distressed debt hedge funds

distressed debt hedge funds

This blog will try to dissect distressed debt investing, up and down the capital structure. We will look at current distressed debt situations, try to explain the ins and outs of how decisions are made in the distressed debt world, probably rant a few times about positions that are working against me, and hopefully enlighten some readers.

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This week, I was sent a paper by Jongha Lim, a PHD student at Ohio State, entitled The Role of Activist Hedge Funds in Distressed Firms. In my opinion this is one of the best academic papers addressing distressed debt and distressed debt investing this year. I reached out to Jongha and we will be doing an interview with him in the coming weeks. Fascinating piece of work.

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Reference ID: #8a29edc0-35b0-11e8-a0fe-b906bb6ec472

Why Hedge Funds Love Distressed Debt

Hedge funds can generate massive returns in relatively short periods of time, and they can also go into financial crises just as quickly. What kind of investments can produce such diverse returns? One answer is distressed debt. The term can be loosely defined as the debt of companies that have filed for bankruptcy or have a significant chance of filing for bankruptcy in the near future.

You might wonder why a hedge fund - or any investor, for that matter - would want to invest in bonds with such a high likelihood of defaulting. The answer is simple: the more risk you take on, the more reward you can potentially make. Distressed debt sells at a very low percentage of par value. If the once-distressed company emerges from bankruptcy as a viable firm, that once-distressed debt will be selling for a considerably higher price. These potentially large returns attract investors, particularly investors such as hedge funds. In this article we'll look at the connection between hedge funds and distressed debt, what ordinary investors can do to get involved and if the risks are really worth the rewards.

A Note About Subprime Mortgage Debt

Many would assume that collateralized debt would be immune from becoming distressed due to the collateral backing it, but this assumption is incorrect. If the value of the collateral decreases and the debtor also goes into default, the bond's price will fall significantly. Debt such as mortgage-backed securities during the U.S.subprime mortgage crisis would be a great example.

The Hedge Fund Perspective

  1. Bond market - The easiest way to acquire distressed debt is through the market. Such debt easily can be acquired from the bond market due to regulations concerning the holdings of mutual funds. Most mutual funds are not allowed to hold securities that have defaulted. Due to these rules, a large supply of debt is available shortly after a firm defaults.
  2. Mutual funds - Hedge funds can also buy directly from mutual funds. This method benefits both parties involved. In a single transaction, hedge funds can acquire larger quantities - and mutual funds can sell larger quantities - both without having to worry about how such large quantities will affect market prices. Both parties also avoid paying exchange-generated commissions.
  3. Distressed firm - The third option is perhaps the most interesting. This involves directly working with the company to extend it credit on behalf of the fund. This credit can be in the form of bonds or even a revolving credit line. The distressed firm usually needs a lot of cash to turn things around; if more than one hedge fund extends credit, then none of the funds are overexposed to the default risk tied to one investment. This is why multiple hedge funds and investment banks usually undertake the endeavor together.

Hedge funds sometimes take on an active role with the distressed firm. Some funds who own the debt can provide direction to management, which may be inexperienced with bankruptcy situations. By having more control over their investment, the hedge funds involved can improve their chances of success. Hedge funds can also alter the terms of repayment for the debt to provide the company with more flexibility, freeing it up to correct other problems.

So, what is the risk to the hedge funds involved? Owning the debt of a distressed company is more advantageous than owning its equity in case of bankruptcy. This is because debt has precedence over equity in its claim to assets if the company is dissolved (the rule is called absolute priority). This does not, however, guarantee a financial reimbursement. (To learn why debtholders get paid first, read An Overview Of Corporate Bankruptcy.)

Hedge funds limit losses by taking small positions relative to their overall size. Because distressed debt can offer such potentially high-percentage returns, even relatively small investments can add hundreds of basis points to a fund's overall return on capital. A simple example of this would be taking 1% of the hedge fund's capital and investing it in the distressed debt of a particular firm. If this distressed firm emerges from bankruptcy and its debt goes from 20 cents on the dollar to 80 cents on the dollar, the hedge fund makes a 300% return on its investment and a 3% return on its total capital. (For examples of hedge funds that ignored the risks, read Dissecting The Bear Stearns Hedge Fund Collapse and Hedge Fund Failures Illuminate Leverage Pitfalls.)

