Liquidity Risk in the Bond Markets

According to an article in the March 21 edition of Pensions & Investments, hedge fund strategies focused on bonds such as relative value and long/short credit are facing increased liquidity risk due to unintended consequences of regulations such as Dodd-Frank and Basel III.  This is especially true in the junk bond arena.  The legislation closed the proprietary trading desks of the banks and increased capital reserve levels have caused a liquidity crunch.  In the past, the proprietary trading desks were the primary trading counterparties for hedge funds.  Some funds that have closed include Claren Road Asset Management, Third Avenue Focused Credit Fund, and Lutetium Capital.

Fund managers have responded in a variety of ways.  They have traded in smaller amounts, reduced their leverage and expanded their counterparties.  According to Aaron Dalrymple, head of credit at Cliffwater, smaller transactions of $5 million in capital are easier now.  There has been some outreach to pension funds and endowments as new trading partners, either directly or through a dark pool in Liquidnet.

Until the liquidity issue is resolved, firms are scaling down or closing credit strategies.  Investors have agreed.  In the second half of 2015, alternative investment data provided eVestment stated that there was no demand for credit strategies.

Hedge Fund Hopes for 2015

Since the global credit crisis of 2008, the central banks of various nations have been using various utilities (i.e. non-existent interest rates, quantitative easing and expanding their definitions of conservative debt) to prop up asset values to protect the banking industry according to Frank Brosens, co-founder and risk manager at Taconic Capital Advisors in New York.  These actions reduced asset price volatility and hedge funds' opportunities to produce alpha.  This is now ending.  The last three months of 2014 saw increased volatility and portfolio managers are predicting it to continue in 2015.

Managers with different strategies are seeing good investments:

• Long/short
• Joel Greenblatt, managing principal and co-chief investment officer of Gotham Asset Management in New York, believes there are "..good opportunities on the short side with currently very expensive stock prices if the market drops."
• Eric Mindich, CEO of Eton Park Capital Management in New York, is long in Japanese and Chinese markets.  Both countries will benefit from cheaper oil prices and valuations are very low in China.
• Global macro - Kenneth Tropin, chairman of Graham Capital Management in Rowayton, Connecticut, is monitoring the quantitative easing initiated by Japan's and European central banks, the improvement in the US economy and unrest in various political hotspots around the world.
• Multi-strategy - Michael Hintze, CEO and senior investment officer of CQS (UK), sees short trades based on geopolitical situations (i.e. Ukraine and Russia), failling oil prices and terrorist activities.
• Credit - Several fund managers are positioning their funds on different themes.  The most interesting one is from Paul Twitchell, partner and global head of event strategies of Whitebox Advisors.  He is looking at energy-related distressed debt.  He is interested in "...supplying secured debt to energy companies at a certain price..."

The source for this article can be found at here.

Update on TXU Corporation LBO

In 2007, a group of private equity firms and investment banks bought TXU Corporation for $45 billion in the largest leveraged buyout transaction.  The company changed its name to Energy Future Holdings Corporation but the fact remains that it is in trouble.  This is due to lower gas prices (the U.S. fracking expansion) and demand (from the recession and jobless recovery).  Two years ago, the debt associated to the deal was trading at a discount.  As of March 31, 2013, KKR has thrown in the towel and is valuing the bonds at 0.05 of cost.

On April 15, the company proposed to re-structure its $32 billion in debt.  Equity owners would be wiped out and the senior debt owners and the original private equity consortium would split the company 85%/15%.  Already, distressed debt managers Franklin Templeton Investments, Apollo Global Management LLC, Centerbridge Partners and Third Point LLC are buying debt which would be converted to equity stakes in case of re-structuring or bankruptcy proceedings.

A few institutional investors were unlucky enough to have negotiated terms to invest directly in the buyout.  Others were only invested in the private equity funds leading the deal.  Some of them are the biggest pensions such as California State Teachers' Retirement System, California Public Employees' Retirement System, Washington State Investment Board, Oregon Public Employees' Retirement Fund, New Jersey Division of Investment and Pennsylvania State Employees' Retirement System.  According to TorreyCove Capital Partners LLC of La Jolla, California, KKR 2006, the fund with the TXU deal, will still have a higher return than the S&P 500 in 2012.  KKR 2006 returned 7.09% versus 3.25% for the index.  The privileged co-investors included California State Teachers' Retirement System and Government of Singapore Investment Corporation.  There is no word if either managed to offload their direct investments through the secondary market.

