Investors urged to act in times of distress

Despite a developing trend among private banks and institutions to allocate increased portions of portfolios to distressed debt, one or two dissenting voices have started to pour cold water over these renewed commitments.

“The real, real distress in the global economy has passed,” suggests Gary Dugan, Singapore-based chief investment officer for Asia and the Middle East at Coutts private bank.

At Coutts head office in London, the view is that distressed debt is simply a proxy of high yield investing, but with higher risk and much less liquidity. Other players, particularly multifamily offices, are also reluctant to advise their clients to take the plunge. “Distressed debt is the most over-hyped asset class we have seen for many years,” warns Khaled Said, chief investment officer at private investment office CapGen Partners. He says the unpredictable nature of political intervention in economies means the once traditional v-shaped recovery from recession, which would have made distressed opportunities attractive, is no longer guaranteed.

“Be careful what you wish for. The opportunities are no longer there for managers.” But these reservations are well away from mainstream thought on the topic of distressed investing, especially when it comes to recommendations for ultra-high net worth clients. Swiss stalwart Pictet, one of the more conservative private banks in the business, is only a recent convert to distressed investing. It is in the process of introducing a 2.5 per cent initial allocation to the asset class, alongside a 5 per cent weighting to commercial real estate. Currently, says Alexander Tavazzi, director of advisory at Pictet in Geneva, there is a uphill task for relationship managers to introduce some illiquidity into sceptical clients’ portfolios, even though risk-averse customers are blind to the benefits, preferring bonds currently yielding close to zero.

“Clients are volatility and illiquidity phobic; this is the name of the game today,” he says, with many investors getting flashbacks to the hedge fund sidepockets of 2008 and 2009. “The last thing they want is to be trapped for the second time in this type of arrangement.”

Rather than near-zero yields from cash and some fixed income segments, distressed debt typically  returns 5 to 6 per cent annually, says Mr Tavazzi. He is seeing key indicators favouring these troubled assets, with some semblance of liquidity gradually creeping in. Large tranches of mortgage-backed securities are starting to be traded by banks, and such activity will be further fuelled as the US Federal Reserve provides more liquidity with QE3, he says. “Some buyers are coming in as assets are being sold by banks, who are the biggest holders of [distressed] assets,” says Mr Tavazzi. Many clients are being “over-obsessive about liquidity and are missing the point in the cycle where investments such as private equity can make sense,” laments Iain Tait, head of the £3bn (€3.7bn) UK private clients business at London & Capital. The wealth management group has avoided constructing its own fund of hedge funds, fearing the effect of 2008-style closures on its client-base, but is aware that distressed investing opportunities are looking increasingly attractive. “We do not have distressed credit opportunities as part of our current offering, but demand is starting to come from investors,” says Mr Tait.

The plan will be to offer access to specialistthird party funds, most of which operate out of the US, including the likes of Oaktree Capital Management, which runs portfolios of distressed assets worth nearly $80bn (€60bn), Apollo Global Management ($65bn) and Avenue Capital ($20bn).

Crucial to the success of these funds in recent years has been their role in restructuring troubled US gambling and entertainment concerns. Apollo is one of the main investors in Caesars’ Entertainment Corporation. Avenue Capital took control of Trump Entertainment Resorts, founded by the colourful US property tycoon and US Apprentice host Donald Trump, in 2011. This empire includes a string of casinos in gambling hostspots such as Las Vegas and Atlantic City.

Buying up the debt or assets of failing companies can be a controversial activity, and few portfolio managers are prepared to speak publicly about their views. But if not exactly licking their lips about current distressed opportunities, it is no secret that the major players see this as a particularly auspicious time to be operating in their chosen business.

While comparisons are sometimes made with 1998, when the LTCM hedge fund blew up and emerging markets were in trouble, most see the current window of opportunity as offering a pretty unique set of circumstances. Unlike the uber-distressed times at the onset of the global financial crisis in 2008, with high yield defaults peaking at 75 per cent, when many even doubted the potential solvency of the US, there is enough faith in the global economy for deals to be made in a low-growth environment. Currently funds are looking at the legacy of the leveraged buyouts of 2004 to 20007, which subsequently left many businesses in trouble.

“We do our homework where there is instability,” says the manager of a distressed portfolio worth several billion dollars. “But these are economic risks we are facing today, not systemic risk as in 2008.” In addition to the gaming industry, sectors favoured by such funds include energy and independent power and the media.

High profile restructures which can prove attractive to distressed investors have included Kodak, American Airlines and recently-bankrupt Houston-based electricity provider Dynergy.

Because the major funds are US-based, they are happier trading on their own doorstep and can be reluctant to dip their toes in what they see as less liquid markets across the Atlantic.

“There is a lot of opportunity in Europe, with lower dollar prices, but the market is much less liquid,” warns a major US manager. “Hedge funds with liquidity issues need to be particularly careful in Europe.”

What both private banks and portfolio managers agree on is having a patient, longterm mindset, and the need to embrace a number of disciplines. These include not only due diligence, but also the type of skills learned across hedge fund, private equity and real estate management, in addition to the valuation backgrounds of long-only equity and bond managers.

To be successful in this area, says Jane Fraser, global CEO of Citi Private Bank, investors have to understand where they are in the cycle and act accordingly. Ms Fraser has seen her clients stepping up allocations to distressed investments since 2008, with evolving priorities.

Five years ago, the cycle started with the purchase of illiquid but intrinsically valuable securities from financial institutions. It then moved through the acquisition of majority and minority business and real estate interests being disposed of by corporations, banks and other enterprises under balance sheet stress. Investments today are more likely to be made in enterprises unable to access traditional capital markets, buying up post-bankruptcy entities and also direct trading in residential housing stock.

“Broadly speaking, the best distressed opportunities are in Europe today,” believes Ms Fraser. “But the cycle is just beginning and likely to follow elements and timing of the distressed cycle in the US.

Therefore we are recommending initial investments in European distressed assets today. Investors are seeking deeply distressed real estate or materially undervalued corporate assets at this time, as there is little expectation of an imminent economic recovery in Europe.”

The long view

Along with long/short credit arbitrage and long/short equity, distressed strategies have been among those attracting the strongest flows to Lyxor’s managed account hedge fund platform in recent months and now account for 11 per cent of total assets.

Lyxor’s Event Driven – Distressed Index returned 6.4 per cent during 2012, against a background of historically low bond yields and a global economic slowdown. Distressed programmes are replicated with enhanced liquidity, usually with a monthly frequency, allowing access to prominent managers including Avenue, Marathon, Halcyon and GLG.

Strategists at Lyxor are reluctant to sate when is the appropriate time to invest in distressed funds, as they see the sector as better suited to longerterm strategic allocations rather than tactical investments.

But they are nevertheless keen to highlight opportunities in both Europe and the US, which they see as living through very different economic circumstances.

“In Europe, the contraction of the economy and the eurozone crisis may continue to prompt spikes of volatility, leading to attractive distressed investment opportunities,” says Lionel Paquin, head of the managed account platform at Lyxor Asseet Management. “In the US, the distressed cycle may already be behind us, but managers are still identifying opportunities in some specific sectors such as energy and media.”