WHEN BLUE MOUNTAIN chief executive Andrew Feldstein wrote to investors in the firm’s Credit Alternatives Fund on November 3 informing them of his redemption and recapitalization plan for the $3.1 billion fund, it was a clear sign that the difficulties faced by credit fund managers had reached a new intensity. The Blue Mountain Credit Alternatives fund is one of the largest and most successful credit hedge funds in the market, having returned 17.4% in 2006 and 8.8% in 2007. But on October 31, the fund was down 2.4% year to date. Feldstein wrote that he was moved to take action on redemptions from the fund, despite "both our distinguished performance through the credit crisis and some of the best investment opportunities we’ve ever seen".
All investors in the fund were given the stark choice of redeeming their existing investment or exchanging it into three new locked-up classes with longer lock-up periods (90 days, one year and two years). "Put simply, the bid-offer around mid-market valuations is at exceptional and unprecedented levels," wrote Feldstein. "If we were to unwind or sell positions to meet current redemptions, the severe liquidation costs would be borne inequitably by the remaining investors. Moreover, selling our most liquid positions would further disadvantage remaining investors and later redeemers by leaving them with a less liquid portfolio."
Blue Mountain’s decision to halt redemptions from this fund has attracted much attention. However, it is just the latest example of the hammering that many credit funds have taken this year. Several other large hedge funds have been scrambling to shore up their credit vehicles: for example, GSO Capital (which is owned by Blackstone) has had to raise an additional $100 million from investors to meet margin calls and GoldenTree has been forced to tap investors for an additional $250 million of rescue capital (see Credit opportunity funds: Hedge fund deleveraging kills opportunity funds, Euromoney, November 2008). Citi has also folded its Corporate Special Opportunities fund. Forced deleveraging is hitting funds large and small: in London, several managers, including Elgin Capital Threadneedle Asset Management and RAB Capital have shuttered or halted redemptions from funds. "It is amazing how many hedge funds are hanging on by a thread," says a US credit hedge fund manager. "Those that are down 25% will never make their high-water mark again. There is simply no incentive for them to keep going."
But the incentive for funds that can position themselves to take advantage of the extraordinary times in credit is not in question. Hedge fund manager John Paulson, having shorted the market since 2006, positioned himself to begin buying US RMBS at the beginning of October. Via a new fund, the Paulson Recovery Fund, he will look at distressed sub-prime mortgage securities and LBO debt. In Europe, spreads on triple-A ABS have gone from less than 10 basis points before the crunch to more than 400bp now, which is a phenomenal opportunity for investors that are in a position to go long. But that is what many credit opportunity fund investors thought a year ago, and they have paid a heavy price for betting against what turned out to be a relentlessly falling market. And the impact of Hank Paulson’s decision to divert the Troubled Assets Relief Progamme’s (Tarp) focus away from mortgage-backed securities was for the market to lurch yet wider – after the announcement the ABX HE triple A index lost 3.1 points in one day. So how can credit investors make sure that this time their strategies are bomb-proof?
New spirit of creativity
The first and most obvious approach is to minimise any exposure to redemptions. "It is better to address the current market with locked up capital. Callable capital is suitable for overnight deposits," says Tim Frost, director at Cairn Capital in London. "In the credit market the violence of the mark-to-market moves has made a mark-to-market approach very challenging to operate successfully. But there is some new money proximate to the market and there are certainly a plethora of opportunities out there." Cairn was one of the first credit funds to feel the force of the looming storm in credit when it was forced to restructure its $1.6 billion Cairn High Grade Funding SIV-lite vehicle in August 2007. It won many plaudits for the speed with which it addressed the problems in that structure, and has subsequently been busy advising other funds in the market on restructuring issues. The firm recently hired ex-Lehman Global Real Estate managing director Peter Hansell and is poised to launch its first commercial real estate fund to take advantage of distressed opportunities in that sector. In November, Cairn’s website carried a quote from early 20th-century Czech economist and political scientist Joseph Schumpeter: "Out of destruction a new spirit of creativity arises". This is something that all in the credit market are fervently hoping remains the case.
A spirit of creativity is certainly arising out of the spread dislocation and dysfunction that has resulted from marking to market. Just how anomalous some of the pricing in credit is was highlighted recently at the Reuters Global Finance Summit. Blackrock president Robert Kapito pointed out that a $30 billion portfolio of mortgage risk that the firm acquired in a distressed sale from Bear Stearns earlier this year was performing as expected. "The cashflows are coming in very close to what we had anticipated from the very beginning," he said. The portfolio was marked at $26.8 billion at the end of September but Kapito pointed out: "I would say that the cashflows on these securities predict a higher value than what is currently marked to market."
That chronic illiquidity has resulted in illogical marks is hardly news. "There is complete dislocation in all instruments," says Neil Neilinger, CIO and vice-chairman at Aladdin Capital in Stamford, Connecticut. "Long-only will be a great business to be in right now."
Income generation
Unlevered ABS investors have traditionally been few and far between – with triple-As at Libor plus 8bp it was an almost impossible approach to take. But in today’s market it is the only approach to take. "Now is the time to like credit," states Alex Veroude, head of credit at Insight Investment in London. "The opportunities are always the greatest when there is the least amount of capital available." Veroude joined Insight, the asset management arm of HBOS, from GIB in May 2007 as head of credit. Insight is poised to launch a new credit fund, the Absolute Insight Credit Fund, by the end of this year. The Dublin-domiciled credit fund is Ucits III structured and will invest in a wide range of fixed-income securities. It will have a minimum investment of £250,000 and a management fee of 1% a year, with a 10% performance fee. "We made a conscious decision not to run funds with leverage and we have not pursued high-risk assets," says Veroude. "We have a very clean slate in credit. We think that the premiums we are accessing now overcompensate for the risks taken."