In another twist, some fund managers think that Energy Future Holdings could extend its debt into the future. Since 2009, the company has re-financed $25.7 billion of its debt.

The source for this article can be accessed here.

Study Shows CDS Trading Increases Bankruptcy Risk

In a previous post, we looked at the bankruptcy and re-structuring process through the court system.  We detailed that the debt holders are converted into equity holders.  Any debt holders with a 33% position have a blocking position to approve any deal.  At the same time, they can hedge their holdings by purchasing credit default swaps (CDS).  Since the recovery rates for a re-structuring range up to 65%, a March study by Marti Subrahmanyamy of New York University's Stern School of Business, Dragon Yongjun Tang and Sarah Qian Wang of the University of Hong Kong's School of Economics and Finance indicates that fully insured and over-insured investors push the company into bankruptcy to recover 100% of their bonds' value.  They are called empty creditors.  They have "an economic interest in the firm's claims but no risk alignment with the other bondholders..."  Companies with empty creditors have higher bankruptcy rates due to less monitoring.  This may lead to higher risk taking by the borrowers.  Finally, companies that have CDS traded on them have more debt holders or lenders.  This impedes the re-structuring process.

The authors analyzed data for 901 CDS for North American companies between June 1997 to April 2009.  Of the 1,628 firms that filed for bankruptcy, 60 had CDS traded.  They reviewed the 3,863 companies that had their credit rating downgraded by Standard & Poor's.  Statistical analysis confirmed the following after CDS began trading on those firms:

• Majority of firms are A or BBB rated
• S&P ratings fall for investment grade firms (A, AA or AAA) and more firms become non-investment grade (BBB and below)

When a company is the underlying for a CDS, it is more likely to be downgraded by a rating agency as a precursor to bankruptcy.  This occurs more readily when there are more CDS contracts traded and when re-structuring does not trigger a payout on the contact.  The probability of bankruptcy is 0.33% versus 0.14% for a non-CDS traded company.

The source for this article, with the authors' statistical analyses, can be accessed here.

Institutional Investors Favor Long/Short Equity, Macro and Special Situations in 2012

The following chart was published on Pensions & Investments Online website from Deutsche Bank's 2011 Institutional Survey.  1 in 4 institutional investors will be adding to its hedge fund investments in 2012.  Long/short equity, macro and special situations seem to be the most popular.  Distressed and long/short credit are the least.

The source for the article can be accessed here

Distressed Debt Funds Seeking Exit Strategies for Their Investments

Distressed debt hedge funds took control of many companies that filed for bankruptcy during the credit crisis in 2009.  They are now seeking the traditional avenues for their exit such as an IPO or selling the business.  They include Cooper Standard (Silver Point Capital and Oak Hill Advisors), Delphi Corporation (Silver Point Capital and Elliott Management), Dura Automotive (Patriarch Partners) and Lear Corporation (Goldman Sachs) in the auto sector.  In the media sector, companies include Vertis Holdings (GE and Avenue Capital), Source Interlink (JP Morgan Chase) and Charter Communications (Apollo Management).  While in bankruptcy re-organization, the companies managed to close unprofitable divisions, reduce expenses and resolve issues with unions.

The source for this post can be accessed here.

Uneasiness in the Credit Markets

The credit markets are pricing in the uncertainty caused by fear of a European debt crisis which will cascade into banking failures.  Some of the market reactions are:

Spreads Up/Prices Down

• In the credit default swaps (CDS) market, the bid-ask spread has risen to 5.4% from 3.0% of the annual cost of the contracts on the 15 most traded CDSs on US investment grade companies.  The 3.0% figure is from August 1, 2011.
• The Bank of America Merrill Lynch Global Broad Market Index has reported that spreads on bonds have increased from 170 basis points at the end of July to 231 basis points.
• The Barclays Capital Global Aggregate Corporate Index has an absolute yield of 3.82%, up from 3.67% on August 19th.
• The Markit CDX North America Investment Grade Index has risen to 122 basis points from 96.3 basis points in August.  This index increases as investor confidence improves.
• The Barcap CMBS Super Duper Index has a relative yield of 3.03% compared to 2.13% on July 25th.
• The Standard & Poor's/LSTA US Leveraged Loan 100 index is down 4.7% in 2011.

