Rich pickings

Vulture investors – those who buy up distressed debt – have long been a feature of the American investment landscape but have so far had little chance to scavenge for profits in Europe. However, the situation is changing. Sunil Jagtiani reports.

If car maker General Motors becomes the world’s next great corporate bankruptcy, which some analysts fear is possible following the near-$11bn (6.34bn) loss the firm posted last year, then it is safe to assume that a crescendo of caterwauling will accompany its slide into turmoil.

Most holders of the firm’s shares and bonds will bemoan the mistakes that led to disaster, and calls for some kind of redress will grow. Talk of the vast sums of money lost by a slew of novice and expert punters alike will dominate the headlines.

A minority of expert investors, however, may view a possible GM bankruptcy quite differently. They could see it as an opportunity to make a profit – and quite possibly a handsome one at that. Indeed, such investors’ interest in GM is likely to rise as public concern about the solvency of the company grows, hitting the price of the troubled automotive giant’s securities.

This may seem counterintuitive but in fact there are a group of hedge funds, investment bankers and – to a lesser extent – mutual funds that seek to profit from corporate distress. The members of the group are sometimes referred to as “vulture investors”, since their sustenance comes from scavenging over apparently dying businesses.

Vultures are basically value investors, trying to buy an asset for a price well below its intrinsic or fair value. They look long and hard at distressed companies to see if their securities have been oversold, even accounting for the problems the companies face. Ordinary private or institutional investors may overreact to the news that a company is struggling and dump its paper, given the nature of human psychology, opening up a money-making window for cooler heads.

Typically, this kind of distressed investing focuses on a firm’s bonds, since bondholders have prior claims on a company’s assets compared with shareholders. The sequence of events often runs something as follows:

A firm looks on the verge of defaulting on bond interest payments, or actually defaults. The market price of the bond falls some way below its par value as existing investors jump ship.

In comes the distressed debt investor to calculate what the bonds are actually worth, given the firm’s assets and the claims on those assets from other creditors. If the distressed debt investor sees an opportunity – if the bonds are trading well below what the investor thinks they are worth – he may make an investment.

Following a turnaround in the company’s fortunes, usually through a restructuring either within or outside bankruptcy, the investor sells the bonds or exchanges them for a package of equity and debt in the relaunched business. The package can then be sold. If all goes well, the distressed debt investor pockets a tidy profit.

Distressed debt investing is most evolved in America. In fact, the US has a history of exploiting investment opportunities arising out of distressed debt – in a non-corporate context at least – going back to the 18th century, according to Stuart Gilson, the Steven R Fenster professor of business administration at Harvard Business School.

“In the chaos that immediately followed the American Revolution,” Gilson writes in a research paper, “Treasury secretary Alexander Hamilton proposed to restore confidence in the financial system by redeeming, at face value, the bonds the American states had issued to finance the war. On the heels of this proposal, speculators acquired large quantities of the bonds, which had fallen greatly in value under the weight of high inflation and the massive war debt, in the hope that Hamilton’s program would be completed.”

But America has the most evolved distressed debt market not just because of its investment heritage and culture, but also because of its highly developed bankruptcy laws. A firm gets legal protection from creditors under Chapter 11 of America’s bankruptcy code and can continue to operate as a “going concern” while its management team works out a reorganisation plan with a committee of its creditors.

In many other countries, bankruptcy involves simply shutting up shop and liquidating assets to pay back creditors – an option the American code explicitly fences off under Chapter 7 of itsbankruptcy law. America introduced this kind of approach to bankruptcy about 30 years ago. Analysts say today it has a large contingent of expert bankruptcy professionals – such as specialist court judges – to make the Chapter 11 process run relatively smoothly.

The modern American distressed debt sector, Gilson says, is “unique in its size and scope” since there is “a market for virtually every kind of distressed claim”. Indeed, he says it is “only a slight exaggeration to say that anything that is not nailed down will be traded when a firm becomes financially distressed”.

Leading distressed investing expert Professor Edward Altman of New York University’s Stern School of Business put the overall value of the market for distressed and defaulted public and private debt at more than $400bn (230bn) by the start of 2005. The face value of the paper was 50% greater. This makes distressed and defaulted debt taken together a significant asset class. By way of comparison, the US high-yield bond market – which spawns most of the defaulted and distressed debt opportunities – is in excess of $900bn.

Analysts say Europe still lags behind America in the opportunities it provides for distressed debt investors, but that this situation is changing as its high-yield corporate bond market and national insolvency laws evolve.

In a research paper, finance experts Itay Singer and John Burke point out that Europe’s high-yield bond market only began to develop in 1997. It took off in 1999, as telecoms firms issued paper to raise money during the technology, media and telecoms boom. Of course, boom turned to bust, the number of business failures rose and from 2001 onwards, European “default and distressed levels… were enormous”. New issuance picked up again a couple of years later.

