Distressed hedge funds come in a variety of styles and strategies, but all their managers have one thing in common: “We’re ambulance chasers,” one says, referring to the fact they’re always looking for securities suffering financial trauma. These funds aren’t for the faint of heart. While they aren’t all high-risk, even the wealthiest of clients may not be suited to them if they can’t cope psychologically with a fund full of battered holdings. But clients who can, stand to make a lot of money.
Buying low—really low
One form of distressed investing involves buying corporate bonds trading at a large enough discount that if the company goes through restructuring or bankruptcy, bondholders will be covered, explains Matthew Skipp, president and CIO of SW8 Asset Management in Toronto.
“Generally, a company that’s going completely bust is a losing scenario for everyone,” he says. The focus is instead on companies that are either going through restructuring that doesn’t end up in bankruptcy, or that restructure post-bankruptcy.
“Say you thought a company’s bonds were protected enough that you were willing to pay 20 cents on the dollar. They are obviously under massive distress, but [you can see that] if the company goes into bankruptcy, you would eventually get paid back—and then some.” If there’s a restructuring, Skipp adds, a distressed specialist quite often negotiates both debt and equity in the new company, which is in much better financial shape.
Most bond managers who aren’t in the distressed space are limited by their mandates to invest only in securities above a certain credit rating. When a bond becomes distressed and its rating drops, these managers are forced to sell. “When the bond drops below a certain credit rating, the sell-off can be pretty dramatic. That creates an opportunity for distressed investors” because they’re not under the same credit-rating constraints as other managers. Distressed managers are able to buy the bonds at prices well below what would be dictated by the company’s remaining value. But the strategy isn’t as easy as it sounds, and Skipp warns it should only be attempted by distressed specialists. They interpret balance sheets, gauge the sale value of hard assets and understand the complex nuances of bond covenants. The last is especially critical because misreading a covenant could result in wrongly assuming you’re higher on the creditor ladder than you actually are. Such mistakes can mean devastating losses (see “Skills of distressed specialists,” below).
Skipp adds the risk level of some distressed-focused funds is “very high, but the payoff can be enormous.”
Building a distressed fund
“Securities of issuers undergoing distress are more likely to be mispriced than others,” says Olivier Blechner, CIO of Distressed Strategy at Polygon Global Partners LLP in London, U.K.
He runs a distressed-focused fund and scans the globe for corporate bonds and bank loans. He ranks companies according to which have dropped the most in the past couple weeks. “I then eliminate [names] that are going to die and nobody’s going to miss.” Blechner refers to each bond play in the portfolio as a situation, reflecting the fact that owning the bonds may, for instance, mean being represented in court during bankruptcy proceedings. “I like to have about 15 situations in the portfolio. And rather than find 15 from Europe or 15 from the U.S. or 15 in oil and gas, I try to find the best 15 to 20 in [the] distressed [space].”
Those picks must be idiosyncratic and uncorrelated, he adds. That means two things: first, what happens on equity markets should have little to no impact on how his picks perform; second, the outcome of any given situation in the portfolio should have no effect on the others. So, if a stakeholder in one situation’s bankruptcy proceeding wins a lawsuit, it may impact how much the fund makes from that play, but should have no effect on other parts of the portfolio. He also wants the upside to be a multiple of the downside. So, he won’t buy at, say, 52 cents on the dollar if he thinks the bond’s worth 65 cents. “It’s not enough of a target return for me.”
Long and short
Blechner uses both long and short positions. Here’s an example of each.
In December 2013, he began examining a multinational telecommunications firm.
“We had seen that the company over the years had done some pretty funny things: [it] inserted new holding companies and moved guarantees around. I thought, ‘That smells funny; it doesn’t sit right with me.’
“Its senior bonds at the time were trading at around 70 cents on the dollar, subordinated bonds at 50. My view was the subordinated bonds were actually pari passu, [i.e.,] at the same [creditor] ranking as the senior bonds.”
Blechner’s call on the subordinated bonds’ treatment was correct. The company filed for bankruptcy and there was a settlement between it and the major creditor groups, whereby the subordinated bonds got a significant uplift.
One of Blechner’s shorts is a large U.S.-based coal producer. Chinese steel manufacturers are one of its biggest customers. The company had far more debt and far less liquidity than its peers.
“[Last year,] we saw China’s imports going down and we had a view that coal was likely going to come down,” he says, adding he modelled potential outcomes and predicted the company would likely file for bankruptcy in 2015.
His analysis also suggested security owners with the highest payback priority would not get all their money back, meaning lower-ranking bondholders would get nothing.
In April of last year, the firm sold a new bond issue to investors, who took a bullish view of the company. “We completely disagreed with that view,” says Blechner, adding he immediately shorted the newly issued bonds.