Investors have de-risked their portfolios by moving out of the leveraged loans and distressed debt.  Banks are continuing to close down their proprietary trading desks and lowering their exposure to corporate debt.  They are not committing capital to facilitate trades or acting as a principal.  There is less liquidity in the market because of these factors.

The source for this article can be accessed here.

CDO: Alternative Assets Being Used as Underlying Assets

CDOs were created to use bonds, mortgages and commercial loans as the underlying collateral.  In the last ten years, they have begun to use alternative assets such as distressed debt, hedge funds, commodities and private equity as the underlying.  They have also created CDOs with one tranche.

Distressed debt is defined as securities of companies in default or that are trading below investment grade.  They have a yield of the Treasury rate plus 10%.  The portfolio of the CDO may include both distressed and not distressed debt.  By the structure of the CDO, the rating of the senior tranche is higher than the underlying portfolio.  Investors can gain access to distressed debt and limit their risk.  Banks are the main sellers of distressed debt to CDOs.  It cuts their losses on the debt, offloads their liabilities to the CDOs and frees up reserve capital by reducing their nonperforming assets ratio.

Collateralized fund obligations (CFOs) have multiple hedge funds as the underlying assets.  The institutional investors interested in this vehicle are pension funds, insurance companies, mutual funds and high net worth clients.  The hedge funds are aggregated under a fund of fund manager.  The manager has restrictions on the total number of hedge funds, number of investment strategies and percentage invested in each fund.  The restrictions are set by the rating agency.  When the payments are due to the investors of the CFOs, the fund of fund manager has to notify the hedge fund managers to redeem the investments.

Commodities can be the underlying assets for collateralized commodity obligations (CCOs).  More accurately, the assets are Commodities Trigger Swaps (CTSs).  These transactions trigger a payment when a condition is met.  An example would be when the price of the commodity hits a price target.  The CTSs would be based on a basket of commodities.  They would avoid extremely volatile assets.  The trigger events would have to be substantially spread out to avoid multiple payouts at the same time.

Unlike normal CDOs, single tranche CDOs (STCDOs), also known as bespoke CDOs or CDOs on demand, only create one tranche.  They are structured as synthetic CDOs, using CDSs to receive premiums to pay the interest rate on the CDOs' securities.  In this security, the investors have more control over the terms than in a CDO with multiple tranches and receive all cash flows.  The advantage for the sellers is that they are cheaper and quicker to issue.  In a normal CDO, the entire risk of the portfolio is transferred to the investors.  In a STCDOs, only a specific portion of the portfolio risk is transferred to the investors.  The seller is still exposed to the underlying assets in this case.

CDO squared invests in other CDOs.  This allows for more diversification and higher spread returns for the investor.  Losses are incurred based on where (the tranche) bond defaults occur.  In a normal CDO, losses are incurred based on the number of bond defaults.  CDO squared may be cash backed or synthetically created and may invest in different tranches or specialize in one tranche across multiple CDOs.  There is a danger that the CDO squared may invest in assets that are in multiple CDOs.  Rather than diversifying the portfolio, these overlapping assets cause the portfolio to be concentrated in them.  This would cause greater losses than expected if the underlying assets default.

Lastly, there also was a CDO created with private equity investments as the underlying assets.  As with CFOs, there were restrictions on the total number of private equity managers.

