Institutional Investor's Alpha Magazine - May 2008 - (Page 46)

Distressed Debt than they should have, critics said, so Congress curbed the judges’ discretion to tinker with the statutory timetable. Fineman says the new rules put more pressure on management to develop reorganization plans long before ﬁ ling for bankruptcy protection. “A free-fall bankruptcy with no plan in place is a long, costly process,” he explains. “Most of the value can go out the door to all the professional advisers involved.” Fineman also says reorganizations have gotten more complex because of the growth in credit derivatives, which allow investors to hedge against the risk of default. Debt holders used to have a clear economic interest in preventing default and maximizing their recovery, but not anymore. “An investor may be able to make far more money on credit default swaps than on the bonds or bank debt,” Fineman notes. (A credit default swap represents a form of insurance in which one party receives a premium in exchange for — STEVEN EISMAN, PORTFOLIO a promise to make the other MANAGER, FRONTPOINT party whole if the referenced FINANCIAL SERVICES FUND credit goes into default.) The best opportunities today are among highly leveraged companies affected by the housing slump that might struggle to meet their ﬁ nancial obligations, Fineman believes. In addition to obvious candidates like Irvine, California–based homebuilder Standard Paciﬁc Corp., he is looking at retailers and restaurant companies, because he expects declining home prices to crimp consumer spending. For example, he says weakness at the malls will spill over to businesses like Phoenix-based Swift Transportation Co., a trucking company that hauls supplies for retailers and restaurants. In every case, Fineman tries to identify what he calls the “fulcrum security” — that place in the capital structure most likely to give holders an equity portion that the creditors carve up. “We tend to go in with a plan already in mind,” he says. “We try to push our restructuring plan onto the debtor.” After often-arduous negotiations, the creditors agree on a plan and the company raises fresh money to support the reorganized entity when it emerges from bankruptcy. Banks and ﬁ nance companies like New York–based CIT Group have traditionally provided such exit ﬁnancing, but they may not be willing or able to fulﬁll that role in this cycle. CIT had to draw down backup credit lines in March after its normal funding through direct sales of commercial paper to the money markets dried up. That was an extreme case, but banks are under such intense pressure to reduce their leverage that Fineman expects the cost of exit ﬁnancing to head higher. Fat fees and spreads may attract hedge funds and other lenders that have not historically supplied such ﬁnancing, but the higher costs will crimp the potential return on Third Avenue’s investments. “If the company is paying more in interest costs, it is coming out of my hide,” says Fineman. But while investors in distressed debt wait for the inevitable increase in bankruptcy ﬁ lings, extreme market conditions have created attractive opportunities in companies that are merely stressed. Christopher Crerend, executive vice president, chief alternative-investment ofﬁcer and a portfolio manager at EACM Advisors, a $4 billion fund of hedge funds based in Norwalk, Connecticut, points out that when the CLO merry-go-round screeched to a halt last summer, the banks had close to $250 billion in loan commitments for leveraged buyouts that they had to either fund using their own balance sheets or sell. The banks initially held out for prices close to par, but as the crisis deepened during the ﬁrst quarter of 2008, they began to throw in the towel. “That stuff just fell off the table coming into this year,” Crerend says. “If investors buy bank debt at, say, 85 cents on the dollar, they are at the top of the capital structure. The likelihood is they will get par in the not-too-distant future, and they clip the coupon in the interim.” Buying bank debt at a discount not only enhances the running yield on the investment but also offers the potential for even higher returns when the discount narrows or disappears. A rally in April has already pushed prices for this type of bank debt back close to 90 cents on the dollar. It’s a natural and potentially lucrative investment for distressed-debt players, who are accustomed to leveraging their knowledge of a particular distressed credit by working their way from senior debt to junior securities as a restructuring unfolds and the risk diminishes. During the downturn of 2000–’01, for instance, some managers took senior debt positions in California utilities like Paciﬁc Gas & Electric Co. that had gone bankrupt. Over time they were able to sell the senior debt at a proﬁt and get another proﬁtable trade out of the junior debt. Crerend says the managers repeated the process all the way down the capital structure; some even ended up buying equity in the reorganized companies. Crerend expects to increase his allocation to distressed debt in the next year but says he prefers hedge funds that focus on more-liquid credit instruments, like bank debt and conventional bonds. He will probably avoid funds that invest in structured debt despite prices that are even more distressed than corporate credits in the current market. Crerend isn’t alone in steering clear of all-ornothing investments, but for people like FrontPoint’s Eisman, the lack of investor interest is an opportunity. “The big money will be made when the bond you bought at a discount goes to par,” Eisman says. “But you aren’t going to par in 2008 when the whole world is deleveraging.” “Not since the Great Depression has an entire asset class had all its underlying fundamental assumptions obliterated at the same time.” 46 • INSTITUTIONAL INVESTOR’S ALPHA • MAY 2008

Table of Contents Feed for the Digital Edition of Institutional Investor's Alpha Magazine - May 2008

Institutional Investor's Alpha Magazine - May 2008 Contents Letter from the Editor Longs & Shorts Pension Corner: Send in the Clones The Good Guys: Outside the Box Cover Story: Welcome to Oz Interview: The Tipping Point Regulation: When Sentinels Go Astray Strategies: Taking Credit Research Center: The Hedge Fund 100 Book Excerpt: Shoot the Messenger Alpha Bytes: VaR Enough? Unhedged: Commentary: Not Your Father's Activist

Institutional Investor's Alpha Magazine - May 2008

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