©Copyright 2000 Rogers Media. The following article first appeared in the August 2001 edition of BENEFITS CANADA magazine.

Vulture Capitalism

By Robert Parnell and Rip Matos

Just because you are invested in blue chip companies, it doesn't mean you'll earn blue chip returns. Take a look at Nortel Networks. Once a paragon of the Canadian equity market, it's now a cautionary tale of excessive index concentration. Then there's Xerox Corp. bonds. The shining example of all that was investment grade, is now a fallen angel of the fixed income market.

Regardless of what the markets are doing, some investors eschew the popular wisdom of investing in blue chips and focus on the opposite extreme. Distressed securities investors--also known as vultures--invest in the debt and equity securities of companies in financial distress, default or bankruptcy.

The speculative world of distressed securities investing represents the darker side of the fixed income market. It's investment territory that's a long way from the blue-chip world of investment grade bonds, and even beyond the Badlands of the high-yield market. Distressed securities are obligations of companies in truly dire financial straights.

Pension funds and other conservatively managed capital pools have generally invested in investment grade bonds with credit ratings in the AAA to BBB range. While some institutions will venture into the high-yield market (BB to C), investing in this area has been limited.

The distressed market lurks at the bottom of the credit rating pool with letters like C, indicating imminent default, and D, indicating actual default (see "Making the grade"). Distressed bonds are sometimes defined as bonds with yield spreads over 10-year treasuries in excess of 1,000 basis points. In the U.S., companies in the distressed category have often already filed for reorganization or liquidation or are trying to avoid reorganization through an out-of-court debt restructuring with creditors.

Institutional investors and pension funds have pretty much ignored the distressed market because of its association with higher credit risk. Fiduciary obligations, restrictive investment policies and the prudent investor legal framework have also limited their participation. This neglect may be the source of inefficiency in the distressed market, and the reason why institutional investors can find some good risk-adjusted returns in this arena.

PLAYERS AND APPROACHES

Distressed securities investing has generally been the preserve of hedge fund managers, private equity pools, banks seeking to offload bad loans along with a handful of strategic investors such as Berkshire Hathaway and GE Capital. Within the hedge fund domain, distressed securities investment has fallen into two distinct strategy groups: dedicated distressed securities hedge funds and event-driven hedge funds, which, in addition to distressed situations, exploits mergers and acquisitions and other corporate events. At the core of these strategies lies a company-specific event, and the analysis of it drives investment decisions.

There are many different kinds of distressed securities, and an equal number of methods to exploit them. Distressed securities hedge funds focus on any or all of the following investment opportunities: distressed or defaulted public bonds and equity; so-called busted convertible bonds (the conversion feature is virtually worthless); private bank and real estate debt; trade and bankruptcy claims; liquidation distributions; receivables; and other privately held obligations of public and private companies.

When, or if, distressed companies emerge from financial peril, there is often some form of corporate reorganization which wipes out the existing common equity as bondholders become the new common shareholders.

Some hedge funds participate in distressed debt obligations for the express purpose of gaining a controlling equity stake when the company emerges from reorganization. These new securities--often described as orphan equities because of the lack of institutional interest and research coverage--are often inefficiently priced and can offer significant potential for profit.

There are two basic approaches to distressed investing: active and passive. In an active approach, investors attempt to use their position as creditors to achieve a control so that they can influence the management of the company or direct its reorganization. A more passive approach is to simply adopt a buy and hold strategy, purchasing undervalued securities trading at distressed levels, suffering from general investor disinterest.

Unlike many hedge fund strategies where the hedge fund will take a long and short position to capitalize on the relative mispricing of securities, the distressed investor is usually taking a long-only approach, because it is usually difficult, risky or even impossible to short distressed or defaulted securities. Occasionally, hedge fund managers will find an irrational disparity between the prices of senior and junior bonds in the capital structure and they may be able to use a long/short approach.

On occasion a discrepancy between the fixed income and equity securities of a distressed company may also permit a long/short approach. For example, Company A has a relatively simple capital structure: senior secured bonds are trading at about 60¢ on the dollar, and common equity boasts a total market value of over US$1 billion. There is inconsistency in this situation. Because the bonds rank senior to the common equity, one of two situations must exist: either the common equity is really worth US$1 billion and the bonds should be trading closer to par value; or the bonds are fairly priced at their distressed level and the common equity should be worth almost nothing.

A hedge fund manager might capitalize on this situation by purchasing the relatively cheap bonds, and short selling the relatively expensive common shares--an approach known as capital structure arbitrage. You may dismiss this example, but the valuation discrepancy was real. Company A was, in fact, Euro Disney and the year was 1993.

The size of the distressed securities market follows a cycle that is somewhat linked to the strength of the economy and the amount and quality of previous high yield new issuance. In 1990, the face value of distressed and defaulted debt (both public and private) was estimated to be approximately US$300 billion. The size of the market contracted steadily during the 1990s as investors allocated more capital to the asset class and supply shrank in the face of historically low default rates. This situation reversed sharply in 1999 and 2000 when the volume of distressed and defaulted debt ballooned as inferior companies with unhealthy balance sheets (who previously found it easy to issue high-yield bonds in a market characterized by poor underwriting standards) were caught in a severe credit crunch.

The high-yield market may, at times, act as an incubator for distressed and defaulted securities. Approximately US$200 billion of the current US$600 billion in outstanding high-yield debt currently trades at distressed levels--this ratio was as high as 40% or US$240 billion at the end of last year.

Ed Altman, a noted expert on distressed securities, estimates that there is probably at least two times as much private distressed debt outstanding (bank debt and other privately negotiated transactions), totaling a whopping US$600 billion in distressed paper. Clearly, the current amount of distressed paper greatly exceeds the highs of the 1991-1992 recession.

The Altman indexes are widely recognized benchmarks of distressed bonds and bank loans. Over the past 12 years, returns from both indexes have been relatively disappointing. The Altman Distressed Bond Index has produced an annualized return of only 2.61% since Jan. 1, 1990. The Van Distressed Hedge Fund Index, however, has produced strong results, up 15.15% over the same period. Interestingly both indexes produced their highest calendar year returns in 1991--in the midst of a recession when default rates where relatively high (see "Sizing up the situation").

There are significant risks involved in distressed securities investing. Most of them are firm-specific or event risks. The outcome of a distressed investment will depend critically on specific factors such as the viability of the business as a going concern, available restructuring and liquidation options, the value of residual assets and even the track record of the bankruptcy judge.

Even in the event of default, bankruptcy or liquidation, a distressed securities investor can still realize an attractive return if the recovery rate is higher than the purchase price. Firm-specific factors are so influential that general market and economic factors will have only a minimal impact. As a result, distressed securities investment returns tend to have a low correlation with traditional market indexes. The Van Distressed Hedge Fund Index, for example, had a correlation of only 0.27 with the Standard & Poor's 500 index over the 12-year period ending Dec. 31, 2000, and a correlation of -0.02 with the Lehman Brothers Aggregate Bond Index over the same period.

In efficient markets where information concerning investments is readily available and widely distributed, it is challenging for investment managers to gain a material advantage. As traditional fixed income markets are extensively researched we should not be surprised to find that few investment managers can consistently outperform fixed income indexes for any length of time.

As the distressed market is so obviously inefficient and under-researched, it may offer strong risk-adjusted returns in this asset class over the long term. We should also expect these returns to continue to have a low correlation to traditional asset class returns. BC

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