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Hedge Fund Monthly

Investing in Distressed Assets
Dean Menegas, General Counsel
Spinnaker Capital Group

August 2004

Assets are usually considered "distressed" when their value is severely depressed for a reason particular to the issuer and not because of general market conditions. The most common situation is a commercial loan on which the issuer has defaulted on payments of interest or principal. Distressed asset investing generally, and emerging markets distressed investing in particular, are undertaken by a small number of firms. Implementing the strategies successfully requires specific skills and particular economic structures. For those firms with the appropriate professional skills and capital base, however, the strategies can be extremely profitable.

Different types of Distressed Asset Investing

Distressed investments can be categorised by the type of exit foreseen. In other words, what is the strategy for cashing out?

Event-driven distressed investments. These are directional investments in distressed and special event situations in sovereign and corporate securities, for which some event is on the horizon which will transform the nature of and increase the value of the assets. The event can be a restructuring of a company's or country's debt, a liquidation of a company's assets, or a buyback of outstanding debt by an issuer or by individuals. Capital gain from the investment is provided either through re-pricing upon occurrence of the event, or through the proceeds of a restructuring.

Valuation-driven distressed investments. These are directional investments made in distressed situations where a transformative event is not at sight. The exit may be either through the market (re-pricing due to credit strengthening), cash flow, or an event (re-pricing upon an event or through the proceeds of a restructuring).

Some investors may buy distressed assets simply because the price seems too good to pass up, but this can be dangerous: what is cheap today may be cheap tomorrow, unless there is a reason for the value to rise. Valuation-driven investments should therefore be made only when a clear reason for triggering an increase in value can be ascertained, even if the timing of the increase is uncertain.

Distressed investing usually involves the purchase of debt, but equity analysis is relevant for two reasons. First, the assets are usually non-performing, and therefore the theoretical yield is less important than the potential for capital gains; successful distressed debt investments will produce equity-like returns. Second, equities are increasingly being distributed to creditors as part of the package of assets coming out of debt restructurings; in this way, control of a company's debt pre-restructuring may later lead to equity control.

Distressed investing strategies may be combined with other complementary but uncorrelated investment strategies in liquid instruments. This can diversify portfolio risk, create hedging opportunities, and provide useful liquidity. Distressed investments are rarely possible to sell short, so any hedges for long positions or outright short positions must be undertaken in the context of a different, liquid investment strategy.


Emerging Markets Distressed Assets

The emerging markets of Asia, Eastern Europe and Latin America have been a great supply of distressed assets over the past two decades. Crises and defaults are an essential part of emerging markets investment. Corporate loans default, trade at a discount, and are restructured; sovereigns create dismal economic situations, crash their economies, default on their commercial debt, learn their lessons, and rebuild.

Emerging markets investment introduces several factors not present in the developed markets. Investments in both sovereign debt and in the debt of domestic corporations are affected by politics, macroeconomic factors, currency valuation and convertibility stresses, the evolution of tax and legal regimes, trading and settlement structures, and market liquidity. Specialist firms develop methods for analysing, pricing, and controlling those factors, so that to the maximum extent possible they can focus on the economics of a particular investment.

Distress and Liquidity

The relationship between distress and liquidity is important, but flexible. Many distressed assets are quite liquid, due to the size of the issuance, the number of interested market participants, and the transfer process for the asset. Sovereign emerging market distressed bonds, for instance, have often been liquid assets even while in default, with issuances in the hundreds of millions or billions of dollars, flocks of interested dealers and end investors from around the globe, and settlements in standard international bond clearinghouses such as Euroclear. Other distressed assets can be quite illiquid, including most defaulted loans of corporates in emerging markets countries.

Liquidity is itself a flexible concept. The liquidity standards used to analyse developed market equities do not apply to emerging markets distressed debt. In developed equity markets, a holding might be considered liquid only if the asset is traded on a recognised exchange. By contrast, almost all emerging markets debt products are traded over-the-counter, and an asset which could be traded at a 1/8 % or 1/4 % bid-offer spread in normal markets would be considered liquid. In developed markets, the term illiquid is sometimes reserved for non-marketable securities like private placements, where transactions are severely restricted by the terms of the assets. For most illiquid emerging markets securities, a thin market exists and transactions are possible, but at wider spreads and over longer periods; such securities may be considered illiquid if the bid-offer spread in normal markets is wider than 2 %.

Liquidity is not only a function of the market, but also of an investor's intentions in holding an asset. When buying a distressed asset with a view to profiting from a future event, an investor needs to be both willing and able to hold the asset long enough for the event to materialise. Even when an event is in sight, it may not be finalised for 6 to 12 months or more; in valuation-driven distressed investing, any event is only anticipated even further in the future. A fund making such long-term investments needs to avoid being forced out of a position for non-market reasons. To ensure against being forced to sell assets by investor redemptions, it needs to match its assets with its liabilities by controlling outflows of assets under management through the use of lockups or infrequent redemption windows. To ensure against being forced to sell assets by counterparties, it needs to control its use of leverage, because leverage providers can force funds to sell out of positions when prices fall - at precisely the worst time.

