Dalton Investments

A natural investor in distressed securities

SIMON KERR

Business partners get together for diverse reasons. In the case of Dalton Investments LLC, the three founding partners had in common investment business experience in Asia and a belief that the timing was right to concentrate on the region. At the time the firm was established in 1999 Steve Persky, James Rosenwald and Gifford Combs each believed that post-crisis turmoil in Asia gave their investment strategies favourable medium-term opportunities. However, they might never have teamed up without the intervention of one Jamie Rosenwald, who was managing a Japanese long-only portfolio for a US pension account in October 1998. He seeded Gifford Combs to manage the Pacific and General Investments fund, which at that time was almost all in Asian equities. In November 1998 Rosenwald was approached by a listed NYSE corporation to manage an Asian distressed debt portfolio, and he recruited Steve Persky who had significant experience in Asia and in distressed investing to manage the account.

These recruitment acts were not random – indeed, quite the opposite. The three partners had informally worked and invested together from 1981 through 1998 and had known each other on a personal level for many years. Gifford Combs and Steve Persky were classmates at Harvard College, and Steve Persky and Jamie Rosenwald met in 1970, classmates at the Dalton School from which the firm derives its name. Creating Dalton Investments was a natural evolution of their shared experiences and aspirations.

Today, Dalton manages more than $1 billion invested through separate accounts and hedge funds (see Fig.1), and the firm, which is headquartered in Los Angeles and has an affiliated office in Tokyo, employs 24 people.

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Dalton Investment’s investment activities are in three categories: distressed debt (under Steve Persky), Asian equities run by Jamie Rosenwald, and Gifford Comb’s global hedged equities. Steve Persky managed a low volatility distressed credit strategy for the first seven years ofthe firm. This delivered 12.6% annualised to its investors over its life. But in 2006 he decided to return approximately $350 million of capital to investors, putting him in the unusual position of placing investors’ interests over capital retention or management fees. Two months ago the firm came back to the strategy and launched the Dalton Distressed Credit Fund.

Why has a manager who stopped investing in a particular investment strategy come back to it after a three year break?

Two themes: Asia and credit
Asia and credit have loomed large throughout Steve Persky’s career. He says: “I showed my interests in Asia as far back as my college days – I studied Chinese at college.”

Persky also worked in Taiwan in his sophomore year. He went out to China for a year in 1980, and taught English there. On coming back to the US, he joined Citibank. At that point, in 1981, Citibank was still in its pomp as an international lender, and the firm was viewed as a highly desirable graduate opportunity.

“I went through the programme to train to be a lending officer – it was a very thorough, structured programme,” he says. “Looking back now, I can see that it was particularly useful in the concentration on cash flow. We were taught to ask: how will this loan be paid back?”

Having come through the training programme, Persky was allocated a role within the domestic operations of Citibank. There had been a wave of transplants and opening of US sales offices by Asian companies, and Persky was to specialise in lending to US-based subsidiaries of Asian companies. However, being in the domestic operations of a bank did not appeal as much as the overseas activities of banks. When an opportunity arose to move into capital markets, Persky joined Salomon Brothers in New York and after eight months moved to Tokyo.

The mood in Tokyo in the mid 1980s was very different from that prevailing today. The Japanese bubble carried on inflating until 1989, so the mid 1980s were about zaitech (financial engineering), ludicrous property and equity values, and real estate speculation. Persky says that one of the attributes he brings to his current job is the perspective of having seen several boom and bust cycles, particularly in Asia. Unarguably, the Japanese bubble is as classic an example of the cyclical nature of investing and speculation as the Wall Street Crash of 1929.

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For a bond and commodity house like Salomon Brothers, although international expansion remained on the agenda for the 1980s and into the 1990s, the main events took place on Wall Street. So Steve Persky took the chance to get closer to the core activities of the firm and returned to New York in 1989. A bubble phenomena of a different kind was in full swing at this time: Mike Milken’s Drexel had grown the previously off-centre high yield bond market from a market for fallen angel corporate bonds to a financing mechanism for large scale M&A. Salomon was a late and somewhat reluctant arrival at “The Predator’s Ball” – as the story of high yield financing became known. Persky was brought to Salomon’s HQ in the shadow of the twin towers in New York to be a high yield (and what he describes as “really high yield”) debt trader to help grow this new area of finance for the bank. Salomon’s core activity was the trading of government bonds, and only to a much lesser extent municipal bonds. In high yield it was a neophyte. When finance companies try to enter growing markets, they can only take share by cutting the margins of the big players and underwriting the shakier credits. This is what Salomon did in high yield.

