Hedge funds see opportunities in credit crisis, but investors and prime brokers are wary

Date: Wednesday, April 2, 2008
Author: Margot Patrick, Dow Jones.com

Courtesy of Margot Patrick, Dow Jones: Hedge funds are seeing the chance to pick up on the cheap an array of assets that have been dumped in the credit crisis. But getting the money to pay for them is proving tricky.

Investors are anxious about adding to the losses they've suffered in funds holding leveraged loans, asset-backed securities and credit derivatives, particularly when they are being hit up for new capital by the same hedge fund managers that lost them money.

Prime brokers that finance funds' positions are also wary of getting involved, since the "distressed" assets could continue to fall in value and they might end up stuck with them. "The opportunities are there but investors are being more selective in who they would like to fund to pursue these opportunities, and credibility is a big issue," said Taco Sieburgh Sjoerdsma, director of research at Liability Solutions, a hedge-fund consulting and marketing firm. "If you are a fund that just lost a lot of money in credit, you will have a tough time convincing people to invest in your new ... fund," he said.

Over the past few months, firms including London's Cairn Capital Ltd. and Cambridge Place Investment Management LLP and New York's Marathon Asset Management LLC have launched "opportunity" funds to take advantage of historic low prices in leveraged loans, mortgage-backed debt and other unloved credit instruments. Beyond the potential returns, these new funds are a way for managers to rebuild their asset bases and reputations with investors after losses from the credit crisis in other business lines.

Large institutions such as Citigroup Inc. (C), Goldman Sachs Group Inc. (GS) and BlackRock Inc. (BLK) are also eyeing this kind of debt, under the assumption that the borrowers will end up repaying much more of it than current market prices suggest.

"Successful businesses will at some point repay their loans. The discounts on the assets give you considerable potential returns, so we are selectively buying some assets and trading some positions," said Andrew Burke, head of the leveraged loan business at Cairn Capital, which launched a loan opportunities fund in January. But Burke and other fund managers said it is a tough environment for fundraising, since many investors are waiting for credit markets to show firm signs of stabilization before committing capital to new funds.

"Very few managers are credible after last year. It's very challenging to find managers who have lived through market cycles," said the head of a funds-of-hedge-funds business at a private equity firm.

In addition to convincing investors that they won't get burned again and that prices are close to bottoming out, fund managers are facing tougher terms with their lending banks, which have become far more discerning in the credit crunch.

"There is a lot more focus on how prime brokers finance their business and how efficient they are at using the balance sheet," said Nick Roe, global head of equity finance and prime brokerage at Citigroup. "Given the current financial environment where you have to be self-funding, prime brokers don't necessarily want to fund sub-investment-grade assets because they then can't finance them with the Street."

This constraint on liquidity, where banks don't want to accept riskier collateral that they can't post with other banks, has resulted in prices on most leveraged loans falling below 90% of face value, and to as low as 20% or 30% of face value on some middle-rated asset-backed debt tranches.

William Healey, managing partner and chief executive at London-based Picus Capital, whose $50 million credit fund, Picus Venator, suspended investor redemptions this week to try to ride out the price falls, said banks are still open for business, but "initial margins on new positions are considerably higher and leverage is considerably lower than it was before." -By Margot Patrick, Dow Jones Newswires; +44 20 7842 9451; margot.patrick@dowjones.com. No online Source