The global financial crisis has created a backlog of distressed companies that are gradually becoming ripe for private equity investments. That was a key message of speakers on a panel titled, “Distressed Investing: Identifying Opportunities and Realizing Value in Recovering Markets,” during the 2011 Wharton Private Equity and Venture Capital Conference.

Panelists agreed that many troubled companies and their lenders were still using a strategy of “delay and pray” for better times, which has kept the firms off the market. But speakers said the strategy is likely to fade as beleaguered companies turn to private equity investors for sorely needed funds. This will create a wealth of fresh opportunities for firms that specialize in turning around troubled assets, according to members of the panel, which was moderated by Michael Ranson, a partner in Blue Wolf Capital in New York.

Ranson kicked off the session by asking the five panelists how the current economic cycle was affecting private equity deals and how the cycle will likely play out. “We’re kind of taking a pause,” noted Harvey Tepner, senior managing director of WL Ross & Co., a turnaround firm in New York. Tepner said deal-making slowed sharply in 2009, but should make a strong comeback when the growing federal deficit drives up inflation and the corresponding rise in interest rates triggers defaults by troubled companies.

This will force borrowers that have been able to sustain operations in a period of low interest rates to restructure or sell out, Tepner stated. “Companies that have depended on ‘delay and pray’ will have their day of reckoning when they need to refinance debt,” he said. While he couldn’t say just when that day might occur, he predicted that it would be before the 2012 presidential election.

For now, Tepner said, his firm is looking for opportunities in real estate, banking and financial services. Health care companies could be another target of opportunity, he added, in the wake of the new health care reform law.

Banks Refuse to Call Loans

Gregory Segal, managing partner at Versa Capital Management in Philadelphia, focused on the unwillingness of banks to force troubled companies to meet their loan obligations. Calling the loans would require the banks to acknowledge that many of the assets on their books are actually in default, Segal said. Consequently, the banks and the companies are collaborating in a policy that he described as “amend, extend and pretend” with regard to bad loans.

This contrasts with the tough-minded policies that banks pursued before the financial crisis, according to Segal. Back then, nearly all of the firms that Versa invested in had a “bank with a gun to someone’s head” that forced the companies to sell or liquidate, he said. “Those people have disappeared for the most part in the past two years,” he noted, referring to such companies.

Segal now spots signs that point to more normalized deal volume. Some companies that might have amended their loan agreements six or seven times no longer see much point in further amendments, for example, and are open to taking in partners instead. Even companies that appear healthy from an income standpoint may be aware that their “leverage is intolerable and still unresolved,” Segal said.

Target companies pass through life cycles that resemble a U-shaped graph, Segal noted. They slump on the left side of the “U” and recover on the right. Versa invests when companies are at the lower part of the “U.” The firm typically buys debt on the left side of this cycle and prefers equity if the company is moving up on the right.

Segal added that economic conditions are now changing at “breathtaking speed,” citing the surge in cotton prices that could dramatically affect an apparel chain that Versa owns. “Distress is tied to the human condition,” he noted. “People make mistakes. They have bad strategies, or they execute poorly, or they get their hand caught in the cookie jar. Those are steady flows of deals. But if you are a player in our space, the number of variables and the volatility in commodities and the economic cycle is overwhelming.” This creates a level of distress that Segal said he has not seen in 20 years.

Other panelists pointed to growing investment opportunities in the real estate industry, which started the financial collapse and remains a drag on the economy. Colorado-based Real Capital Solutions expects to acquire $200 to $300 million of distressed real estate assets this year, according to founder and CEO Marcel Arsenault, who noted that the industry has always been highly cyclical.

A ‘Great Flushing Sound’

Eventually, the “blue light” signaling rock-bottom prices will go on, said Arsenault, and this will be followed by a “great flushing sound, which is going to be an opportunity of a lifetime” for real estate investors.

While the industry could face another two to four years of “extreme pain,” he added, “It will be sunny again.” Large real estate investment trusts already have made major investments in high-profile assets, he noted. “That bus has left,” he said. “But if you get out to Main Street and start looking at strip centers and office buildings in Peoria you’re going to find plenty” of attractive investments.

Panelists noted that the current economic cycle calls for a variety of investment approaches. Marc Baliotti, managing director at GSO Capital Partners in New York, described his firm’s successful experience in the auto and light truck market. GSO Capital aggressively bought out a company’s lenders at a sharp discount when the industry was reeling in 2006 and is now poised to benefit from a turnaround in the automotive sector.

On the other hand, GSO holds a stake in a Midwestern drive-through fast-food chain that has not yet recovered from the recession. “People are not driving through the window” because unemployment is in the high teens in the area, said Baliotti. “In that business, we are very defensively focused,” he noted, since GSO is managing the investment without taking new risks.

The fast-food business entered the recession about nine months after the automotive company and will probably exit nine months later, Baliotti predicted. “We try to time when particular markets will come back, and how strong the comeback will be, and position our capital accordingly.”

What most worries Baliotti about the current economy is that unemployment has remained stubbornly high. “We’re 18 months out and unemployment has really not declined, and that’s not been the case in previous recessions,” he said. “There’s a real case to be made that there is structural unemployment.” On the bright side, he added, the uncertainty about job security that the 90% of the workforce that is employed has experienced is beginning to clear, which should help to boost the recovery. “That second big flush [of investment opportunities] is coming,” he noted, “we’re just not sure when it will happen.”

Cleaning Up Portfolios

Maureen Downey, a principal at Pantheon Ventures in San Francisco, said the firm plans to increase its stake in distressed companies to between 20% and 30% of its portfolio over the next three to five years, up from about 15% five years ago. Downey expects a number of distressed companies to come on the market this year and next as pension funds and institutions that hold endowments retrench. “There is just an overarching need for institutions to clean up their portfolios,” she noted.

Downey specializes in secondary offerings and said the financial sector looks particularly attractive for such deals. Buyers of secondary offerings purchase their stakes from initial investors in private equity funds. Many current investors are now expected to exit the financial sector in response to the “Volcker rule” section of the new Dodd-Frank financial reform law, which limits activities by banks and financial institutions. Downey also looks for the “vast quantity” of private equity funds that were raised between 2005 and 2008 to begin to turn over as limited partners seek exits, “and that’s a great deal of volume for us in the next three to five years.”

Downey pointed to poor performers in the U.S. consumer Internet, health care services and software industries when moderator Ranson asked which sectors were likely to provide the best opportunities for distressed investing. Opportunities are also opening up in Europe, she said, as governments put public assets on the market to reduce debt. “Finally, I don’t think you can overlook the emerging countries,” Downey said. “We are an intertwined, global economy. There will be cycles in commodities, and you can’t overlook interest rates and currencies, but there is tremendous growth in the global middle class.”

Segal noted that Versa Capital does little prospecting and typically waits for deals to flow into the firm as if it were “an emergency room.” But he said the health care industry could become a source of distressed assets because of uncertainties surrounding the health care reform law, including its ability to survive legal challenges. “Uncertainty is great for my business,” he said. “When things are volatile, people get panicky and they make the wrong decision. They pull the trigger too soon or too late.”

He added that Versa’s own portfolio companies seem to be turning around. “Demand is coming back stronger,” he said. “I think we may have underestimated the recovery, just like we underestimated the decline.”