2011 Year in Review: Chekhov’s Gun

By Sheon Karol

There is a principle in literature known as ‘Chekhov’s Gun.’  If a gun is seen at the start of a play, it should go off by the end of the play.  In 2011, ‘Chekhov’s Gun’ was seen at the beginning of the year but it was never fired.  The pundits predicted that a wave of debt maturities would sweep over us and the restructuring industry would be awash in work.  This never happened.  Some people assure us that the wave has just been delayed a year or two while others worry that the low tide will continue for years.  

So what did happen in 2011 and what does 2012 hold in store?

Corporate bankruptcies declined in 2011.  In the first half of 2011, chapter 11 filings declined to 6,071 filings, almost 15 percent below 2010.  Several large companies filed bankruptcy late in the year (such as MF Global, NewPage, American Airlines and Dynegy) but corporate default rates remain low (~1%). 

Returns from hedge funds have declined and, according to a study in The Journal of Financial Economics, the average hedge fund investor did not earn much more from 1980 to 2008 than a holder of Treasury securities.  However, new money is still expected to pour into hedge funds, in part due to the need for pension funds to find a way to achieve large gains.

David Barse, Chief Executive Officer of Third Avenue Management, says “the distressed market in 2011 is a tale of two halves.  The first part of the year was ‘risk-on’ turbocharged by the Fed’s QE2.  The second half of the year was ‘risk off’ as hopes for a V-shaped recovery diminished and investors re-focused on Europe’s sovereign crisis.”  Mark First, a Managing Director with Eos Partners, explains that after a strong start, private equity activity slowed in the latter part of 2011, “likely as a result of the weak credit markets and greater economic uncertainty.”

A recurring theme in contemplating what 2012 holds in store is that there will be opportunity for investors.  First expects to “continue to invest assuming a backdrop of modest and uneven economic growth in the U.S.  High unemployment, together with energy, food and other commodity prices, has created consumer headwinds and margin pressures.  State and local government deficits, though improving, will likely remain a drag, and austerity measures in Europe may lead to further economic headwinds.”  Nevertheless, First believes that “secular and cyclical trends will lead to growth in certain industry niches.  While many companies never fully restructured and continue to be internally focused, others approach 2012 as a year to ‘play offense’ and there should be many interesting investment opportunities in support of these companies.”

Top performing companies, especially those that demonstrated growth throughout the economic downturn, have continued to attract strong interest and high prices.  Many PE backed companies, however, have leverage in excess of what is achievable in the current market, a barrier to increased deal activity.  First says that “investment bankers speak of the large backlog of PE backed companies and the need and/or desire of PE firms to sell.  However, in the absence of more robust credit markets, I suspect the pace of activity will be slower and steadier rather than a large wave of deals in 2012.”

Barse expects that, barring an Italian default, which he views as “a Lehman-like event,” macro concerns over a European Sovereign default, a double dip recession in the US and a slowdown in China are likely causes of volatility in 2012 that will provide opportunities in 2012 for distressed investors.   He predicts that “U.S. default rates will inch higher but remain low overall with interesting opportunities in shipping, technology, telecom, energy and power.  At some point it seems to us that European banks will be forced to be a net seller of distressed assets, however, it could take longer than first believed and all the hedge fund offices set up in London and the European Continent are going to be big expenses and have little to show for it in 2012.”