Its two big financings in high yield at the time were 7-Eleven franchisor Southland and United States Gypsum Corporation, or USG, the wallboard manufacturer. Both companies had a lot of debt. 7-Eleven was a stable business but the debt load caused the US parent to fall under the control of its largest franchisee, Japan’s Ito Yokado. USG eventually filed a bankruptcy petition in March 1993 – vertically-integrated wallboard manufacturing is cyclical. Steve Persky says that this period gave him a good appreciation of bad markets: “I became suspicious of bad credits from that experience, and that has stayed with me.”

High yield reached its apogee as a takeover mechanism with the leveraged takeover of RJR Nabisco in 1989. Although that deal was not his, Milken’s star also peaked that year – he was indicted on 98 counts of racketeering and securities fraud in 1989 as the result of an insider trading investigation. The whole pyramid of high yield funded takeovers collapsed, and the prices of securities of leveraged companies were badly hit. The market for high yield was never going to be the same again from an underwriter’s perspective. However, it was a very rich time from a buyer’s perspective.

The ability to recognise the market outlook on a multi-year basis is one that Steve Persky has demonstrated through his career. Recognising that it was great time to be on the buy-side in bonds he joined institutional bond managers Payden & Rygel on the West Coast as a Portfolio Manager.

Having learned about money management and portfolio construction with a wider markets brief at Payden & Rygel it was his interest in Asia that took Persky to Dalton. At the then-new firm of Dalton Investments, Persky could concentrate on Asia again as that was where he saw outstanding possibilities to make returns on a multi-year basis. In the 1990s, Peregrine had created a market for dollar denominated bonds for Asian companies. Many Asian currencies, as now, had currency pegs to the US dollar, and in the crises of 1997-98, many of these collapsed. Hong Kong and China were able to sustain their pegs, but the Philippines, Thailand, Korea and Indonesia all lost the ability to control their currency values. Inevitably, prices of the dollar bonds of many Asian companies collapsed. Price drops were triggered as much by of the lack of clarity about the application of bankruptcy laws as by the impacts of declining currencies and growth rates.

“As time went on, Asia repaired,” states Persky. “So we had made the return we were going to from assuming credit risk there. But then, as it always does, other opportunities arose. In the period after 9/11, securities that were backed by aircraft assets and aircraft leases became distressed. So a new sector opened up. Electricity generating companies like AES had spent the previous years making major capital commitments to new capacity. The consequence was that their securities became distressed around the same time as the credit problems emerged for aircraft financing. We could see ways that cashflows could reduce the debts of these companies in time, and the underlying businesses had good attributes.”

The demise of Enron in 2001 and the unwinding of the tech bubble also created opportunities for Persky’s Fund, some on the short side. “We shorted Adelphia Communications in 2002 and made money there,” he says. “We also started looking at the securities of German residential mortgage backed securities around this time. They turned out well for us. The markets evolved again: 2003 was a big bull market for yield, and we became more circumspect in 2004. The markets then started to become frothy. For example, the amount of capital that was thrown at building-related companies at this time was storing up trouble for later. After 2004 we started to build shorts and reduce the net exposures we were running.”

The Dalton Global Opportunity Fund that Persky was running made good returns right through to 2005. In particular, the fund made absolute returns when the benchmark index, Merrill Lynch High Yield Master Index, had down years in 2000 and 2002. By 2006, there was plenty of capital reaching for yield, and the impact of private equity buyers was malign for many hedge fund strategies. “There was too much capital out there. Yields were down, and although I had started to short some companies that I didn’t think would make it, along came private equity companies to recapitalise them,” explains Persky. “So shorting was painful and I couldn’t have conviction about the longs – I was running a low net exposure. I would characterise the environment then as a buying panic. Credit spreads were way too low. To give you an example, there was triple-B rated paper off sub-prime securitisations, by the likes of Countrywide, which was trading only 200 basis points over the yield on treasuries. Even then, the underlying loan portfolios were called ‘liar loans’ because they were self-certificated mortgage borrowers. I was shorting some sub-prime, but it was too early. Those loans are now trading at two cents on the dollar, but they represented very poor value to investors back in 2006.”

Some investors in the Dalton Global Opportunity Fund were bemused by the low net and gross of the fund. There was some grumbling – was Persky even trying to make them money? It is easy to say from the perspective we have today that the market environment then was more suited to capital preservation than risk assumption. It is a rare manager that gives themselves that explicit priority, but Persky did. He wound up the Global Opportunity Fund in June 2006.

