Overlooked models for distressed plays
Shamillia Sivathambu argues that emerging market debt offers opportunities for institutions searching for undervalued opportunities
The formation of the US Troubled Asset Relief Programme (TARP) was designed to remove distressed assets from troubled US banks to help shore up their balance sheets. However, US Treasury Secretary Hank Paulson has abandoned TARP's initial mandate and plans to use the funds to jump-start the securitised market, which has suffered a massive blow since the onset of the sub-prime crisis, by injecting capital directly into banks.
Leaving aside the wisdom of his decision for the wider US economy, investors are suddenly presented with a window of opportunity to buy up distressed assets at attractive prices.
According to recent news reports, John Paulson - the hedge fund manager who made a killing from betting against sub-prime mortgages last year - has started buying up debt backed by US home loans. Paulson is thought to have taken advantage of the cheap prices following the announcement which saw both residential and commercial mortgage-backed bonds tumble to new lows. Investment grade mortgage-backed bonds are now trading between 32 and 35 cents on the dollar.
Paulson is not alone. The market has been awash with news of new funds gearing themselves up to take advantage of the large capital inflows into distressed investment strategies.
GLG Partners, PIMCO, Pequot Capital Partners, PSource Capital and Avenue Capital, are just a few names that have either launched or hinted at launching separate funds dedicated to distressed investing. Most of these managers will focus almost exclusively on the US and Europe, which is where the distressed debt pipeline is expected to be the greatest.
But with so many distressed investors expecting to glean returns from the developed markets, attention is diverted away from developing markets and their numerous opportunities. In fact, as the global credit crunch continues to develop and the space becomes increasingly saturated, investors will have to turn to smaller transactions in overlooked markets to enhance returns.
Assets in emerging markets are arguably better placed to hold their value than those in developed markets given the stronger fundamentals of the former at both sovereign and corporate level. A good number of emerging market economies are now being affected by the current market turmoil from a position of relative strength built up over the last 10 years.
With strong GDP growth, large foreign exchange reserves, limited use of leverage, and growing affluence, emerging markets may be in a better position to withstand the current economic downturn and generate better risk-adjusted returns than developed markets. The debt-to-GDP of the US is 300%, while most emerging economies' debt-to-GDP is between 20-30%. The developed world has been living on borrowed money for far too long and while emerging economies will be affected by the wider market dislocation, they will not come down the way developed markets will.
Good quality emerging market assets are trading at levels that do not reflect their fundamentals. Emerging market bonds issued by companies operating in oligopolies have strong cash flows and low debt ratios and are currently trading at levels that are more than 300% wider from where they were just a year ago. The market is pricing in a high probability of default. But with their sound fundamentals and current high yields - averaging 15-30% - such assets look interesting at current prices.
However, despite the strong fundamentals of some emerging market companies, defaults are expected to occur as they struggle to refinance in today's market conditions. As this is more likely to be symptomatic of the wider credit freeze rather than the strength of the company's balance sheet in some cases, creditors with good asset valuation skills are in a strong position to negotiate attractive restructuring terms.
But the decision either to participate passively in restructurings or take on a more active role in creditor committees is best left to the experts as they can throw up a number of challenges for the unprepared.
Distressed investing requires specific expertise including knowledge of bankruptcy law, negotiations and workouts, valuation of a broad range of securities, access to additional capital and a strong network of contacts. A reputation for winning over management and experience in trading through crisis periods are also prerequisites.
This is why choosing the right manager is crucial to successfully diversifying into distressed assets. A proven track record in broader fixed income or equity investing does not necessarily translate into the required know-how for distressed investing. The distressed investor's skill-set is especially relevant when the investment remit is extended beyond the home market and into new regions, namely emerging regions.
In today's global economy there are very few companies that operate solely as domestic entities. Many companies will have international assets and operations. Under such circumstances, global experience and perspective will significantly affect the success of a fund and prove critical in tackling the wave of restructurings the market is anticipating post credit crunch. However, there are still just a handful of managers that have the expertise and experience to deal with such far-reaching investment mandates.
Global mandates offer investors greater access to opportunities. Funds with a country or region-specific mandate would have been unable to take advantage of all the opportunities that were made available in recent years.
The aftermath of the Asian crisis, the Russian default in 1998 and the Argentine moratorium in 2001, all provided a wealth of undervalued assets for the investor to benefit from. Although buoyant economic conditions and the wide availability of credit during the last couple of years have reduced the scope for such strategies, the picture is again changing dramatically.
The onset of new opportunities is great news for the strategy but in the interest of generating risk-adjusted returns, investors should find experienced managers with strong local contacts and on-the-ground investment teams. A good grasp of local markets and their respective peculiarities will allow a fund to identify overlooked opportunities while remaining fully conversant with the associated risks.
But managing a global distressed opportunities mandate is not just about proficiency. In some instances managers are expected to produce innovative responses to unprecedented problems, especially in the context of a legal framework. When Essar Steel, a large Indian company defaulted on its debt, we were not prepared to litigate in the local courts as we felt our rights might be difficult to enforce. Instead, we sued for repayment through the English courts - and won - in a landmark case which helped establish hedge funds as formidable players in the loan market.
Another issue investors have to contend with is the strategy's demand/supply disequilibrium, which is often accentuated when investment is concentrated in one region or market. While the supply of stressed assets has increased in the last 12 months and the present economic situation is likely to fuel supply further, the absence of any meaningful defaults means many investors are still playing a waiting game. Planning successful entry and exit strategies is a manager skill often overlooked in the selection process.
Investors have to plan their entries early enough to benefit from any eventual default but not so early that they cannot stomach the ride to the top. This is a skill requirement especially relevant to the current market where spreads have widened to levels that do not represent where we are in the default cycle.
An experienced investor, however, will have the ability to time opportunities accurately and invest in stressed situations in lieu of distressed opportunities. This entails investing in companies that have sound underlying assets and cash flow potential but face reversible liquidity issues.
As the global credit crunch continues to develop and the distressed space becomes increasingly saturated, investors will have to turn to smaller transactions in overlooked markets and rely on financial engineering to enhance returns.
It will be interesting to see how the slew of newcomers to the strategy will rise to such a challenge, especially when liquidity dries up in loans or bonds in complex structures and expert assessment of transaction documents is required.
Shamillia Sivathambu is at Argo Capital Management, an emerging markets specialist investment manager based in London