Restructuring

Distressed managers ahead of the game as credit cycle shifts

MARK BARKER, CO-CIO, FUND OF HEDGE FUNDS, PIONEER ALTERNATIVE INVESTMENTS

While equity cycles are the subject of continual analysis and conjecture, the credit cycle can be a much more ambiguous concept particularly as inflection points can be dramatic in their arrival even if broadly anticipated. From a position of low volatility at both an index and a single credit level, most cycles move through an initial stage of single credit differentiation or individual sectoral distress before reaching a turning point where broader credit dislocation and systemic credit failures result in a dramatic widening of spreads and associated level of defaults.

Restructuring

Over the past four years, economic growth has, in large part, been based on increasing levels of liquidity funded by leverage. As leverage is taken out of the economy not only does it impact growth prospects but it also impairs the ability for companies to cheaply refinance their debt; that is lever their way out of difficulties. Add to this, loose lending standards and securitisation and the combination of effects are widely expected to drive a new default cycle.

From a position of compressed risk premia where only a limited number of sectors have fallen into distress (for example airlines, autos, merchant power) the next stage of this credit cycle is expected to provide a plethora of opportunities across markets, sectors and individual companies. However, in previous cycles where restructuring was very much the preserve of investment and traditional banks, evolving credit markets and increasingly complex corporate balance sheets have attracted both hedge funds and private equity firms to the restructuring market.

Extracting vs creating value

In the restructuring space, the hedge fund industry has gathered many of the sharpest minds in the financial industry and the value creation talents of these individuals are in high concentration. While a small number of highly specialised hedge funds have been quietly restructuring companies in the quasi-public/private equity space for a number of years, there are a growing group of hedge funds that have been extending their focus and investment horizon towards that of a typical private equity shop. This is either through a dedicated restructuring fund or via a special situations investment within an event-driven/distressed hedge fund, where managers recognise the risk/return possibilities associated with deploying capital and expertise over the longer term to rebuild company value. The environment in which these managers operate is complex and the market often illiquid, which creates the opportunity to purchase securities far below their intrinsic value. Managers have to be able to assess all the operational, financial, legal and political issues of each potential investment and may utilise experienced management, legal and financial advisors in the transformation of corporate value.

Increasing opportunity set

Within the hedge fund industry, restructuring managers may take a number of different approaches but all will classify themselves as having the ability to influence the outcome of their investments either through taking an active role in the restructuring of the companies that they invest, advising management of companies in which they invest, being active in creditors' committees or by encouraging investment by third parties who may take an active stance. The key strategies include:
 

  • Active long-term restructuring strategies
    Managers take an active role in the restructuring of companies that are in some form of stress or distress – this may include taking controlling or even 100% stakes in companies that are in need of operational or balance sheet restructuring.
  • Distressed value positions
    Distressed securities are generally undervalued by financial markets as a result of over-reaction to negative news, complex legal issues, poor publicly available research or difficulties in conducting a thorough financial analysis. Typically, such undervaluation provides a substantial margin of safety to investors seeking to generate returns from operational or balance sheet restructurings of distressed companies.
  • Event-driven special situations
    An event-driven strategy is usually predicated by a significant corporate event, such as a restructuring, spin-off, carve-out, re-capitalisation, bankruptcy or work-out. The corporate event will typically be complex and multi-faceted and will be characterised as possessing its own discrete beginning, middle, and conclusion. The objective is to exploit a significant perceived gap between current (usually severely undervalued) prices and anticipated prices on completion of the work-out process.
  • Equity value creation
    On the equity side, there is also a growing group of activist managers investing explicitly in publicly traded companies that are undervalued and whose value should appreciate considerably as a result of better management, less fragmented businesses, more strategic marketing, enhanced distribution, targeted cost controls, or more focused corporate direction or management activity. By taking an active stance following accumulation of a significant position in a company's equity, managers will seek to improve shareholder value over a defined time-period.

Convergence with private equity

Convergence is a recurring theme in the asset management industry and both hedge funds and private equity firms are actively looking to take advantage of the premium associated with these longer term investments. There are however some significant differences, in particular in relation to the types of companies they look at, the entry point in the economic cycle, and most importantly, in their attitudes towards leverage.

Private equity is generally best supported by healthy economic conditions, allowing managers to pursue a strategy of growth coupled with a leveraging of the balance sheet to reduce capital at risk. Distressed managers on the other hand typically take advantage of more uncertain economic conditions, de-leveraging the balance sheet to focus on margin improvement rather than top line growth. These managers are also supported by an increasing set of institutional investors who are now very comfortable with illiquid investments and have been actively seeking alternative sources of alpha through an increasingly 'off-piste' approach. From the backdrop of market turbulence in the second half of 2007 there will inevitably be support for strategies that can generate real alpha without the use of leverage.

As we have seen in 1999 and 2003 strong returns from distressed managers after credit cycle corrections can provide investors with a counter-cyclical and uncorrelated investment opportunity where performance rests with the managers' specific skill-sets rather than general market movements. From a corporate perspective, there is also a real possibility that hedge funds will be a driving force in leading an over-leveraged corporate world through the next stage of the economic cycle.