The bonds were second lien, which means they sat one level below the most senior issues. They’re now trading at about 10 cents on the dollar (as of April 14, 2015). “I like shorting high-priced bonds of companies we believe will be in serious trouble within, say, a year, and where the security has a high probability of being impaired.”
Blechner adds the great thing about shorting high-priced bonds is it’s an asymmetric bet. For example, if you short it when it’s at 90 cents and you’re wrong, you only lose 10 points. But if you’re right and it goes down to 20 cents, you make 70.
But he still hedges his bets. “What happens if coal prices go up 50%? All of a sudden this becomes a very cash-flow-positive company. [To] mitigate that [risk], we bought a very small amount of equity. My base case is [the equity] is going to be worthless; in the case where coal prices go up, the bonds go back to par, but the equity flies.”
Distressed structured products
Another distressed strategy focuses on securitized loan pools. These exploded in popularity in the early and mid-2000s; their implosion took centre stage in 2008. But there’s money to be made on debt still teetering in the aftermath of the crash.
Here’s how these pools were built. A bank bundles debt, such as corporate loans and commercial or residential mortgages, into a bankruptcy remote trust. The bundle’s divided into sections and securitized; the securitized sections are called tranches, which get a credit rating based on the structural protections of the underlying debt. Pre-crisis, some were rated AAA, others B, and others everything in between. Higher-rated tranches get lower returns but are first in line for payouts; lower-rated tranches get higher returns but are last in line for payment if things turn sour.
“As we went through 2008 and 2009 in the U.S. […] a lot of the underlying assets severely deteriorated,” notes Marjorie Hogan, CIO at Altum Capital Management LLC in New York. As a result, “not every tranche is likely to be paid in full; those distressed tranches are among the investments we make.”
In many cases, Altum is buying the right to interest payments from the tranches’ underlying distressed loans. “You’re legally entitled to everything, including the principal, but you’re not likely to get anything but four or five years of interest,” Hogan explains.
Return on investment is essentially the difference between the price the firm pays for the right to the interest, and the cash flow the interest payments generate. So, the tranche’s seller has offloaded the risk to Altum.
To mitigate this risk, Hogan, a Stanford math Ph.D., and her team have built statistical models to evaluate the contents of tranches they’re considering investing in. “We’re trying to understand the behaviour of the individual assets in the pool. If they’re corporate loans, for instance, we want to know something about their creditworthiness.”
The models allow them to project whether and for how long interest will be paid. They also model prepayment probabilities. “If you estimate 20% of corporate loans will prepay this year, and instead it’s 40%, […] it can shorten the tranche,” says Hogan. “So, instead of getting seven years of interest, you get three.” She emphasizes that, in most cases, it’s unlikely a distressed tranche will rebound to pre-crisis performance. “Usually the impairments are permanent. The tranche has a number of defaulted loans and they’ll never be made up. So it’s a question of estimating the return from what remains.” She adds that, to reduce risk, her fund doesn’t use external leverage. “We’re not strictly barred from it, but we’ve never used any.” Investors include endowments and foundations, institutions and high net-worth investors.
Distressed stress test
Olivier Blechner of Polygon Global Partners LLP in London, U.K., models what he believes would happen to his portfolio in the event of a major shock.
The scenario he runs assumes stock markets drop by 30%, unsecured credit spreads widen by 75% and secured spreads widen by 50%.
“We want to be standing if that happens, and try to take advantage of lower security prices. But our biggest protection comes from the fact we have both long and short positions,” Blechner says, adding that a variety of hedging strategies provide further safeguards.
Skills of distressed specialists
Distressed investing is a highly specialized discipline, says Olivier Blechner of Polygon Global Partners LLP in London, U.K.
In his view, you have to be able to answer three main questions:
1. How big’s the pie?
An investor must be able to gauge the difference between market price and a company’s intrinsic value.
Blechner looks for good companies with bad balance sheets, and says he tries not to touch bad businesses with bad balance sheets—even if it appears their liquidation value may be higher than the current price. “[Often] they turn out not to be as cheap as you think,” he says.
2. Who gets what?
“You have to be able to do all the legal analysis,” says Blechner. “It’s important for us as investors to understand the documents ourselves.”
This acts as a barrier to entry. “It’s the first hurdle: Are you willing to do that much work?” Blechner and his colleagues each go through the documents, which include bond indentures, and then meet to discuss what they found.
“It’s really about determining, for each key constituency in the bankruptcy process—bank creditors, bondholders, the pension plan, employee representatives, management, etc.—who has what rights under the documents.”
3. How do you maximize value?
Stakeholders have varying degrees of negotiating leverage, depending on what the documents prescribe; but ambiguities in the legal language can trigger prolonged negotiations or even lawsuits, notes Blechner. Prepared and tenacious parties are more likely to achieve a better result.
He adds that the specifics of this preparation depend on jurisdiction. The rules governing bankruptcy vary significantly from one to the next.