Distressed debt hedge funds to shine in 2008

Date: Wednesday, December 19, 2007
Author: Laurence Fletcher, Reuters

LONDON (Reuters) - A predicted golden age for distressed debt hedge funds has so far failed to materialise in spite of the global credit crisis, but 2008 should be their year.

"You ain't seen nothing yet ... It's going to be huge," said one funds of hedge funds executive who declined to be named. "The tea leaves are not difficult to read."

After the start of the credit crisis this summer caused by the U.S. subprime meltdown, and after subsequent turbulence in equity and bond markets, a number of funds of hedge funds have again turned to distressed investing, a cyclical strategy that tends to do well when times are tough for everyone else.

Distressed funds look to buy the discounted bonds, loans or other debt of firms that have defaulted on debt payments or are set to enter bankruptcy or financial restructuring and bet they can weather the storm and earn strong returns from a turnaround.

Given that a prolonged period of ample liquidity and easy borrowing conditions is over and many banks are stuck with debt they are keen to get rid of, distressed funds, which have had slim pickings in recent years, should be coming into their own.

The problem is that these opportunities have so far failed to emerge -- in part because corporate defaults remain so low.

According to Moody's Investor Service, the global "junk" bond default rate was at a 26-year low of 1 percent in November.

"As it stands, it's a bit precipitous to suggest there are lots of opportunities," said Tim Gascoigne, a fund of hedge funds manager at HSBC Alternative Investments.

"I think opportunities may arise later on down the road. I don't see many opportunities in terms of corporate defaults at present. It may happen in the second half of next year."

Meanwhile, despite their well-publicized troubles, banks still appear reluctant to sell on packaged debt at distressed prices, despite a leveraged loan backlog estimated recently by Centaurus Capital at around $400 billion (200 billion pounds).

"We're sitting in a denial phase. Nobody wants to be the first one out ... Nobody's doing anything right now," Ken Kinsey-Quick, fund of hedge funds manager at Thames River Capital, told Reuters.

"I would have expected it (the bursting of the credit bubble) to be far faster and more brutal."

"THE TIME MUST COME"

Betting on a lower price in the subprime sector has proved the must-have trade of 2007 as rising interest rates caused more and more high-risk U.S. mortgage borrowers to default.

The trade has provided returns of several hundred percent this year to funds such as John Paulson's Credit Opportunities and Lahde Capital Management.

However, while some further gains are seen, many funds who got in early have now begun to scale back such positions.

Event-driven funds, which bet on merger and acquisition activity and do well in bull periods, also face a tougher environment, so funds of hedge funds are looking for new areas to deploy their cash.

The good news for distressed funds -- which have returned 8.29 percent from the start of this year to end-November, behind a 12.04 percent gain in the Credit Suisse/Tremont Hedge Fund Index -- and the bad news for traditional bond investors -- is that most commentators expect default rates to pick up next year as corporate refinancing becomes tougher.

This month, Moody's Investor Services said the global default rate is likely to quadruple to 4.2 percent by the end of 2008, as credit woes limit access to funding, while a U.S. recession could push default rates to "near double-digit levels".

However, in the interim, hedge funds are eyeing distressed sellers, be they institutions not able to hold junk debt, or banks, nursing reported subprime write-downs of more than $60 billion globally so far, and facing slower growth next year.

"It will come in all sorts of forms -- banks having to offload stuff ... It's not just the debt of distressed companies," said the funds of hedge funds manager who requested anonymity.

"The time must come (for banks to sell assets), ... having got themselves into a tremendous hole. If it's a choice between cutting the dividend, raising more money or selling assets...?"

According to restructuring bankers, some banks have already started selling some of their worst loans at a discount to their face value, but in private transactions between parties, shying away from publicized sales.

"With distressed securities it's probably 12 months out -- from the summer of next year," said Thames River's Kinsey-Quick, who says he has 20 percent-plus of his portfolio in cash.

"We're really seeing an opportunity set in the interim of more distressed sellers ... They're going to start dumping these things, they don't trust the ratings agencies anymore. You're going to get a lot of babies going out with the bathwater."