As credit hedge funds increasingly stall, the distressed markets might seem the only option left. Another month, another hedge fund closes its doors because of bad credit bets. In February, Sailfish Capital Partners, a $2 billion-plus fixed-income manager, shut up shop because of sharp falls in value in its supposedly safe top-rated investments. Sailfish certainly wont be the last to fall either. Event-driven funds average losses were more than 2% in January, according to most hedge fund indices.
An increasing number of funds invested in credit, if not closing, are being left with no alternative but to prevent redemptions. To avoid a fire sale of illiquid assets, Citi was forced to suspend investor withdrawals from CSO Partners, a hedge fund that focuses on corporate credit. The fund lost 11% last year. "We have temporarily suspended redemptions of all shares of CSO to stabilize the fund and allow time to address its funding needs to meet anticipated obligations," Citi said in a statement. And in January, Elgin Capital, a $3.3 billion London credit specialist, blocked withdrawals after big losses on leverage loans.
Investors are unhappy about being locked in but they are in a weak legal position. Guy Locke, a partner at law firm Walkers, says: "If investors sign up under terms where directors can effectively shut down redemptions then there is nothing that can be done. It is important for managers to have these provisions to protect investors. It has become industry standard."
With credit funds taking a dive, opportunities are opening in distressed credit. A poll of hedge funds, institutional funds and proprietary desks by Debtwire, commissioned by Bingham McCutchen and Macquarie Securities in January, indicates that 2008 will be the year of distressed investing. Almost three-quarters of the 101 respondents said they planned to allocate more of their investment portfolios towards distressed debt in 2008 than in 2007. "There are so many cheap assets out there right now that, for those who have the stomach to deal with less-liquid strategies, there is a killing to be made," says a head of prime brokerage. "Banks need to lend, that is how they make money, and lending is not being soaked up by the housing market, so they are under pressure to lend somewhere. At some point that dam will burst and it will jump-start the market again. For now, though, opportunities in the distressed credit markets abound."
Deepak Gurnani, co-head of hedge funds at alternative investment firm Investcorp, which manages about $7.2 billion in hedge fund money, says his firm has been looking at opportunities with distressed credit managers and volatility players over the past four months. "In distressed credit there are a number of established managers," he says. "Some distressed credit managers have evolved from having a narrow credit focus perhaps in long/short or stressed high yield, and are now multi-strategy."
Gurnani says that finding the right funds will take time, as not all sub-sectors in distressed credit present the same opportunities, and not all the funds starting up look attractive. "You have to be selective and look for managers who are experienced and know the companies they are investing in," he says. In structured credit, he says, there are still few established managers with expertise. "It is a relatively new phenomenon," he says. "Some have tried to get in resources but we believe it is still a specialized area. We are looking for these structured credit managers, with a focus on long/short and stressed high yield." That managers in structured credit are struggling is evidenced in their returns. Palomar Capital Advisors, a Zurich-based firm focusing on credit-related alternative investment products, produces a structured credit hedge fund index. The index for 2007 posted a net fall of almost 18%, compared with a net positive return of 8.3% in 2006. In December, half of the 30 funds included in the index reported negative results, specifically those sub-strategies of long investment-grade leverage, long junior debt, value-oriented and relative value and intra-credit.
Whether now is the right time to invest in distressed is debatable. One manager says that Citadel jumped too early in buying Etrades debt despite the deep discount. Most managers are predicting the bottom to be later in 2008. However, opportunities will be plenty enough to absorb the growing cash pools waiting to invest in distressed credits, says Gurnani. "There is a lot of capital we see that is waiting on the sidelines to invest," he says, "and some people question whether there is too much to put to work. We still think, though, that supply of investment opportunities will far exceed demand."