Debt hedge funds turn to Europe and mid-market companies for returns
Distressed debt hedge funds are looking to Europe and middle market companies to sustain returns as money returns to the strategy.
Distressed debt funds are venturing off the beaten path in search of investments as the influx of capital into the strategy and a prolonged US corporate credit rally erodes returns on traditional distressed assets.
Oaktree Capital Management, which manages $33 billion in distressed assets, is pursuing more middle-market deals and distressed asset sales by European banks as these offer higher returns than traditional US distressed debt.
Oaktree began returning $3 billion to investors in January after deciding not to reinvest the asset sale proceeds from a $10,9 billion crisis fund it raised in 2008 to invest in traditional distressed opportunities.
Europe is also on the radar of Marathon Asset Management. It is exploring opportunities in sovereign restructurings throughout Europe and potential portfolio asset purchases, including European distressed debt and performing and non-performing loans. Marathon manages around $10 billion in credit funds.
European banks have announced plans to offload a combined $500 billion in distressed assets as they prepare for tighter capital requirements under Basel III. This pool of assets is being eyed by US distressed debt funds facing shrinking opportunities on their home turf.
The 12-month trailing US corporate speculative-grade default rate fell to 2,75% in February from 2,76% in January, according to recent data from Standard & Poor’s rating services.
S&P’s global fixed income research group has recorded only three defaults so far in 2011 and none in the five weeks to March 28, the longest stretch since June 2007 when there were no defaults for six weeks.
Investors are concerned that funds that raised billions of dollars to invest in financially troubled companies in the wake of the credit crisis are left chasing limited opportunities.
«The default rate has fallen much quicker than distressed debt managers anticipated which inevitably leads to crowding around the popular names,» said Sean Molony, senior investment specialist at International Asset Management (IAM) which invests in hedge funds on behalf of clients.
Combined assets managed by funds that invest in distressed companies and restructurings grew to a record $122 billion at the end of 2010, surpassing the prior peak of $106 billion in 2007, according to Hedge Fund Research data.
Distressed debt funds are not the only ones investing in financially troubled companies. A recent survey by Reuters and the law firm Dykema revealed 72% of hedge fund managers have some portion of their portfolios invested in distressed assets, the highest level in the four-year history of the survey and up from 65% in 2010.
«There are more hedge funds investing more money in financially troubled companies and distressed securities than ever before,» said Rick Bendix, co-head of the bankruptcy and restructuring practice at Dykema.
Many investors fear distressed assets have become too popular. «The market is crowded. Liquid, publicly traded debt securities are fully priced. The opportunities have been picked over,» commented Eric Harrison, a partner at Luminous Capital, a private wealth manager.
Luminous started allocating to traditional distressed debt strategies in mid-2008 and has realised strong returns on these investments. More recently Harrison has shifted capital to niche funds investing in illiquid credits, including those purchasing portfolios of non-performing corporate, consumer and real estate loans from US regional and community banks.
«There are still returns to be made in the illiquid, private debt market for managers who are prepared to roll up their sleeves and service or restructure the assets they are purchasing. We think some of these strategies could generate IRRs [internal rate of return] of 18%-20% in 2011,» said Harrison.
«The return potential of traditional distressed investing is no longer particularly compelling,» noted Oliver Wriedt, a managing director at Providence Equity Capital Markets, which manages a range of credit funds.
Providence has been steering clear of crowded trades and focusing on middle-market companies facing near-term maturities and amortisation payments. «These are companies that don’t have access to the broader capital markets. We acquire the debt and work with management and existing lenders to restructure their balance sheets without resorting to bankruptcy,» Wriedt explained.
The middle-market sector remains attractive because the barriers to entry are high, he said.
«The manager needs to be able to access the opportunity and underwrite the credit risk. This is about working with business owners and lenders to execute a restructuring. We’re not buying the bank debt and waiting for it to trade up,» stated Wriedt.
The Dykema survey confirmed that hedge funds are investing in a broader range of distressed debt securities and strategies. The number of managers investing in senior secured loans has fallen to 32,6% compared with 57% in 2010.
The percentage of funds investing in mezzanine loans rose to 18,6% and unsecured debt grew to 25,6%. The number of funds pursuing ‘loan to own’ strategies also grew despite a recent court decision which adversely impacts the strategy.
For many managers the real opportunity hinges on European distressed debt sales and rising defaults amid the $500 billion in US speculative grade debt that is set to mature by 2017.
«For there to be an interesting second act in this distressed cycle there either needs to be a fairly significant crack in Europe, more residential mortgage-related distress in the US or a real deterioration in the ability of corporate issuers to refinance maturing debt,» concluded Harrison.
