After
four years of fair winds in the stock market, conditions
once again turned choppy in 2007. While the blue chip FTSE
100 managed to stay aloft, closer inspection reveals its buoyancy
relied on a handful of stocks, such as mines. Shares in sectors
such as banking, property and retail sank as the US subprime
problem broadened into a credit crunch and the ripples spread
to other sectors of the economy.
Analysts were unusually united in agreeing that this year
could present even more of a bumpy ride for investors, as
the crisis continues to unravel. A portent of what this may
entail for equities came in January, when a disappointing
Christmas trading statement from Marks & Spencer triggered
a one-day slide of nearly 20 per cent in the share price.
If harder times lie ahead, as seems likely, the more turbulent
conditions could be to the advantage of hedge funds. According
to Francois Barthelemy, a partner at F&C Partners, the
subprime crisis has produced a number of attractive opportunities,
particularly in distressed assets.
Barthelemy points out that as subprime contagion has spread,
many banks and insurance companies have been left with the
burden of distressed assets on their balance sheets. Accumulated
losses have destroyed large chunks of capital and restricted
their ability to write further business.
In order to raise fresh capital, they are resorting to selling
impaired assets to investors able and willing to nurse them
through bankruptcy or restructuring. “Only hedge funds
have the legal and investment expertise to buy that type of
asset and they are likely to do really well as a result of
it,” predicts Barthelemy.
He adds that with economies on both sides of the Atlantic
nearing a recession in 2008 – after several strong years
in which the way to make money was all about growth –
we are “moving into a very different environment”.
In a recession, corporate capital comes under pressure while
cashflow can turn negative for many companies, so they are
no longer a going concern.
Pryesh Emrith, hedge fund and structured products analyst
at Charles Stanley stockbrokers, cites as an example the casualties
of the telecommunications “boom and bust” at the
start of the decade. Some telecoms companies buckled under
the strain of their huge capital expenditure requirements
and went under, yet at the same time many owned very valuable
assets.
As the economy slows down, credit spreads increase and more
companies file for bankruptcy or, in the case of US companies,
file for Chapter 11 protection to gain breathing space and
the opportunity to restructure.
It also offers hedge funds the opportunity to gain control
of the distressed company. A typical move presaging a takeover
would, for example, involve the fund buying bonds in the company
at a deeply discounted price of, say, 17 cents to the dollar,
then swapping the bonds for equities to gain control.
“Distressed managers are those providing liquidity in
tough market environments and are remunerated for doing so,”
says Emrith.
The strategy by which they buy stocks or bonds in troubled
companies, with the aim of getting an improved price following
a subsequent liquidation or reorganisation, is not always
risk-free.
Take the recent case of Northern Rock. When the mortgage bank’s
problems became evident last September and its share price
slumped, hedge fund RAB Capital raised its stake in the conviction
that the bank’s underlying value remained intact. Undaunted
by the Rock’s worsening prospects, it bought more shares
in December but now faces heavy losses if, as is a possibility,
the bank is eventually nationalised (At time of press, the
bank had not yet been nationalised).
Time to move in?
So what are the prospects for hedge funds that target distressed
assets for their portfolios? And if they are poised for
such a stellar performance should charity trustees, who
have often been wary of the sector generally, overcome their
reluctance and move in?
On past form, the potential rewards are enticing. Much depends
on how credit spreads evolve, but in the 1991-92 recession
the returns from distressed funds were as much as 30 per
cent plus, while even the less depressed conditions of 2004
produced a figure of 18 per cent.
For Philip Pearson, deputy head of alternative investments
at fund manager Morley, which is owned by insurance giant
Aviva, the outlook for investing in distressed assets is
one of "cautious optimism”. As he points out,
the problems experienced by the subprime part of the credit
market have started to spread to other sectors, but the
extent of the contagion is not yet clear.
So only the hedge funds that specifically focus on subprime-backed
Collateralised Debt Obligations (CDOs) have so far seen
a significant upturn in distressed opportunities. Default
rates and distress elsewhere is still fairly low, meaning
that most distressed debt hedge fund managers have yet to
see the opportunities enabling them to significantly increase
the size of their funds.
