, which specialize in risky bonds and other forms of credit with ah high likelihood of default, have seen capital raised grow by 28 per cent relative to the first half of 2007.

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Further, a survey of private equity investors conducted by Preqin indicates that 35 per cent have either increased their exposure to distressed debt or are planning to do so—at the expense of allocation to buyout funds. Only 52 per cent of the investors polled said that opportunities in distressed debt markets will not influence their current allocations to buyout funds. A quarter of the investors surveyed anticipate increasing their exposure to distressed debt funds, while another 50 per cent may follow suit, depending on distribution rates from existing portfolios.

Private equity, as an asset class, is proving its resilience, though investor focus is moving with the market. To take advantage of the opportunities afforded by current market conditions, many are beginning to gravitate toward distressed debt funds. Interest has been sufficient to keep alive global fundraising’s record-setting pace. As buyout funds lose their luster, particularly because of the tightening of global credit markets, fund managers are finding new ways to generate returns.