Keith M. Berlin
Vice President
“In this environment, risk taking of all kinds was punished, from the top of the corporate capital structure in bank loans to the bottom of the capital structure in equities.”
PRIVATE EQUITY: Special Sits
Distressed
Flight-to-quality has been the underlying theme in the markets since the beginning of the credit crisis in July 2007, and this premise remained in place through 2008. As global de-leveraging possibly reached a crescendo in October, U.S. Treasuries and the dollar remained the top choice of investors seeking safe-haven from the carnage. In this environment, risk taking of all kinds was punished, from the top of the corporate capital structure in bank loans to the bottom of the capital structure in equities.
There are many ways to dissect the recent performance of the markets. Often times, special situations investors and opportunistic distressed investors seek specific areas within the corporate capital structure of a company in which to invest. Historically, in periods of weakness in the credit cycle, these investors would allocate more to the top of the capital structure in bank loans and shift out of high yield bonds or equities. With that in mind, a look at the performance of these areas since the beginning of the credit crisis through the end of the third quarter offers an interesting perspective.
From July 2007 through the end of the third quarter, small cap value equities (Russell 2000 Value Index) lost 17.8%, high yield bonds (Barclays Capital High Yield Bond Index) declined 10.9%, and bank loans (CSFB Leveraged Loan Index) declined 8.5%. October 2008 was not just a bad month for taking risk, it also was the worst month in the history of the bank loan market, the high yield bond market, and the worst month for small cap value stocks since October 1987. Bank loans declined by 12.5%, high yield bonds lost 15.9%, and small cap value was down 20% for the month.
September and October of 2008 packed one of the worst one-two punches in the past 25 years for taking risk, as small cap value stocks declined by 25.7%, high yield bonds lost 23.4% of their value, and bank loans declined 17.4%. This two month decline was unprecedented for high yield bonds and bank loans. Although on a relative basis, remaining on the top of the capital structure benefited investors with smaller losses, the losses were nevertheless undoubtedly painful. Investors had few areas to protect their capital outside of cash or U.S. Treasuries.
We have seen a more pronounced interest in bank loans among the experienced private distressed managers and multi-strategy credit hedge funds. With bank loan prices reaching the mid-60s due to the massive wave of de-leveraging, investors seeking to gain control of a company or the ability to influence the reorganization process have stepped into the market to take “toe-hold” positions. Distressed and special situations investors generally seek what is known as the “fulcrum” position, which is the position in the capital structure that allows them to control or influence the reorganization process. The “fulcrum” security is not always known ahead of time, which is why some managers prefer to take multiple “toe-hold” positions, allowing them to begin the process of determining if gaining control is possible. With bank loans trading at levels commensurate with the historical recovery rate for loans (approximately 65 to 70 cents on the dollar), “toe-hold” positions in bank debt are attractive because one of two things can happen. One, the loan pays back at par, in which case the investor earns an annualized return in the high teens to low 20s; or two, the loan defaults and the investor ultimately owns the company, with the potential to earn even better returns following the reorganization process. Credit selection, as always, remains paramount to successful distressed or special situations investing.
The distressed and special situations opportunity in the mortgage-backed securities area remains murky. Pricing for high quality agency-backed mortgage backed securities has tightened versus Treasuries due to the shift in guarantee from implicit to explicit from the U.S. government. Non-agency mortgages do not have the same guarantee, however, and as a result trade wider than agency-backed mortgages. With banks and other non-bank financial institutions continuing to take write-downs and de-lever, we believe there are more attractive opportunities in the residential whole loan space and commercial loan space, and are actively reviewing managers in this area.
We have opted not to recommend the “special opportunity” mortgage funds that are raising funds, primarily due to the lack of clarity with regard to price discovery for securitized mortgage instruments. For example, one of the original beliefs in the securitized mortgage market was that the Troubled Asset Relief Plan (TARP) would help bring price discovery to the market. At this point, the plan has shifted its focus from buying cheap securitized mortgages to investing directly in banks to help support the financial system. Furthermore, we are unclear how much TARP will ultimately end up investing in the securitized mortgage sector. Additionally, we have concerns regarding conflicts of interest, real and perceived, with managers who already invest in these securities through traditional investment vehicles, their desire to raise distressed pools of assets for mortgages, and their interest in managing similar pools of assets for the government.
Opportunities in the whole loan market for residential mortgages are more appealing and more straightforward. We anticipate further write-downs from banks in the next 12-18 months as the recapitalization process continues. This should lead to multiple auctions for whole loans, where investors can buy the rights to mortgage pools at distressed prices and take over the servicing of the loans. These strategies have a social good component as well, as the buyers of the pools have an interest in helping the mortgage holders restructure their terms to keep cash flow positive.
Outside the U.S., the special situations and distressed opportunity set is expanding in Europe. In many ways, European consumers were more leveraged than U.S. consumers in this cycle, particularly in housing. LBO deal volumes were also more leveraged in Europe than in the U.S., leading to a high degree of potential opportunity for distressed investments in European companies. European distressed and special situations investments are not as straightforward as in the U.S., however, due to the multiple bankruptcy codes and social restrictions on restructuring companies. Some would argue that the European Central Bank’s desire to fight inflation by keeping overnight lending rates high and treat the global credit crisis as a U.S. problem may ultimately “break the back” of the European economy.
U.S. distressed and special situations opportunities are particularly robust and warrant allocations as defaults are likely to increase in 2009. We are also optimistic about European distressed opportunities and have been actively reviewing managers with a local presence in Europe and a proven ability to understand the various bankruptcy rules in these countries. Specific skills and capabilities are required to successfully navigate these markets, and we will recommend those managers that we believe possess these unique traits.
2At the end of October, Barclays Capital announced that it was re-branding its unified family of indices under the “Barclays Capital Indices” name. This combines the existing Lehman Brothers and Barclays Capital indices into a single platform. All Lehman Brothers indices will be maintained, with only the name of the index changing from “Lehman Brothers” to “Barclays Capital.”