MBS: A new chapter
The next chapter of the story of Dalton Investments on the credit side of the business opened a few years on, when Steve Persky saw an echo of a familiar market cycle unfolding in mortgage backed securities. “It is an advantage in having been through up and down phases several times over,” he says “The problems of the residential mortgage backed securities (RMBS) market this time around reminded me of the collateralised bond problems I had seen previously.”

It was clear to Persky that securitised sub-prime was becoming interesting from a long perspective. The headlines at the start of 2008 were still of toxic bonds, but to Persky the turmoil in markets was creating gross opportunities.

To look further into the opportunities being created, Persky took advantage of the fact that Countrywide Credit is based only 15 miles from Dalton’s Los Angeles office. A meeting and presentation was arranged with Countrywide Asset Management. Todd Sherer, the manager of the trading desk, impressed his audience with the scale of returns available. Asked “If we gave you $100m what would you do with it?” he described a strategy for picking up distressed mortgage securities that would garner internal rates of return, or IRRs, of some 50% to 60%.

Persky was so impressed with this investment strategy – and the man pitching it – that he invited Sherer to join Dalton in April 2008 as the portfolio manager of the Dalton Distressed Mortgage strategy, along with two colleagues. By June, they had raised hundreds of millions of dollars to put their ideas to work.

Interestingly, given the scale of the fall in the RMBS market, the early ideas were not dependent on the market coming back to make returns. Unlike most other forms of distressed bonds, those backed by residential mortgages still tend to produce cash flows. Homeowners do not give up their home and mortgage easily – it is better to carry on making payments. The securitised form of these mortgages had fallen in price so much that even using negative assumptions and taking a conservative view on cashflows it was possible to generate very high IRRs. The average life of the underlying loans was only a year to 18 months, so risk really was limited.

Dalton’s distressed mortgage strategy has been applied to pools of three kinds – direct client investments, four loan performance series, and long duration investments for four clients, and the IRRs have ranged from 14% to nearly 50%, with most of in the range of 20% to 35%.

The range of securities and hedging tools available make RMBS investing a rich area to invest in even now. In particular, the monthly cash flows permit continual reallocation to the best available opportunities. The average life is still fairly short but that will vary through time, and credit enhancement strategies may be applied. The investments currently being pursued include interest-only securities, seasoned AA-rated debt and pay-option triple-As.

While 2008 looked a good time to Persky for snapping up mortgage-backed securities, the end of the year exposed a classic opportunity in the corporate bond market. His reputation preceding him, Persky was approached in early 2009 by a cash-rich family that had sold a company business and was looking to put capital to work. He explains: “We had an approach in mind – we were looking for good companies taken private but which remained heavily leveraged. If you like, franchise businesses with bad balance sheets. As the year has worked out, the market has moved a lot in a short time. We thought we had investment opportunities that would take two to three years to generate the returns, but a lot of the potential returns have already come. Where we have been is not even priced like a market for distressed securities – it’s more like high yield now.” These developments mean that managers now have to be more thoughtful in finding returns – the market will not rescue them in the same way again.

Managers of hedge funds with a knowledge edge have to find ways of exploiting that edge and keeping the insight and knowledge fresh. In Persky’s case, he is going back to sectors and tiers of companies where he has an information edge and better understanding. In particular, he is concentrating on mid-tier opportunities. Here, there should be sufficient liquidity to trade the securities, but not too many competitors also looking to trade them. For example, Persky and his team are looking again at aircraft financing – an area where they have experience and practical knowledge – and have made money.

Persky has also recently launched a new fund, the Dalton Distressed Credit Fund (see Fig. 3). Despite the rapid appreciation in distressed assets this year, he still sees potential for good returns in more select sub-strategies. Persky believes that the aircraft sector still offers 20% to 30% gross IRR, with the wider mid-market also offering good potential. Being in the flow has enabled Persky to get invested quickly: at the end of the first month he had only 12% left in cash, with 40% in corporate debt, 30% in RMBS and 18% in asset-backed securities. There is some diversification by credit type and industry with investment typically spread across some 25 to 30 names.

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Persky says he avoids industries where outcomes are binary, or rather, may take two distinct courses. In his experience, and he is based in California, such binary outcomes occur too often in the biotech and technology industries. He will also avoid the securities of small financial companies. Managers have to know where they are not going to make money, as well as where they can excel.