“But I believe that the problems created by subprime
are set to spread more widely,” he adds. “The
areas next to be affected are likely to be corporate entities
that have been heavily dependent on cheap debt – for
example, large private equity transactions – and retail
firms that may be exposed to cutbacks in consumer credit
and expenditure.”
Also vulnerable are many retail firms that are exposed to
cutbacks in consumer credit; particularly those selling
“big ticket” items, such as furniture and electrical
goods.
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Look beyond these sectors, however, and the pain could be
more limited. As Pearson points out, corporate balance sheets
elsewhere generally remain strong, and many companies may
be able to withstand a period of tighter credit.
But opportunities will undoubtedly arise now that the credit
spread is rising, says Charles Stanley’s Emrith. “Investors
need to be ready to take advantage of the right conditions
and those fund managers with the biggest cash chest will
be best placed to take advantage of the opportunities.”
He expects these to begin accumulating in the latter part
of 2008 and to continue into early next year.
Charity trustees evidently have an increasing awareness
of these opportunities. Emrith’s colleague Nic Muston,
an investment manager at Charles Stanley, says that an increasing
number have demonstrated an interest in investing in hedge
funds over the past couple of years, and there have been
in-depth discussions on whether they should take the plunge.
“Trustees’ caution is understandable, because
it’s not their own money being invested,” he
observes. “But more are beginning to consider hedge
funds as part of a well diversified portfolio.”
Distressed investing is only part of a wider picture, Emrith
adds. A hedge fund portfolio should be well diversified
including, for example, commodities and currency strategies.
Distressed is nonetheless an interesting asset class; the
source of risk is very specific and there is only a low
correlation with equities, which means it tends to perform
well during recessionary periods when more opportunities
arise.
A cocktail of assets
Like other institutional investors, charity trustees must
assess whether they have the level of expertise necessary
to make a direct entry into the market. Choosing the right
timing is essential, with capacity and prospective returns
depending on the number of available opportunities, and
these vary greatly over time.
Selecting the sectors and the individual companies within
them that offer potential for recovery is an exacting science,
involving a lengthy due diligence process. And, later on,
deciding when to make an exit is equally challenging.
For several years, UK commercial property has provided a
favourable diversifier to UK equities, but in recent months
its attractiveness has rapidly faded.
This is likely to prove overly daunting for trustees who
only serve their charity on a part-time basis. The alternative
is to pay for the services of an adviser able to demonstrate
expertise and a sustainable strategy.
“Market timing is always the hardest part,”
observes Emrith. “It’s therefore advisable for
charities to start increasing their exposure to distressed
investing via funds of hedge funds which target these strategies.”
In addition to F&C, both FRM Credit Alpha and AcenciA
are among those following distressed strategies; AcenciA
being a listed fund of hedge funds that specifically invests
in distressed hedge funds.
However, he stresses that distressed investing is only one
of many hedge fund strategies, as many trustees tend to
put all hedge fund strategies in the same basket. However
good a strategy may appear, charity trustees like any investors
should diversify over several strategies and limit their
exposure to each. His recommendation then? “Leave
the allocation of the single hedge strategies to the experts.”
One major advantage of multi-strategy funds of hedge funds
is a correlation between the various asset classes, dubbed
the “cocktail approach”, with much depending
on how skilfully these different components are mixed.
Among the best-regarded multi-strategy fund of hedge funds
are Signet, Liongate and Dexion Absolute. These are suitable
for first time investors with a limited capacity to perform
due diligence, even if the performance of a multi-strategy
fund is likely to be less impressive than distressed investing.
Finally, what if charity trustees have qualms with the ethics
of distressed investing? Emrith agrees that the ethical
question is a “tough call”, but suggests as
it is very deal specific, much depends on the restructuring
proposed.
“Given that the companies are in ‘survival mode’
it is quite hard at this stage to make ethical priorities
rank high among other decisions,” he adds.
“There is also the issue of transparency. Most hedge
funds try to remain secretive about the deals they are involved
with. This would apply not only to distressed but to other
strategies as well.”
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