Credit Derivatives: Some Basic Information

In prior posts, we have looked at credit default swaps.  Let's take step back and look at credit derivatives as a whole.  They are financial contracts such as options, forwards, futures, swaps and credit linked notes that are used used by fixed income managers to hedge positions (credit protection) or to enhance portfolio returns (credit exposure).  Through credit derivatives, portfolio managers are able to isolate and transfer credit risk, get liquidity in the market and have transparent pricing by trading the underlying credit.  Previously, they would have to hold the underlying assets in their portfolio which is capital intensive.  To manage risk using this method, the manager would have to look at each company's financial statement and balance sheet to rate their soundness.  He would also look at the industries of the portfolio companies and diversify loans to companies in different industries or sectors.

What is credit risk?  There are three components:  default, downgrade and credit spread.  Default risk is the risk that the bond issuer or loan borrower will not pay the bond or loan in full.  A loan is in default if a scheduled payment is not made.  Downgrade risk is when a rating agency such as Standard & Poor's, Moody's or Fitch's lowers the credit rating of the debt.  Credit spread risk is when the market spread between the underlying bond or loan increases for the remaining debt.  Credit risk is usually measured by rating agencies or using the credit spread.

What are the underlying / reference assets that credit derivatives are used for?  They are high yield bonds, leveraged loans, distressed debt and emerging markets bonds.  These assets have low to medium correlation with US equities and low or negative correlation with US Treasuries.  They have a high exposure to large declines in prices.  High yield bonds a.k.a. junk bonds are rated below investment grade by the agencies (either below BBB by Standard & Poor's or Baa by Moody's).  Leveraged loans are bank loans made to companies of credit ratings below investment grade or with a spread of 150 basis points over LIBOR (London Interbank Offer Rate).  LIBOR is the interest rate at which banks borrow from other banks in London.  In addition to the three credit risks listed above, the borrower can pre-pay the loan by re-financing or pre-paying the balance.  This is call risk.  There are to types of loans - revolvers and term loans.  Revolvers are committed lines of credit that also back commercial paper loans of companies with high credit ratings.  Term loans are given to companies with lower credit ratings, are funded commitments with fixed amortization schedules and are based on floating interest rates.  In addition to credit risk, emerging markets debt is exposed to political risk.  Distressed debt is composed of bonds of companies that are in default because of a missed payment, bonds going through Chapter 11 re-organization, the company having cash flow problems or have low credit ratings.

Options, futures and forwards are known as binary options.  They are similar to equity options.  If an event occurs as dictated by the terms of the contract, then the option seller pays money to the holder.  A credit-linked note is a bond with an embedded credit option.  These notes have a higher interest rate than regular bonds but the holder of the note provides the issuer with some credit hedge.  The referenced asset is either a corporation or a basket of credit risks.

A total return credit swap allows an investor to rent a balance sheet.  The investor trades the return of an asset for a guaranteed rate of return, usually LIBOR plus a spread.    The seller of the swap retains ownership of the asset.  For example, an investor could be positive on Apple bonds.  A swap can be bought on the returns of Apple bonds.  The buyer would receive that return and pay the seller LIBOR plus a spread.  The seller has hedged his position in Apple bonds and is now receiving payments of LIBOR plus a spread.

A Different Way of Looking at the Current Investing Environment

Members of CAIA were invited to an event sponsored by the New York Hedge Fund Roundtable last week.  Mark Yusko, CEO and Chief Investment Officer of Morgan Creek Capital Management (with $10 billion in assets under management), presented on how to invest in the current low return environment that he called the 0-3-5 problem.  Cash is at 0%.  Bond yields are at 3% and stocks are expected to return 5%.  In order to attain returns in the high single digits that investors such as pension funds and university endowments need, he proposes that investors move to a skill based portfolio.  There were a multitude of themes presented.  They centered around the lack of returns in the developed world and the rise of the emerging markets.

The best portfolios will not have alternative investments as a separate asset class.  They will ignore these classifications and integrate them.  A traditional portfolio may be 50% US equity, 15% international equity, 30% fixed income and 15% in hedge funds.  The updated concept will ask where the hedge funds invest.  In this example, let's say the funds invest in US equity.  Then the asset allocation of the portfolio will look like this:

• US equity 65%
• International equity 15%
• Fixed income 30%

Adding assets with uncorrelated returns such as hedge funds "can boost expected returns, while reducing portfolio volatility."  Private equity returns for funds operating during a recession are higher.  Yusko encourages investors to take advantage while funds are having difficulty with fund raising.

