But while it seems clear that severe credit distress is imminent, and credit securities are “getting smashed” across the board, it is still too early, he believes, to invest in many of the distressed debt funds being marketed. Indeed, some vehicles have returned money to investors because the anticipated distress hasn’t yet occurred. Buying this truly distressed debt is dangerous. “If you’re willing to stand in front of that bus, you’ll need to double your money”, says QIC’s Field. “It’s not just buying something that’s cheap; it’s changing a situation.”
True opportunities in distressed debt are typically scarce, and there are few managers with the skills to pick them, says Harry Liem, senior consultant with Mercer IC. Nevertheless, “some people are waiting and have deep pockets,” according to Field. QIC may be among these investors. Field says the manager’s fixed income division takes a long-term approach, and says an allocation to distressed debt within the year is likely.
Mercer is also eyeing the asset class closely. Russell Clarke, the firm’s chief investment officer, expects the falling prices of distressed debt securities to begin to settle, but is waiting until Mercer estimates they have hit bottom. “There is probably room to fall further,” he says, and while some assets might be available for a fraction of their full value, there are good reasons why some have attracted bids as low as 30 cents in the dollar. “This is one of the most significant crises in credit markets, but where is the entry point? If you’re prepared to brave it, it could be a good time [to invest],” Clarke says.
But overly cautious investors can miss prime opportunities: when credit markets recover, they will snap back sharply, he adds. The best opportunities will probably be distressed loans, some of which are high-quality, Mercer IC’s Eagleton says. “It’s stuff that’s not to do with the mortgages but the general drying up of liquidity in the system.” Many institutional investors are already exposed to distressed debt managers through allocations to hedge funds-of-funds (hedge FoFs). Stan Beckers, head of alpha management at Barclays Global Investors, pointed out last year that the mean commitment to distressed debt within these hedge FoF allocations would be around 8 per cent.
Distressed debt managers have recently been focused on mispriced mortgage securities, senior secured debt, and special situations, Liem says. Vult ures wait in the wings In a report titled, ‘Until debt do us part,’ published in October 2007, Liem and Mercer IC associate Chris Collins surveyed hedge fund managers about which strategies they saw as the most fruitful in coming years. For the next 12 months, 27 per cent of respondents saw good opportunities in distressed debt, while 64 per cent saw merger arbitrage as the most lucrative play.