Distressed debt strategies need to wait for opportunities to emerge

The liquidity crisis continues to claim casualties. Although forecasts of company closures and bankruptcies across the board are increasing, now may not be the best time to start a fund focused on distressed debt.

According to Bill Maldonado of the Halbis Distressed Opportunities Fund, this is not an easy area to move into. Hedge fund managers are seeing some opportunities in convertible and merger arbitrage as well as in a number of other event driven strategies, says Maldonado. These strategies, unlike distressed debt, are fairly easy to move into and with some speed.

Distressed is a more elusive strategy. Maldonado believes it is rare to find a fund that does it well. It is a singular skill set that a manager needs together with a long credit education, says Maldonado. Managers need to understand in great detail long and complicated legal documents that define the rights of bond holder.

"The real skill," says Maldonado, "is how you are going to manage the fund in a way that is prudent and conservative and preserves capital between now and the time when the value in these distressed situations become more recognised. What you don't want is to be too early. You want to have some confidence that you are somewhere near the bottom of the stock price."

Maldonado explains why his fund chose a multi-strategy approach. "While the distressed side is unfolding we have ways of managing our investor's money and being able to move those assets away from distressed debt into related areas, like capital structure arbitrage, which is a great way of preserving capital until the opportunities in distressed become more appetising," he explains.

"What is likely to happen is the default rate should increase materially from a low basis over the next 12 to 24 months, perhaps a bit sooner than that. This would create opportunities for distressed debt funds like ours. The thing to add is that the default rate is acting on a much larger universe than the one operating last time around. Allowing for a greater number of companies to be exposed," concludes Maldonado.

Derek Stewart of Mellon Global Alternative Investments runs a dedicated distressed debt fund of funds. He has exposure to distressed debt in an event driven multi-strategy fund. Looking at the existing drivers in distressed, Stewart believes they vary from sector to sector.

Some sectors will not be so exposed to the current liquidity crisis. Sectors that are more exposed to the consumer - home construction, retailers and restaurants - are more vulnerable, says Stewart. Areas where consumers have less cash to spend will be the sectors hit the hardest during times of weak credit.

"I think the main drivers of distressed opportunities are always bankruptcies. The more bankruptcies there are, ultimately the better the opportunities. But it is important to differentiate between good companies that will recover and companies that will remain bankrupt and won't emerge," explains Stewart.

He notes that if a recession were to emerge, there would be more bankruptcies, more defaults and more companies coming under pressure to meet interest payments. Only then will fund managers will employ more of the classic distressed strategy.

"This is where you buy companies' debt really cheap and you go through the workout process and legal process to bring the company back from bankruptcy," Stewart says.

He warns not to get excited too early. Distressed debt could - and probably will - become more distressed before it gets better. Stewart expects the default rate to rise significantly. But he does not know when this will start.

Moody's Investors Service, a source for credit ratings, research and risk analysis, is projecting that the default rate 12 months from now will rise to just under 5%. When the default rate begins to rise, downward pressure may be greater on existing supply of distressed debt. Entering into this strategy is now optimum when the default rate is increasing and prices falling.

Stewart agrees there is nothing at present to get particularly excited about in the distressed sector. He expects few opportunities in the next six months. "The default rate in the US is 1.3% and in Europe it is 0.2%, which tells you there are not a lot of defaults," says Stewart.

"The last time we were excited about distressed was late 2002 early 2003. Rather than 20 bonds in the distressed index as there are now, there were 436 bonds in the index. That's when we get excited, when we have a large supply of opportunities to pick through. And you pick which are the best companies with the best recovery rates."

Stewart thinks the excess supply of credit in recent years and relaxed lending standards will eventually lead to opportunities in the distressed debt area over the next three years and see potentially huge offerings. Excessive credit positions will eventually expose weak companies, he believes.

According to Stewart many companies are not likely to survive any prolonged economic downturn and will have to file for bankruptcy. This in turn will create a greater supply of distressed opportunities than seen in early 2002.

Stewart concludes: "The key to success in any distressed strategy is: understanding the business, understanding the value and working out the recovery rate."

DISTRESS CONTINUES TO IMPACT VALUATIONS

Tim Gascoigne, portfolio manager at HSBC Alternative Investments Limited (HAIL) sees some profits available from the distressed sector. He says valuations continue to be affected in the short term by distress in the credit markets and cautions that extreme volatility could negatively affect valuations because of limited liquidity and a flight to quality by investors.

Although increased volatility levels and new issuance may be good news for convertible bond managers, those who are heavily invested will face a tough environment, comments Gascoigne. Widening credit spreads and an overall de-leveraging has stressed an already illiquid market.

As issuers have been forced to re-price new deals lower, in order to attract investors, secondary market prices have been forced lower, hurting managers on a mark-to-market level. Those with free cash and low levels of current investment will benefit as they are able to buy into cheap new issue converts.

A premium has also been added for liquidity, reflected in the outperformance of larger cap over smaller cap issues. Several managers have used this opportunity to reduce the overall duration of their book and increase their credit quality.

"Due to heightened levels of volatility and the expected elevated issuance levels, with a robust pipeline over the next few months, we maintain our position of neutral/positive," adds Gascoigne.

He says default rates are slowly picking up in high yield/distressed where there are modest profits from select bankruptcies and short exposures. "Credit markets remain under high stress levels, largely felt as cash markets continued to weaken, with poor bid levels from both bank proprietary desks and investors," he says.

Overall he says the outlook for the distressed strategy remains neutral given the potential opportunities for the next 12-18 months. "We remain negative on the high yield space due to the continued stress in the markets."

In fixed income arbitrage some managers have highlighted the decreased risk/reward profile of directional shorts in credit, which have been profitable for the past couple of months, says Gascoigne. "The implied probability of default seen in spreads is so drastic it predicts a default of a scale that has not been seen in decades."

However, many managers do not agree. At some wider level of spreads, a general clearing of the backlog "would occur as forced sellers and deep bargain hunters emerge". He believes the increased levels of volatility and the increasingly attractive prices of depressed assets should be good news for this strategy.