Some institutional investors have begun appointing distressed debt managers, on stand-by as big financial institutions look for buyers of risky debt instruments that have slid in value. But many think there is room for the valuations of these assets to fall further. SIMON MUMME reports.

Despite the multi-billion dollar write-offs, stashes of venomous subprime debt and corporate loans whose values have dived for want of liquidity weigh down the balance sheets of big American investment banks. Would-be buyers stand by, looking for gold in the muck. Some hedge funds had already shorted the subprime mortgage securities market before it tumbled, with US firms Paulsons and Harbinger among the prescient.

Those who missed out the first time are now awaiting the second opportunity to profit from the carnage: by investing in some of these now-distressed assets for the long-term, according to Simon Eagleton, principal with Mercer Investment Consulting. But the valuations of these assets continue to reduce, and investors are waiting to see how much wider credit spreads will go.

The short answer? “No one actually knows what this stuff will be worth,” Eagleton says. Last December, there was approximately $430 billion of subprime losses in the global financial system that no institutions had owned up to, according to Peter Quinton, head of research at Bell Potter. He said that while a lot of subprime paper will be worthless, vultures are known to have bid 30 cents in the dollar for some of the derelict assets.

As early as June 2007, $9 billion hedge fund firm Marathon Asset Management announced it was setting up a subprimefocused distressed debt fund. In Australia, institutional investors are waiting to see how far valuations fall, and which assets their vulture managers want to pull out of the muck.

The Australian Reward Investment Alliance (ARIA) has set aside 1 per cent of its $18 billion portfolio to put into distressed debt opportunities as they arise. Alison Tarditi, ARIA chief investment officer, calls this strategy a “recession hedge”. According to David Field, senior portfolio manager in the global fixed interest division of Queensland Investment Corporation (QIC), investors should hit the distressed debt “sweet spot” some time in the second half of 2008, with more opportunities emerging in the following two years.

Field, who is responsible for researching and selecting external credit managers, says the definition of distressed debt has been stretched to include securities that have lost up to 10 per cent of their value, trading at $0.92 instead of $0.98, for example. Such assets were overvalued, not distressed. However, “about 80 per cent of the money in distressed debt vehicles goes to this type of debt,” Field says. Truly distressed assets have lost 70 per cent or more of their value, he says. Many of the subprime-backed securities that were written in late 2005 and onwards stand in this category.

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.

For the longer-term, 75 per cent viewed distressed debt as the most profitable strategy, with only 17 per cent keen to pursue merger arbitrage. For now, classic merger arbitrage is the strategy in which $14 billion multi-strategy US hedge fund manager Halcyon Asset Management is placing most of its weight. John Bader, Halcyon’s chief investment officer, says the firm has put 75 per cent of its money into merger strategies, 15 per cent to credit strategies and 10 per cent towards special situations.

The manager views equity long/ short strategies as crowded, limiting the prospects of generating alpha through them. Also, it doesn’t think conditions suiting a tilt to distressed debt strategies have yet materialised. This is due to an environment in which Credit Suisse reported that quarterly high-yield default rates in the US for Q4 2007 were at 2 per cent, compared to 18 per cent in 2002. “You make money when default rates have peaked and are on their way down. Right now high yield defaults are still low. The default rate will go up when the economy goes down the tube,” Bader says.

Yet Halcyon has recruited a team to buy asset-backed distressed debt. Pricing of debt of structured vehicles has dropped dramatically. Bader says the type of debt the firm is currently targeting is not corporate distressed, but involves other forms of “often misunderstood” credit, such as manufactured housing, aircraft leasing, AAA-rated non-subprime mortgages and credit card structured debt. The manager will also consider loaning money to midcap companies who may find it hard to draw money from seized-up credit markets.