Meanwhile, experts report that developments in insolvency law in countries such as Germany and Italy, among others, have seen them move towards a system a bit more like the Chapter 11 process in America.

Italy, for example, enacted the Marzano law following the collapse of Parmalat in 2003. The legislation sought to make the process of restructuring an insolvent firm quicker and easier. Germany has seen a couple of relatively high-profile restructurings of insolvent firms – such as pharmacy chain Ihr Platz – that in the past may simply have been liquidated. But for now America is likely to remain the main market for distressed debt opportunities.

For investors, the most interesting aspect of distressed debt investing, which by itself is generally viewed as risky, is the portfolio diversification benefits it offers. Although distressed debt opportunities are cyclical, in that they multiply during economic slowdowns, the time taken to profit from them depends on how long a firm takes to restructure, which varies from one case to another. The process can be lengthy – for instance, if the negotiations between a firm’s management team and its creditors start to drag. Alternatively, it can be expedited in a matter of months.

Research by Altman helps to bear out the point that distressed debt investing can help to diversify an investment portfolio. For example, the correlation of monthly returns between the Altman-NYU Salomon Center Defaulted Bond index and the S&P 500, from January 1987 to December 2004, was 28.9%. The correlation between the defaulted bond index and returns from the 10-year US treasury bond was -19%. A figure of 100% would represent perfect correlation.

Altman’s analysis of returns shows that between 1987 and 2004, the Altman-NYU Salomon Center Defaulted Bond index provided an annual average return of 11.3%, compared with 13.4% from the S&P 500.

“Several domestic pension funds and foreign portfolios have… [allocated] a portion of their total investments to defaulted debt money managers,” Altman writes in a research paper. “The principal idea for this strategy is that the returns from investing in distressed debt securities have relatively low correlations with most other major asset classes. This can be clearly seen from the data on returns that we have been tracking for many years.” Peter Langerman, manager of the Franklin Mutual Shares fund, whichincludes investing in distressed debt as part of its mandate, echoes the point. “Distressed investments… tend not be correlated with the overall equity market,” he says. “They are interesting investment opportunities and there is competition in the area, but they are complicated and long-term enough that lots of people don’t want to get involved. The individual bankruptcy – the fight among creditors or between creditors and equity holders – dictates the outcome, rather than what the S&P 500 is doing. That lack of correlation is a good thing, because as part of a larger portfolio, it helps to create a more consistent return.”

The problem for ordinary British investors is getting access to the diversification benefits offered by this kind of investing, since it is dominated by hedge funds and specialist teams at investment banks. Mutual funds engaged in distressed investing tend to be US-registered and off limits for UK investors.

“I think distressed investing could be an area of interest for UK investors,” says Tim Cockerill, head of research at Rowan & Company. “But they have not really had the opportunity. In some ways, it is just taking value investing to another level. The risk is certainly going to be higher, but with a diversified portfolio, the potential long-term rewards could be good.

“I think it is worth pointing out that the UK is now very focused on short-term performance. In contrast, distressed investing is about the long term, and about being patient. But there isn’t an abundance of patience in the UK market right now.” That said, there are at least a couple of mutual funds available to British investors that include investing in distressed securities as a part of their investment remit (see box below). Cockerill points out that a few UK equity funds look at recovery or turnaround situations, and even near-distressed firms. But it is not so easy for a British investor to gain exposure to “pure” distressed securities investing.

For the past two to three years, it has also been difficult for managers of funds investing in distressed securities to find many investment opportunities. Solid economic growth and an abundance of cheap capital have enabled companies to repair balance sheets and stay healthy.

The corporate bond default rate has been depressed. It fell to an eight-year low last year, according to ratings agency Standard & Poor’s. Both S&P and Moody’s, a rival ratings agency, put the high-yield bond default rate at about 2%, which compares with a long-term average of roughly double that figure. The default rate was in the double digits during 2001 and 2002, following the deep new millennium bear market and economic slowdown.

But analysts say the rise in interest rates from their post-9/11 lows, together with the possibility of slowereconomic growth, could eventually push up default rates. For example, S&P forecasts that the high-yield bond default rate will rise to just over 2.7% during 2006 and then edge above 4.3% the following year. If these predictions are right, distressed debt investors are likely to be presented with new investment opportunities.

“With respect to the past few years, 2002 was an active year, but it has been less active each year since then,” says Langerman. “Last year was a pretty quiet year. There have been a few one-off things, but by and large it has been very quiet, because of the availability of capital, generally strong economic conditions and the wall of private equity money out there.”