That being said.  Investing in US markets will be difficult.  The US is in danger of mirroring Japan on government debt, low interest rates and low growth in GDP.  Investors should concentrate in Brazil, Russia, India and China (BRIC) with an overweighted allocation in Asia.  Over the last 10 years, this has returned 250% cumulatively.  The Standard & Poor's 500 and NASDAQ have negative returns.  Credit Suisse, the World Bank and PricewaterhouseCoopers have predicted that China will surpass the US as the world's largest economy by 2020.  The emerging markets have the same forces that propelled the US to become the largest economy in the 20th century:  population growth and low debt in local companies.

Commodity prices will rise as the emerging markets nations develop.  As China and India industrialize, oil demand will rise.  The best way to play this is to invest in oil services stocks or indices such as OIH (Oil Services Holders Trust Index) or OIX (CBOE Oil Index).  Gold prices will continue to reflect the rise in US government debt as a percentage of GDP.  Other commodities with rising prices are platinum, palladium, corn and wheat.

Yusko also commented on various risk factors in the current environment.  They were:

• Inflation - There will be none unless there is growth in the money supply.  The Federal Reserve Bank is putting money into the financial system but the banks are keeping it on their balance sheets.
• Valuation - Stock valuations have been above the historical average since the 1990s.  The market will be reverting to the mean.
• Monetary - The Fed's Quantitative Easing 2 Program will end on June 30th.  US equity markets will be discounting by 20% for that event before the date.
• Growth - Rise in unemployment may signal low growth in Gross Domestic Product.
• Wealth - Housing prices continue to fall in the US and developed nations (i.e. Western Europe).
• Demographic - The US is an aging nation that will spend and grow less.
• Government - Deficit levels are not sustainable.
• Default - Municipal bonds, especially in California, Illinois, New Jersey and New York are in danger of defaulting.
• Sovereign - There may be another debt crisis in Europe because banks own the bad debt of Portugal, Ireland, Greece and Spain.
• China - The renminbi was re-pegged to the US dollar in July 2008.  This caused the dollar to strengthen and commodity prices to collapse.
• Devaluation of the dollar - Largest risk for US investors

One old rule still applies - diversify your portfolio.  In addition to the ideas above, he listed other possible assets:

• International Real Estate
• Absolute Return Strategies as a substitute for bonds
• Distressed debt in US and Europe

Thanks for the roundtable for setting up the presentation and Mark Yusko for presenting their views.

Is Your Portfolio Truly Diversified?

During the credit crisis of 2008, all assets (equities, fixed income, real and alternative assets) declined in value.  Welton Investment Management wrote a research report regarding asset allocation.  According to Modern Portfolio Theory, the most efficient portfolios have assets that are not correlated.  This minimizes any excessive decrease in assets during a crisis.

They tested this theory by taking 24 indices representing the 4 asset types and calculated the correlation of returns over 10 years across 2.5 business cycles.  They discovered that 80% of alternative assets and 75% of real assets were correlated with stock returns.  The alternative assets were private equity, event driven, long/short equity, distressed securities, multi-strategy, fixed income arbitrage, convertible arbitrage and risk arbitrage.  Only global macro and managed futures were non-correlated.  For real assets, infrastructure, real estate and TIPS (Treasury Inflation Protected Securities) were correlated.  Commodities was the only real asset that had non-correlated returns against equities.

The 4 revised asset types should be:

• Equities, correlated alternative and real assets
• Global macro and managed futures funds
• Commodities
• Fixed income

The research report may be accessed here.

Distressed Debt Strategy: Chapter 11 Bankruptcy Process

In a prior post, I had mentioned that, during the bankruptcy process, an investor can take control by holding 33% of the debt.  How can the investor have control with a large yet minority postion?  The answer is in the Chapter 11 process.  It gives the company breathing space for its debts and the ability to reorganize its capital structure.  This gives the company a second chance to become a profitable concern.

