Institutional Investor's Alpha Magazine - March 2009 - (Page 26) DISTRESSED DEBT INVESTING What Are Funds Buying? ith the likelihood that the economy will worsen before it gets better, and with exit strategies looking uncertain, many distressed-debt funds are buying right at the top of the capital structure, purchasing senior secured loans. There’s little incentive to buy junior debt, the first to get wiped out if conditions deteriorate, when there’s not much competition to buy firstlien debt, which also offers covenants, collateral and control over potential restructurings. Indeed, first-lien buyers are being offered favorable terms because there’s so little financing available. That means still less value in a distressed company trickles down the capital structure to junior creditors. According to the Debtwire survey, 78 percent of respondents thought first lien-secured bank loans offered the best investment opportunities in 2009 (see p.7 ), with the second mostfavored investment being senior secured bonds. Common shares, subordinated bonds, collateralized loan and collateralized debt obligations and preferred and mezzanine debt were voted the least-attractive investment opportunities. The industry-leading companies with valuable assets are seeing demand for their debt. “There are buyers in the market. The sectors of the high-yield bond and leveraged-loan markets which are of the highest credit worthiness have been doing very well. I don’t think that there have been corresponding moves in the more suspect credits,” says Howard Marks, chairman of Oaktree Capital Management. W Karl D’Cunha Houlihan Smith “It’s almost like a return to the 1980s, when there was a preference for simple, transparent, unstructured products.” a simple structure. “It’s almost like a return to the 1980s, when there was a preference for simple, transparent, unstructured products,” says Karl D’Cunha, senior managing director of Houlihan Smith. Keeping it simple might be another way for hedge funds to accumulate larger distressed funds and get more investors on board, particularly when Congress is pressing for more hedge-fund regulation and more rigorous registration requirements. “Investors want more transparency. In investing in distressed debt, hedge fund managers are As the economic outlook worsens and Congress pushes for more regulation on hedge funds, today’s investors are turning to simple, transparent products. going to have to balance their ability to generate alpha without their peers discovering their investment strategies against the regulatory need of the hour,” says Sal Shah, a managing director with accountancy, tax and business consulting firm RSM McGladrey. Still, among loans arranged recently, some have included innovative new structures that represent a break from the past. Consider, for example, Lyondell’s $8 billion debtor-inpossession loan, a record-breaking deal the company arranged in early January when it filed for bankruptcy. “There are some unusual mechanisms that affect distressed investors,” says Ron Cohen, a partner in Seward & Kissel’s Litigation Group and head of the firm’s Bankruptcy and Corporate Reorganization practice. “Instead of having a specific piece of collateral when they bought the loan, investors got a pro rata allocation of a much bigger pool of collateral. If people take pieces of this loan on the secondary market, they need to know what they’re getting.” Senior loans fetch equity-like prices The returns on senior secured loans are compelling. “What people are buying is changing,” says Craig Sklar, a partner in Seward & Kissel’s Business Transactions Group. “Secured loans are being priced at levels you used to see for unsecured debt or mezzanine. They’re not willing to go in and take an unsecured debt or common stock position in the company right now.” Today’s investors prefer quality asset-based loans, which are overcollateralized and have 6 • Alpha Sponsored Report • March 2009
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