Transfer and settlement processes can have significant effects on liquidity. Loan transactions are settled via contract between the seller and buyer, with transfers occurring on the books of the debtor or its agent. These contracts are often lengthy and heavily negotiated, so market participants must either have the requisite legal and administration skills internally, or must source and pay for them externally. Documentation and procedures for debt restructurings can also be very complicated. This minimum skill requirement provides a significant barrier to entry, enhancing the illiquidity of the asset class.

Information and Sourcing

Value discovery is particularly difficult in distressed investing, because of poor information dissemination. Little information is gleaned efficiently by outsiders, because most assets are not analysed or promoted by investment banks. Lack of liquidity means little trading, and little opportunity for investment banks to use research to generate fee income from a client base; this deters the banks from devoting scarce research resources. Little information is made available by insiders, because there is rarely an insider with interest in the price rising before or during a restructuring. The information gap has two important effects: it is an effective barrier to entry, and it allows for huge pricing inefficiencies.

Distressed investing therefore favours institutions which have the people, the skills and the infrastructure necessary to research both the market and the assets. Market research entails building relationships with potential sellers. Good contacts with the holders of large portfolios of distressed debt are critical; to understand what assets are potentially available on the market and to obtain the best prices.

Asset research entails close review of the issuer. Distressed debt is valuable if the issuer has the ability to make payments or service a fair restructuring, and if those in control have the willingness to take those actions. For corporations, investors should ideally meet with management, shareholders, and major creditors, as well as reviewing financial information and visiting the company, to get a comprehensive picture; factors to consider include the strength of a business plan, management's history in the business and the company, and the existence of visible cash flows. If a restructuring is in process or foreseeable, key contacts will include a corporation's creditors sitting on the restructuring committee, or the leaders of the "London Club" of a sovereign's commercial creditors.

Structural Factors Affecting the Market

Larger institutions holding distressed assets are often forced to sell at inopportune times or for less than full value. Commercial banks make loans, some of which turn out to be mistakes. The manager and group responsible for working out the loans are usually different from the ones that made the bad loans initially. There are may incentives for them to sell: positions are often written off internally, making it easier for the new team to show an accounting "profit" upon exit; positions that have moved from performing to impaired or defaulted on the balance sheet of a bank require a larger risk capital allocation, thereby becoming increasingly costly to hold; banks often see an improvement in share price when exiting from a situation that the market perceives as risky. Traditional mutual funds are often constrained by mandates setting minimum ratings of assets held; when assets default or issuer ratings drop, they become forced sellers, often exactly at the point of least liquidity.

Among investment funds and other end investors, there is a scarcity of capital with the required flexibility. Restrictive mandates limit the flexibility of most investible capital, be it from investment bank proprietary capital, traditional dealers or even the growing number of alternative asset managers. Restructurings often involve transformation of securities, moving from debt to equity or to some form of hybrid security, and are surrounded with uncertainty; this drastically reduces the investor base. Investment banks have yet to allocate significant amounts of capital to distressed debt (with limited domestic-market exceptions), due to adverse capital allocation restrictions.

US and European distressed funds have provided capital in the developed markets, but most are deterred from emerging markets by the perceived additional risks. Those who are not deterred, but do not adapt their normal approach to the realities of the emerging markets, may regret the decision: the rules of the game in Ohio are not those that apply in Jakarta.

Liquidity is key to most investors, so most emerging markets capital is not structured to fund longer-term opportunities where the exit is less predictable. Distressed investments in emerging markets require a very special kind of capital: capital that is not benchmarked to any index; that can handle the debt-to-equity transfer; that can sustain mark-to-market volatility; and that can remain locked into a situation for a lengthy period of time.

Example of a Successful Distressed Investment

Thai Oil Company had over $2 billion of debt outstanding in the late 1990s. After default, the debt was traded in the market at prices in the region of 30% of face value. The company bought back almost 50% of its own debt at prices from 50% up to 96% of face value. It agreed on a debt restructuring, in which it issued clean debt and gave ½ of its equity to creditors. Improvements in its business and the decreased amount of outstanding debt propelled the new debt to trade at par, and made its once-worthless equity very valuable.

Trading in emerging markets distressed investments can therefore be extremely profitable for those who understand the value inherent in restructurings and have a capital structure enabling them to hold investments through the completion of those restructurings; can price the risks presented by the lack of clear bankruptcy laws, legal structures that often favour shareholders, and the other relevant sovereign risks; have the capacity to provide liquidity and the knowledge base to dispense it properly; and can bridge the natural structural mismatch between sellers and buyers in distressed investing and especially in emerging markets.


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