The Individual Investor Perspective

The first hurdle is actually finding and identifying distressed debt. If the firm is bankrupt, you can easily tell this from the news, company announcements and other media. If the company has not yet declared bankruptcy, you can infer just how close it might be by using bond ratings such as Standard and Poor's or Moody's. (For more tips on finding weak companies, read Profit From Corporate Bankruptcy Proceedings and Z Marks The End.)

After identifying distressed debt, the individual will need to be able to access it. Using the bond market, like some hedge funds do, is one option. Another option is exchange-traded debt, which has smaller par denominations like $25 and $50 instead of the $1,000 par that bonds are usually set at. These smaller-denominated investments allow for smaller positions to be taken, making investment in distressed debt more accessible to individual investors.

The risks for individuals are considerably higher than those for hedge funds. Multiple investments in distressed debt likely represent a much higher percentage of an individual portfolio compared to a hedge fund's. This can be compensated for by using more discretion in choosing securities, such as taking on higher-rated distressed debt that may pose less default risk yet still provide potentially large returns.

Hedge funds were up 1.83% in February, recovering from their losses in the start of the year as the MSCI World Index posted gains of 3.87% during the month, according to the latest research from Eurekahedge.

Key takeaways for the month of February 2014:

· Hedge funds recovered from January losses – all investment strategies yielded positive returns during the month with long/short equities and distressed debt leading with gains of 2.42% and 2.33% respectively

· North American managers posted their sixth consecutive month of positive returns, up 2.46% during the month and 10.5% over the last 12 months

· All regional mandates delivered positive returns during the month, excluding Japan focused hedge funds which posted their second consecutive month of negative returns – down 1.06% in February

· Latin America focused managers outperformed the MSCI EM Latin America Index by 6% on a year-to-date basis

· Distressed debt investing hedge funds delivered their eighth consecutive month of positive returns – up 2.33% in February and 17.7% in the last 12 months

· Asset flow data from 2013 shows that 2,027 hedge funds had positive asset flows during the year, out of which 357 managers raised more than US$100 million. Meanwhile, 879 hedge funds recorded net asset outflows in the previous year while 1,557 funds reported marginal or no inflows

Global markets trended upwards during the month led by a resurgence of investor confidence in the global economy. Market sentiment held strong as weaknesses in recent US macroeconomic data were largely attributed to the weather conditions, with Fed chair Janet Yellen reaffirming the need to keep the QE tapering on track as the US economy continues its recovery. Emerging markets also showed signs of stability with the MSCI Emerging Market Index rising 2.15% during the month. Meanwhile, positive macroeconomic data from the Eurozone showed acceleration in manufacturing activity which provided further support to the markets.

All regional mandates, with the exception of Japan, ended the month in positive territory with North America focused hedge funds realising the strongest gains. The Eurekahedge North American Hedge Fund Index was up 2.46% as MSCI North America Index 5 gained 4.47% during the month. European fund managers were up 1.87% with the FTSE 100, DAX and CAC Index rising 4.60%, 4.14% and 5.82% respectively. Fund managers focused on Eastern Europe and Russia were up 0.29% during the month, emerging largely unscathed as the crisis in Ukraine intensified towards the month-end. Latin America focused hedge funds outperformed underlying markets yet again, with managers delivering gains of 0.50% in contrast to a 0.69% decline in the MSCI EM Latin American Index. The Eurekahedge Asia ex Japan Hedge Fund Index was up 1.81%, with Greater China and India focused hedge funds delivering gains of 1.02% and 4.05%. Japan investing hedge funds were down 1.06% as the Yen remained largely flat versus the US dollar (marginally down 0.06%) with the Nikkei 225 Index and Tokyo Topix declining 0.49% and 0.74% during the month.

Hedge fund laws, starting a hedge fund, news and events…

Distressed Debt Fund of Hedge Funds to be Launched Soon

As many hedge funds scramble to keep investor’s from redeeming and/or proposing to restructure the terms of the fund, other funds are getting ready for the next wave of hot investments: distressed assets.