The express business philosophy of Dalton Investments’ management is that they consider “capital preservation to be their primary concern.” Or, as Persky says: “When I get involved now, I’m looking to buy top-of-the-capital-structure securities that can survive a reorganisation.” In other words, he is looking down as well as up whenever he makes a purchase.

Hedging at the position or portfolio level reflects a manager’s belief on the current phase of the investment cycle. Persky view is that we are still mired in an immature phase of the current cycle, meaning investors in distressed securities should be long-biased. He is keen to point out, though, that he has had sectoral hedges in place in previous cycles. “When I was in aircraft-linked bonds in the past, I shorted equities and related bonds when I needed to. So I have experience in doing it, but don’t see the need at the moment from a cyclical perspective.” He also believes that given how RMBS trades are structured, the RMBS strategy doesn’t need hedges either.

Distressed is a preferred strategy
That the opportunity set for distressed managers has been very rich has been widely recognised in the hedge fund industry. For over 18 months now, and on a consistent basis, distressed investing has been high up the list of investment strategies preferred by investors in hedge funds.

For the 2009 Deutsche Bank Alternative Investment Survey, funds of funds and other investors were asked in February where they were planning to increase allocations. Distressed investing was the second most commonly cited investment strategy, with 57% of respondents planning to increase allocations.

Brighton House Associates, an alternative investment research firm, found in a survey in a third quarter survey that investors had gravitated towards event-driven hedge funds, primarily in the merger/risk arbitrage and distressed fixed-income areas. So investor interest in distressed investing is still current.

To some extent investors in hedge funds have already acted on their on-going interest in distressed investing. For example, it has just come to light that Australia’s $58 billion The Future Fund increased its investments in distressed assets in its last financial year. The Future Fund, a form of sovereign wealth fund, committed A$4 billion ($3.6 billion) to distressed private equity and debt investments during the year to June 2009.

There is also evidence of investor commitments from the supply side: Oak Hill Advisors runs more than $11 billion in specialty credit funds including credit hedge funds, distressed funds, and long-only funds, and of that total $3 billion was raised in the last 18 months. Oak Hill put together a new distressed fund, OHA Strategic Credit Fund, last year which started investing the capital in October 2008. The final closing of the new fund came in September this year, at which point investor interest in the fund exceeded by more than 50% the initial target of $750 million. So investors have been backing their investment strategy preferences.

But is the opportunity set still rich for distressed investing? Looking at how the credit spread has moved in the last year (see Fig.2), it is plain that the gross opportunity – the once-a-generation opportunity if you like – has gone. Credit spreads are back to where they have spent the majority of the last 20 years – excluding the past two years. So the 22% gain of the HFN Distressed Index year-to-date through October cannot be expected to be repeated next year, but double digit gains are still achievable on an index basis. This is despite the fact that hedge funds are over-represented in distressed investing.

Greenwich Associates’ recent research confirms that hedge funds still make up more than 90% of trading volume in distressed debt, and almost 60% in high yield credit derivatives. This is not the same situation that convertible bond arbitrage faced in 2005 because of the wider choice of securities and companies. Moreover, the risk assumptions made by managers are much more idiosyncratic – or bottom up – in distressed investing than in many hedge fund strategies. This is part of the potential for Dalton’s distressed investing approach, where the manager specialises.

Dalton advantages
So what is Dalton’s edge for its distressed debt strategy? First, the exposure to distressed mortgage-backed securities is both unusual and – to date – highly profitable. Persky himself sees the middle market emphasis as being something of a niche, and relatively under-exploited. In contrast to some providers, Dalton has been unburdened by investor redemptions and underwater positions, and has not had to put up gates or have positions in side pockets. The legacy issues are only positive, and investor attitudes are untainted.

Perhaps the most positive attributes are attitudinal: Persky is willing and able to take multi-year views. He is open-minded about opportunity. As he says himself: “Distressed investing evolves: what is distressed now will not be distressed in five years time. You cannot stand still; you have to be looking at where the opportunity is emerging.”

Persky finds himself well-suited to the business: “I like the intellectual challenge of distressed investing, that it is an evolving business. That we are always getting up to speed and getting in depth into something is an attraction. There is also appeal in distressed investing being something of a contrarian strategy. I think I learned that from my Dad: when I was growing up he bought Chrysler stock when it was on its knees and made sure I knew about it. He also bought New York municipal bonds when the City was close to default and nobody would touch them.” Maybe the aptitude runs in the family, and Dalton’s Steve Persky is just a natural investor in distressed securities?