Institutional Investor's Alpha Magazine - June 2008 - (Page 87)

Distressed Investors, Don’t Stress By Marc Lasry W e are at a pivotal point in the credit cycle, and I believe that the next several years will offer tremendous opportunities for distressed-debt investors worldwide. As one such investor, I believe this market is highly appealing not only because of the large volume of debt available, but also in light of the relatively sudden and dramatic reduction in the appetite for risk. The price of debt of many non-investment-grade companies has fallen to new valuation levels that present very compelling opportunities. The correction has occurred across several asset classes, including senior secured bank debt, unsecured bonds and subordinated debt, and in a wide array of industries. In U.S. markets record volumes of high-yield debt and leveraged loans have been issued over the past ﬁve years, with much of this new issuance being of a lower ratings quality. In addition, some of this leveraged debt had weaker covenants (commonly referred to as “covenantlite” debt) than investors have historically demanded. But in the late summer and fall of 2007, the rising subprime problem across the U.S. created apprehension in the ﬁnancial markets and the booming market for the issuance of bank debt and bonds slowed dramatically. Recently, however, there has been a rally within the high-yield and investment-grade markets. This appears to be a relative ﬂight to quality, prompted in part by the bailout of Bear Stearns Cos., which showed investors that the Federal Reserve was willing to play an active role in helping to remove systemic risk from the markets. Despite the uptick in prices among higher-quality securities, many of the more deeply distressed names have barely moved. Furthermore, although the U.S. debt capital markets were effectively closed for almost three quarters, several investment banks have recently been able to unload signiﬁcant amounts of bridge loans underwritten in the summer and fall of 2007. Notwithstanding this progress, banks have much on their balance sheets that still needs to be sold. The conﬂuence of these events will provide an increase in distressed-investment opportunities. Beyond the scope of the capital markets, the U.S. economy may well be heading into a recession. This likelihood, coupled with the weakest U.S. GDP growth rate in the past ﬁve years — 1.8 percent projected for 2008 (reduced from 2.5 percent previously) — suggests that distressed investing may prove to be particularly attractive in the years to come. According to Standard & Poor’s, default rates in the U.S. may rise to as high as 8.5 percent over the next 12 months. Unlike after the economic slowdown we saw during the 2001–’02 period — which was driven largely by isolated cases of fraud and overall excess within the credit markets — this time we will not see a rapid snapback. Recovery will take longer, as there is an unprecedented amount of leverage in the system following an easy credit environment and the widespread creation of structured products that readily transferred the risk of underlying mortgages. Europe has been battling similar challenges, albeit on a smaller scale. Recent problems in the European capital markets are twofold: Some have come in response to the U.S. credit and housing crisis, while others, such as bank bailouts and currency issues, are speciﬁc to Europe. The LBO loan overhang in Europe, although massive, is slightly smaller than that in the U.S. but is equally rich in opportunity. Basel II’s capital requirements, many of which began to take effect this year, are forcing banks to unload riskier, capital-intensive loans. In addition, European banks have recorded multibillion-dollar write-downs due to subprime mortgage exposure; they are also facing regulatory pressure to bring off-balance-sheet assets onto their balance sheets. Furthermore, the leveraged loan market in Europe has grown exponentially, from €42 billion ($44 billion) in 2002 to €165 billion ($243 billion) in 2007. Despite the slowdown in the second half of 2007, I believe this market will continue to grow in the foreseeable future. The default rate is expected to rise to 3.5 percent by the end of 2008, nearly triple its current level, and to 4.4 percent by year-end 2009. These factors will likely produce a distressed environment ripe for investment in Europe over the next few years. I expect the transformation of the European market to continue, as it evolves from a local, bilateral, primarily loan-focused market into a pan-European, standardized bond and loan market, although weakness in the markets will likely continue in the near term. In Asia distressed investors are largely waiting on the sidelines as they determine the magnitude of the economic wave coming from the U.S. and Europe. The subprime crisis has left Asia relatively unscathed: Only $19.6 billion, or 5 percent, of the $379.2 billion in reported provisions and write-offs worldwide occurred in Asia. However, both rising commodity prices and overall inﬂation will continue to pressure businesses across Asia, with a heightened effect in China, India, Indonesia, the JUNE 2008 • INSTITUTIONAL INVESTOR’S ALPHA • 85

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

Investor's Alpha Magazine - June 2008 Contents Letter From the Editor Longs & Shorts Cover Story: Alpha Hall of Fame Bruce Kovner Michael Steinhardt Kenneth Griffin Louis Bacon Steven Cohen George Soros James Simons Seth Klarman Julian Robertson Jr. Jack Nash Leon Levy Paul Tudor Jones II Alfred Winslow Jones David Swensen Looking Ahead: Back to the Future Research Center: Europe Hedge Fund 50 Unhedged: Let the Sunshine In

Institutional Investor's Alpha Magazine - June 2008

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