Alpha through restructuring
Paolo Barbieri discusses the opportunites provided by restructuring hedge funds
The removal of leverage from the global economy not only impacts growth prospects but also impairs the ability for companies to refinance their debt cheaply. The growth of securitisation is 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, the next stage of this credit cycle is expected to provide a plethora of distressed opportunities across markets, sectors and individual companies.
Hedge funds are generally seen as vehicles for the extraction of value from inefficiently priced markets, and to a large extent they have proven remarkably efficient. While it may be fashionable to target hedge funds for destroying value, asset stripping is not a significant hedge fund strategy, while restructurings and corporate turn-arounds are increasingly becoming so.
Leading the next stage of the cycle?
What was once seen as a sector focused on vulture investing, perhaps offers real hope for leading an over leveraged corporate world through the next stage of the economic cycle.
Today, evolving credit markets and increasingly complex corporate balance sheets have attracted hedge funds to the restructuring market. As the world deleverages, the distressed investor will end up owning much of the distressed paper, and will own it with a view to generating meaningful returns, often through active and controlling positions. This loan-to-own strategy will allow investors with longer-term horizons to actively restructure balance sheets and corporate operations.
At the same time, we are witnessing the rise of the measured activist from the long/short equity sphere and the distressed space. Using superior research, coupled with practical experience as an investor in numerous turnaround situations, managers can advise and influence boards in taking strategically beneficial decisions and in selling those ideas to other shareholders. The fact that these managers can bare their teeth allows them to be taken more seriously than traditional institutional investors. A lot of noise is created by a small number of short-term activists, but their results do not always measure up to the volume of their tactics.
While many private equity firms are currently looking at this area, we believe that dedicated hedge fund specialists will be best placed to take advantage of these more uncertain economic conditions, focusing on de-leveraging balance sheets to drive margin improvement.
For some investors, restructuring is simply a strategy where hedge funds look at the active long-term turn-arounds of businesses with good business franchises, poor balance sheets and, quite often, mediocre management. In the next stage of the cycle, many of the opportunities are expected to arise from the excesses of the private equity boom, over-leveraged balance sheets and the vast expansion of high yield paper.
Restructuring managers may take a number of different approaches but all will say they have the ability to influence the outcome of their investments by taking an active role in restructuring, advising or encouraging others.
There are four key strategies:
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 need to exhibit a deep knowledge and understanding of the bankruptcy or restructuring process and be able to analyse and interpret positions through the changing course of events, maximising investment opportunities through the various stages of the distressed cycle.
Most managers favour investments in companies with hard assets where there is a measurable level of downside protection. They must be able to demonstrate a disciplined approach to managing investments with a strong conviction to buy, sell or hold even when the market diverges from true value.
This is also a network-driven business where proprietary research dominates and where managers have to be able to assess all the operational, financial, legal and political issues of each potential investment. Many hedge funds have teams of experienced management, legal and financial advisers who are instrumental in the transformation of corporate value.
Lock-ups of two years or more are common, alongside redemption cycles possibly every 18 months or two years, and notice periods extending to 180 days. For investors there has to be a premium associated with these terms.
Figure two highlights the risk/return profile of the HFR index US distressed securities and HFR index US event-driven to illustrate distressed and event driven strategies, both of which are less liquid than other hedge fund strategies. There is a material overlap of these strategies with the restructuring theme.
Over a seven-year period, these two strategies provided a higher return than many alternative and traditional asset classes for lower volatility. A downside is that investors in some funds have to be prepared to invest over the long term with either low or no access to their capital in the early years. For those comfortable with longer-term investments, these strategies potentially offer an illiquidity premium and a substitute for other illiquid investments that may be reaching the peak of their cycle.
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 managers' specific skills rather than general market movements. Amid market turbulence, there will inevitably be support for strategies that can generate real alpha without the use of leverage.
Paolo Barbieri is deputy CEO of Pioneer Alternative Investments