Institutional Investor's Alpha Magazine - March 2008 - (Page 60) Unhedged Commentary Why Johnny Doesn’t Short By Basil Williams arely noticed amid the clamor of subprime bailout schemes, rogue French traders and withering credit markets, hedge funds that specialize in distressed investments — and the law firms that represent them — are revving their engines in timehonored anticipation of a long-awaited up cycle for their business. It’s a well-known ritual. Distressed managers hope to profit by buying deeply discounted securities of companies teetering on the precipice of bankruptcy or in the midst of a reorganization during an economic downturn. But that raises questions rarely if ever heard at times like these: Why don’t more distressed managers short? And why don’t they regard distressed investing not only for what it is but for what it could be — a strategy that can profit during all Distressed hedge phases of an economic cycle? Distressed investing paid off funds are poised very handsomely during record levels of corporate anguish and to pounce on the default in the early 1990s, and current downturn, again in the post-Enron era at the beginning of this decade. The relabut they can profit tively rapid emergence of investor appetite for this sector can be readin any part of ily seen in the sheer growth of distressed hedge funds, whose assets the cycle if they are swelled from roughly $9.8 billion willing to short. in 2001 to $116 billion through the third quarter of last year, according to Fairfield, Iowa–based data provider Barclay Hedge. From 1993 to 2006 the Hennessee distressed index tells a tale of enviable returns, with a sprinkling of down years (1998, 2000 and 2002) and a peak return of 25.8 percent in 2003. Although performance has trailed off the past few years, I contend that if distressed managers shorted more often, those returns would look even better. Traditionally, distressed managers see opportunity on the long side. Money is made after the bets have been placed and the race has run its course — that is, once a company’s assets have been sold or a reorganization completed. Conventional distressed investing conforms to established, predictable models. Companies that are in trouble are reasonably easy to target. They can be identified by their credit spread or the fact that they’re in reorganization or bankruptcy. We don’t see more distressed managers on the short side for a number of reasons, including cultural, practi- B cal, risk-related and historical biases, none of which are insurmountable. • First, the recent cycle of easy credit was extremely kind to long-biased distressed investors — at least until August 2007. The great bull credit run early this decade killed off many potential short-sellers because even the weakest companies were often rescued through continued access to low-cost funding. • A smart distressed manager can do fine operating only on the long side. Absent a relative-value-based orientation, shorting as an investment idea remains nonstrategic or irrelevant. However, properly incorporated into one’s toolbox, it can produce even better returns for investors. • Why place your bet on a bad credit when you can rescue a good one? Wishing bad things to happen to a company places you at odds with the company’s management, its employees and in some cases the public interest. • Shorting credit, while far from rocket science, calls on a specific set of skills and an outlook that are generally more complicated than those required for making long investments in stocks and bonds. Shorting distressed credit or equities demands its own creativity and requires looking under the right rocks for troubled assets before they’re underwater. Ironically, though, the necessary skills and insights map surprisingly well to the general information streams with which a traditional distressed manager works day in, day out. The single most important factor may lie in our notion of risk. When we regard the trading galaxy, we’re accustomed to seeing less risk and more transparency at the core, with higher risk and greater opacity migrating outward to the edge. That edge — the heavily marked terrain of hedge funds — is where the greatest opportunities (and the most risk) are found. As markets go through economic cycles, the best managers can successfully exploit those opportunities and control the risk only by shorting effectively. Short selling isn’t for everyone, to be sure. Nonetheless, it’s probably just a matter of time before certain strategies that have become associated with hedge funds — shorting and relative value, to name two — start to move from the edge back to the core. Perhaps then we’ll see shorting become a mainstream practice within the distressed-investment community. Basil Williams is CEO of Concordia Advisors, a $2 billion multistrategy hedge fund firm with offices in Bermuda, London, New York and Singapore. 60 • INSTITUTIONAL INVESTOR’S ALPHA • MARCH 2008
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