As evidence that money will be moving into these areas is a story by Reuters about a new launch of a distressed debt fund of funds. According to the article, the fund of funds will invest in other distressed asset hedge funds and will have a two year lock up person. GAM chief executive David M. Solo told Reuters that “We are completing a thorough review of a range of the best managers in the U.S. and Europe so as to create a diversified vehicle to benefit from this unique opportunity.”

While this is the first article I have seen announcing a fund of funds focusing on this asset strategy, there are likely to be more of these fund of funds launching in the future. The New York Times also ran a story this morning about “vulture investors” sitting on the sidelines for now. While the NYT article discusses players biding their time, it also notes that the “volume of loan portfolios sold in the first three weeks of October has already beaten the previous monthly record.” This indicates that the area is heating up and is likely to be a popular strategy near the end of this year and the beginning of next. Additionally, other types of credit based funds, like asset based lending funds, are likely to be popular in the next year as the credit markets continue to be locked.

Investing in distressed assets has always been one of the central hedge fund strategies. These investments might include investing in distressed debt and other types of distressed assets. One of the bigger issues for investors in distressed asset hedge funds is going to be lock-up period. Because the asset class is not as liquid, the lock-up for investors is going to be longer, as it will generally be in the hedge fund industry going forward.

Other relevant articles include:

Distressed debt hedge fund closes doors

I previously wrote an article about distressed debt hedge funds and the popularity of such funds as they try to get in for a deal. However, the considerable amount of media attention which has been focused on this sector of the market has spooked investors enough to get them moving on redemption day. FINaltenatives is reporting that a fairly large hedge fund managed by Turnberry Capital Management is completely closing its doors. It is at least somewhat surprising that a group this large (the fund reportedly ran up to $800 million at one point) would close its doors immediately instead of trying to wind the fund down over the course of a couple redemption dates.

A few reasons why they might want to wind down the fund over a period of time may include: (1) the fund offering documents did not include a hedge fund gate provision, (2) the manager no longer thought the fund’s strategy was viable with such a severely reduced asset base or (3) the manager thought that he could get the best prices on the assets if he sold them in a large bundle instead of piece meal over time. The article also stated the manager is planning to start a corporate bond fund, which is another reason the manager decided to wind the fund down immediately.

What is most interesting about this event is the disconnect between the strategies managers wish to pursue and the strategies that the investing masses are willing to (remain) invest(ed) in.

The article is at http://www.finalternatives.com/node/5251.

ABL and distressed debt hedge funds are hot

For the past nine to twelve months a central question from anyone I meet is: with the markets the way they currently are – how is your business? The answer, maybe surprisingly, has been great. Each month we have more and more clients; each month there are new hedge fund managers who are eager to get their fund up and running. As the conventional wisdom goes, there is always a hot market somewhere and there will always be managers who think they have an edge and who can exploit that hot market. Which brings up the million dollar question – what is the hot market now?

Recently we’ve seen an increase in the amount of asset-based lending and distressed debt funds. With the market dynamics changing and the level of liquidity decreasing on a daily basis, a niche for smaller liquidity providers has arisen. These funds will focus on a variety of distressed debts and other types of assets – we’ve seen: real estate hedge funds focused the acquisition of land, single family homes, multi-family units and other retail properties; asset-based lending hedge funds; factoring hedge funds; distressed debt hedge funds which may buy and repackage certain types of debt including mortgages and credit card receivables. For a discussion on the structure of distressed debt hedge funds (and other hedge funds with hard to value assets) see structure of distressed debt hedge funds.

As noted in this week’s issue of Business Week, hedge funds are stepping up as buyers of pools of mortgages which the banks are selling at fire-sale prices. The article notes that oftentimes distressed debt hedge funds are leaner organizations which have more room to negotiate with borrower’s because of their cost basis in the loan. Because of this, and because their employees deal with far fewer borrowers on a daily and weekly basis, the fund’s are able to fashion more manageable terms to borrowers.

The Business Week article can be located at:

Cole-Frieman & Mallon LLP provides comprehensive legal services for new and existing hedge funds as well as for other investment management companies.

If you are thinking of starting a hedge fund or an incubator fund, please call Bart Mallon of Cole-Frieman & Mallon LLP today at

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