But Langerman adds that he expects this to change. “The bottom line is that we would anticipate there being more activity, because of a slowing economy and rising rates, for instance,” he says. “There has also been a lot of issue of high-yield-type debt and historically the pattern is that two to three years out, the default rates, even if they are average default rates, will generate a fair bit of new merchandise. We are not of the ‘new era’ type of mentality. In the next 12-18 months – it is hard to predict exactly when – we believe there will be another wave of activity.”

Meanwhile, equity strategy consultancy GaveKal says evidence of a recent increase in merger and acquisition activity could portend more corporate distress in the future. “As we have highlighted numerously in the past, US companies have spent the past few years cleaning up their balance sheets and shedding their capital-intensive operations,” GaveKal said in a recent research note. “They are now loaded with cash. As such, we expect takeovers to increase markedly over the near future.

“One important question raised by the large increase in merger and acquisition activity is that of the financing of the deals. Indeed, if the merger and acquisition activity leads to an increase in leverage, then what is now perceived as good-quality corporate debt could suddenly be downgraded to junk status. Merger and acquisition activity usually leads to a deterioration in balance sheets… and thus owning corporate debt at very tight spreads might today be riskier than most people think.”

So if the experts are right, then in the next couple of years the unusually clement environment the corporate sector has enjoyed recently could give way to a spate of new bankruptcies. The vultures are perched, but ready to swoop into action.

British distressed debt opportunities

An ordinary British investor does not have many avenues through which to gain exposure to distressed investing to diversify his or her investment portfolio. Franklin Templeton, the US-headquartered asset manager, offers a couple of investment funds with mandates allowing them to invest in distressed securities. These are the Franklin Mutual Shares open-ended investment company, a mirror of the multi-billion dollar US-registered fund of the same name, and the Luxembourg-based Franklin Mutual Global Discovery fund.

However, it should be noted that distressed securities form only part of the value investment style practised by these funds. They also look for non-distressed undervalued stocks and arbitrage opportunities, so they do not offer exposure purely to distressed investments.

Tim Cockerill, head of research at Rowan & Company, suggests an alternative option could be a UK recovery fund, such as the M&G Recovery portfolio run by Tom Dobell.

“The companies Tom Dobell invests in aren’t really in the distressed category,” he says. “Rather, it’s more like they are down but not out. Dobell invests for the long term, at least three years, and he works with the companies to help the recovery process.”

Another option, Cockerill adds, is the Liontrust First Income fund run by Jeremy Lang. “Jeremy Lang often invests in companies that are on the verge of being distressed,” Cockerill explains. “He looks for an area where there has been a lot of pessimism to find what he calls ‘deep value stocks’. These are stocks that look completely helpless, where the yield has to be much higher than long-dated gilts – another sign of distress – but which the manager believes will still be in business and paying dividends in five years.”

Lang reports that there is “very little” correlation between the performance of First Income and the wider equity market. However, it should be pointed out that such alternatives to actual distressed debt investing may not offer the same portfolio diversification benefits as those highlighted in the main text.

The American approach

Professor Edward Altman, a leading distressed debt expert, has identified a number of distinct distressed debt investing strategies in America, each targeting a different level of return. One approach, the most short-term tactic, is what he labels “passive”. This involves investing in bonds trading at distressed levels for about six months to a year.

The passive approach sees an investor wait for a return from the bonds he judges to be oversold. The investor does not get involved in the struggling business’s attempt to turn around its operations. The target return is about 12-20%.

Altman labels the second approach “active/non-control”. Here the distressed debt investors play an active part in a firm’s attempt to restructure its debt and business operations during bankruptcy, by trying to influence the process.

However, they do not seek to take control of the business. Instead, they make an investment for one to two years, often in a large or medium-sized company, and aim for a 15-20% return by selling equity or debt allocated to bondholders during the bankruptcy reorganisation.

The final approach outlined by Altman also focuses on large and medium-sized companies, but is more aggressive. Here the distressed debt investor buys enough paper either to block restructuring proposals or take control of a distressed firm, possibly working with one or more partners.

The investor then swaps debt for equity and restructures the business, perhaps injecting more cash into its operations or acquiring related firms. The investor runs the firm and restores it to profitability before selling it after two to three years for a profit of about 25%.

Another way of making money from distressed companies may come from their shares – but only once they have been through a restructuring. A study by finance professor Allan Eberhart and Altman assessed the stock return performance of 131 firms emerging from bankruptcy. The study found “evidence of large, positive excess returns in 200 days of returns following emergence”, based on different estimates of expected returns.

“Our results suggest that, although these firms may not do well in their [post-bankruptcy] accounting performance, they appear to do better than the market had expected at the time of emergence from [bankruptcy],” the authors say.