The company initiates the process by filing Chapter 11 petition with the court.  Upon receiving the filing, the court freezes debt and collection actions.  The company, now called the "debtor in possession" maintains its business operations and submits a reorganization plan to the court.  This plan may be "prepackaged" or may be created within 120 days of filing.  The company has to get the debt owners to accept the plan 60 days afterwards.  Obviously, if the debt holders are paid in full, the plan will be approved.  Otherwise, the plan is accepted if 50% of debt owners and if holders of 67% of the total amount of debt approve it.  This is when an investor with 33% of the debt holds a power position.  Since the investor is able to block any approval of the reorganization plan, this forces the company to negotiate with them.  After this original period has passed and no plan has been accepted, anyone can submit their own plan.  If the company agrees with the new plan, the court may approve it.  If none of the plans are acceptable to the company and debt owners, the court can force a cramdown plan.  Basically, the court tells everyone what the plan is.

Reorganization of the company usually means reimbursing debt, converting debt into equity and wiping out the current equity holders.  Within the company's bond structure, senior secured debt is paid back first.  Subordinated debt receive less than face value and other debt is converted to equity.

The source for the bankruptcy process summary is Mark Anson, The Handbook of Alternative Assets, pgs 483 - 487.  The book forms the core of the CAIA curriculum.

Distressed Debt Strategies for Private Equity

Distressed debt strategies can be classified three ways.  The investor can try to control the bankruptcy process by buying 33% of troubled company's debt.  Using this large position, the investor will take over the company by getting seats on the board of directors, obtaining ownership by wiping out the equity holders and converting the bonds into equity.  The large debt position allows the investor to influence any reorganization plan.  This is the riskiest strategy.  The investment period is two to four years and the target return is 20% to 25%.  The second strategy is to buy 33% of the bonds and use it only to map out the reorganization plan.  This is called an active investor not seeking control.  The holding period is one to three years and the target return is 15% to 20%.  The last approach is passive.  These investors buy distressed debt that is undervalued.  The debt may be used as part of a capital structure arbitrage strategy.  In this case, the investor buys the bonds and shorts the stock, hoping the stock will decrease in value more than the bonds.  The target return is 12% to 15% and the bonds are held for a year or less.

Using Distressed Debt to Take a Company Private

An investment firm may turn a public firm into a private firm by buying its distressed debt.  The target firm may be going through bankruptcy proceedings, close to defaulting or already defaulted on its debt.  There are four main methods of buying a company.  A leveraged buyout (LBO) may not have worked.  As part of the LBO, the banks providing financing issued debt to the buyside.  In this case, new investors will buy the loans of the failed deal at distressed prices.  During the bankruptcy process, the debt investors will receive all the equity of the target firm.  A second way is to buy the company's equity and initiate a turnaround of the company.  The last two methods involve Chapter 11 bankruptcy.  Before filing for Chapter 11, a reorganization plan where the debt holders convert their bonds to equity and become majority equity holders.  The public equity owners are wiped out completely.  The last method requires a major debt holder, primarily the company's competitor, to propose a reorganization plan.  This allows the competitor to obtain non-public material information about the target company and initiate a takeover.

2010 Hedge Fund Industry Review

Credit Suisse recently published their 2010 Hedge Fund Industry Review.  In a previous post, we had mentioned that the Dow Jones Credit Suisse Hedge Fund Index had returned 10.95%.  The good performance of hedge funds has investors returning.  Hedge funds have returned 31.55% since the bottom of the markets two years ago.

Of the ten strategies tracked, eight had positive returns with Global Macro, Event Driven and Fixed Income Arbitrage leading the way.  Global Macro funds used two themes for investing ideas:  intervention by central banks and commodities.  Event Driven funds using the Distressed Debt strategy found better investments due to the European debt crisis.  Fixed Income Arbitrage managers took advantage of the intervention by central banks to find investing opportunities.

The most successful strategies:  Global Macro and Event Driven received the most interest from investors.  Global Macro had $16.8 billion in asset inflows and Event Driven had $13.8 billion.  Multi-Strategy had $16.9 billion in outflows.

