The credit crunch has the makings of a protracted distressed debt cycle, but many believe this is still years away. STEPHEN SHORE talks to institutional investors weighing up whether to sort through the plethora of new specialist distressed debt products in order to take advantage of some short-term opportunities.
“This is a once-in-a-twenty-year opportunity,” reckons Charles Wall, director of institutional business at Putnam Investments Australia. He is not alone. Over the past nine months, literally hundreds of new funds have sprung up to try and take advantage of the dislocation in debt markets stemming from the credit crisis.
The challenge for institutional investors is to determine which of these opportunistic managers have the skill to exploit the persistent opportunities in credit, says David Field, associate director in the ‘implemented absolute return’ division of Queensland Investment Corporation (QIC). “An average manager can take advantage of a price dislocation because it is primarily a beta opportunity,” he says. “But there will be greater differentiation of credit managers than we have seen in previous cycles because of the anticipated greater dispersion in default and recovery rates. Manager selection in the credit space has never been as important as it is now.”
One fund confident in its manger selection is the Australian Reward Investment Alliance (ARIA). The fund allocated around 1 per cent of its $19 billion portfolio to distressed debt in the second half of 2007. It has hired one manager so far. Appointed with a dry powder mandate, the manager made its first draw down – 5 per cent of the allocated capital – in June. Alison Tarditi, chief investment officer at ARIA, says that to identify the right manager, the fund “understood capturing sound long-run returns without undue risk would require patience, a specialised skill set, and a hedging strategy. “We sought to hire a manager with a long record of success that would only invest our capital when genuine opportunities to meet or exceed our hurdle rate of return, within limits, arose,” she says.
However, some super funds are hesitant to hire an opportunistic manager. Sam Sicilia, chief investment officer at the industry fund Hostplus, says that the problem with an event the magnitude of the credit crunch is that it has sparked the creation of funds by a whole lot of managers who do not have experience in either credit markets or the institutional space. “We are inundated by them,” he says. “It takes so much time to filter down to the mangers that have genuine skill and opportunities.” That is not to say he would not consider a specialist manager, Sicilia says, but when you have an event of such a huge magnitude as the global credit crunch, it is reasonable to expect that things will snap back. “If that happens in the short term, then you have gone through the diligence and cost of hiring a manager whose opportunity set will soon disappear,” he says.
Sicilia recommends that the first port of call for funds seeking to take advantage of the market dislocation should be to check the capabilities of its existing bond managers. “We extended the mandate of [international bond manager] Loomis Sayles in 2006,” he says. “It wasn’t because we foresaw the credit crunch. We made a decision that we wanted to move the capitalisation structure, so we gave the managers the discretion to switch between high-yield debt and bank loans. The manager has the freedom to move and take advantage of opportunities as they arise, the legals and due diligence is already done, and when the opportunity dries up the manager can go back to focussing on the original mandate.”
While the opportunity may be short-term, ARIA’s Tarditi says that dislocations in markets can provide attractive entry-prices to sound investment strategies for the long-term. “Distressed debt is a genuinely compelling long-term investment strategy because it is diversifying and the market is inefficient, given that many investors are forced sellers of debt on downgrades,” she says. “But a primary issue when acute dislocations arise is that there is often an influx of new managers seeking to capitalise on the theme to grow their funds under management.”
She cautioned that in this environment, the success of the investment is likely to be heavily reliant on employing managers with deep experience in identifying which risks to take and which to avoid, as well as ensuring that the strategy satisfies overarching risk controls for the fund overall.
Whether to go through the hassle of appointing a specialist manager appears to depend on whether the investor sees the dislocation caused by the credit crunch as an isolated aberration with its own opportunities, or the beginning of the next deeper and longer distressed debt cycle.
With so many mangers offering different strategies, it might be both. For instance, Wall at Putnam says that institutional investors with a tolerance for illiquidity are well placed to take advantage of an unusually high liquidity risk premium. He says that in derivates with no credit risk, such as AAA rated commercial mortgage-backed securities, the yield has gone from a historically stable 25 basis points (apart from a small blip when the hedge fund Long Term Capital Management imploded) to a yield trading at between 100-300 bps, “depending on which month you look”. Wall says what is most distressed in the current market is liquidity; the opportunities in credit risk are still some time away. Derek Stewart, managing director at Mellon Global Alternative Investments, was in Sydney in July to talk to institutional investors about opportunities in the Mellon Recovery Fund, a hedge fund of funds dedicated to distressed debt.
He agrees the premium is currently in liquidity, but believes that the next distressed cycle is not far away. “We figure it will take investors six months to do their due diligence on us, by which time we should be getting into the swing of the next distressed cycle,” he says. “There will short-term liquidity opportunities, such as in senior secured bank debt, for the next 12 to 24 months” Stewart says. “But most of your money is made in the end phase of a distressed cycle when companies are restructuring.”
He cautions that the best credit managers are likely to reach capacity quickly, and investors waiting for the perfect timing could miss out. The underlying managers in the Mellon Recovery Fund specialise in different regions, sectors, capital structures, and the way they execute their exposures. Stewart says that while it might suit some funds to extend its existing mandates, hedge funds’ flexibility to go long or short gives them an advantage over the traditional bond managers. He adds that outsourcing manager selection to a fund of funds is an obvious solution for funds unable to do the due diligence on the proliferation of new managers.
Whether it is for the short or the long term, or there is enough skill to go around, the consensus is that opportunities abound.