Small funds with assets under management of $100 million have outperformed large funds (with $500+ million AUM) by 3.95% annually.  They may be nimbler than large funds - being able to quickly get in or out of positions due to the smaller size or less bureaucracy - or they may be riskier.  During major market moves, the outperformance is more pronounced.  When markets are quiet, large funds perform on a par with smaller funds.

The research report may be accessed here.

Private Equity: Taking a Company Off the Market

Pension funds are one of the institutional investors that are part of the buyside.  Because of their long term view, they have invested in private equity and hedge funds - two vehicles that have varying lockup periods.  According to www.preqin.com, more pension funds (from 5.1% in October 2008 to 6.3% in December 2010 of US and Canadian funds) are investing more (from 5.7% to 7.5% of their asset under management) in private equity.  According to one article, private equity is replacing fixed income in portfolios.  I have even read that one pension is lowering its hedge fund exposure in favor of private equity (I am sorry that I cannot find that article.).

So, what is private equity?  It is an alternative investment in companies that do not have stock traded on an exchange.  The prime example in the news today is Facebook.  The main strategies are:

• Venture Capital - investing in start-up companies
• Leveraged Buyouts - buying an established public company and turning it into a private company
• Mezzanine Financing - combines private debt and equity investments
• Distressed Debt - investing in companies in financial stress

Since the credit crisis, private equity has struggled to raise funds.  In 2010, there was $225 billion raised.  In 2009, there was only $109 billion.  The high was $800 billion in 2007.

Distressed Securities Investing

Hedge funds using the distressed securities strategy invest in companies that are being reorganized, going thorough bankruptcy proceedings or going through some poor performance.  These companies have the lowest credit ratings from such companies as Moody's and Standard & Poor's.  The notes below are a summary of the article "Hedge Fund Investing in Distressed Securities" by T.Casa, M. Rechsteiner and A. Lehmann that was part of CAIA's curriculum.

There are five main sub-strategies:

1. Short
2. Long/short
3. Capital structure arbitrage
4. Value
5. Rescue financing

For stocks, the first has been tackled in a prior article.  A manager can be short by buying the derivative instrument credit default swap (CDS).  To sum up, the manager is obligated to pay a counterparty a fixed amount on the bonds of the distressed company.  In return, if the company has something known as a credit event, the counterparty pays the manager a fixed amount.  The details of the fixed amounts and credit events are listed in the CDS contract.  As the company's situation worsens, the CDS appreciates in price or the hedge fund receives the payment.

Long/short using bonds instead of equities but the premise is still the same.  The manager will establish a position in undervalued bonds and be short in overvalued bonds.

Capital structure arbitrage is similar to long/short except that positions are taken within the same company's securities.  The manager takes a long position in the senior securities such as senior bonds and a short position in junior securities such as stocks.  In the bankruptcy process, senior securities are favored if any assets are recovered.  In theory, the net value of the long and short positions should be positive i.e. the short position should decrease more than the long position.

Value managers take a long position in the company before it announces a reorganization plan to court.  They hope to profit from the rise in prices after the plan is approved by the company's creditors.  They can also take a long position after the plan is approved as other investors will not take the risk at this stage.

In rescue financing, the hedge fund lends money to distressed companies right to prevent bankruptcy filings or establishes a long stock position.

The above five substrategies differ in their approach and timing.  There are five stages in the lifecycle of a distressed company and each substrategy (in parentheses) invests during a certain stage:

1. Pre-default:  the company is restructuring  (rescue financing)
2. Early bankruptcy:  the company tries to restructure its finances;  usually by giving creditors an equity stake for debt reduction or extension  (short, long/short, capital structure arbitrage)
3. Mid-bankruptcy:  balance sheet is stabilized  (short, long/short, capital structure arbitrage)
4. Late bankruptcy:  company is almost recovered  (value)
5. Emergence:  company is recovered  (value)

In 2007, there were $105 billion in estimated assets in distressed securities; up from $30 billion in 2002.  With the market turmoil in 2008, this strategy will grow as there will be more distressed situations to invest in.

Maybe we can examine the bankruptcy process later.  There were many interesting articles in the Wall Street Journal about it during the General Motors and Chrysler crises in 2009.