Wednesday, July 06, 2005

Flying the Coop / New Distressed Debt Funds

Flying the Coop
Matthieu Wirz
July 4, 2005

Defaults in corporate America hit an eight-year low of 2.2% in May, but chief financial officers should not get too comfortable with this state of affairs. Some of the brightest lights in the vulture fund business predict a surge in distressed situations by mid-2006, and are repositioning themselves accordingly.

Brand name personnel at several top shops on the Stamford-to-Midtown corridor consider the timing perfect to start their own funds in order to capitalize on the expected restructuring wave, and turn a tidy profit in the bargain. Veteran vultures at Angelo Gordon & Co., The DE Shaw Group, Elliott Associates, Och-Ziff Capital Management, Ramius Capital Group, Sagamore Hill Capital Management, Satellite Asset Management and WR Huff Asset Management have all flown the coop recently to set up distressed or event-driven shops of their own.

"They're preparing themselves for what they have coming up, and rather than generating returns for Elliott or Angelo Gordon or what have you, they'll be generating them for themselves," said Jonathan Rosenthal, head of corporate restructuring at Saybrook Capital, an investment bank specializing in workout situations.

A recent surge of easy money into hedge funds hasn't hurt either. Capital flows into hedge funds reached $27 billion in the first quarter of 2005, roughly 37% of the total assets allocated to the sector last year, according to Hedge Fund Research Inc. (HFR), a Chicago-based independent research provider.

Distressed hedge funds make money shorting troubled companies on their way down, buying back in at the bottom and then collaborating-or fighting-with management to unlock value through restructuring. The strategy accounted for only 4.73% of the hedge fund universe in the first quarter of 2005, according to HFR. Nevertheless, returns on distressed outperformed HFR's market index in each of the past four years by 6.73%-10% and beat the average last quarter by 1.9%.

"From a macroeconomic standpoint, there's a great deal of capital looking for a home, and a lot of that is being allocated to hedge funds," says one of the start-up fund managers. "But it's also a function of some of the longer-standing funds being closed to additional capital from even existing investors."

The search for returns sent hedge fund assets under management over the $1 trillion mark in 2004, according to HFR, but many larger funds have started capping investments from their existing clientele to reduce redemption risk. "If you're a fund with over $1 billion, you don't want to take any risk to mess up your 10%-15% in management fees," says Joe Aaron of Wood, Hat & Silver LLC, an investment adviser that allocates to hedge funds. "If you have a client with a particularly large investment that says it wants out, that could send you into a death spiral."

That pent-up demand from fund-of-fund managers who have maxed out at pre-existing funds represents a golden opportunity for top-rung distressed specialists eager to become principals at their own shops and, at long last, get equity. Says one of the new crop of distressed managers: "I left because [my previous fund] has no employee ownership program. It's that simple."


The prospect of autonomy also plays a big part in the rash of recent start-ups. The next generation of principals are all middle-aged graduates of firms run by founding partners who show no inclination to pass on the reins of power. "There's a big difference between having an equity-like participation and actually running your own fund," said Peter Lupoff, who left Eagle Rock Capital this year to form Azura Capital with Mark May of Sagamore Hill Capital.

That counts doubly in a vulture universe full of eponymous shops where brand, ego and fear of competition often create insular, top-down investment organizations.

WR Huff, named after founder William "Bill" Huff, epitomizes the domineering imprint principals can stamp on their funds. Based in suburban New Jersey, well away from the hedge-fund hubs of Manhattan and Stamford, Conn., Huff rarely speaks to the press and avoids using office e-mail for security reasons.

The secretive bargain hunter built up a $20 billion fund over two decades by pursuing an activist-and litigation heavy-investment strategy, particularly in telecom and cable situations around the world that include NTL Inc. and Telewest Communications Plc in the U.K., Adelphia Communications Corp. in the U.S. and Alestra (owned by conglomerate Alfa SA de CV) in Mexico.

Huff's hard-nosed negotiation tactics earn him respect from investors and bankers alike, but his Big Brother management style rubs some the wrong way. "Every decision went through Bill-at the end of the day, you can't make a decision on your own," says a restructuring banker who sat across the bargaining table from Huff in past restructurings. "Frankly, I'm surprised more people haven't left."

Joe Thorton did. He took off late last year after serving as counsel for Huff for 12 years, most recently taking point for the firm's participation in the Adelphia bankruptcy. Thorton set up a new firm called Pardus Capital Management with Karim Samii, an analyst at Huff who played a key role in many of the fund's international cable investments. He denies, however, that Huff's culture influenced their decision to leave.

Ed Banks, a senior portfolio manager at Huff, says the fund is no autocracy, but he acknowledges a rigid approach to management. "Bill constructed an investment framework, and we use a team approach to work within that framework," Parks says. "We all have to adhere to that, and if someone like Karim wants to do something different, this is not the place." He adds that neither Thorton nor Samii made investment decisions for the firm.

A dark horizon

Regardless of the impetus for their departures, the new crop of vulture investors all see a new wave of defaults and restructurings on the horizon. Those expectations have grown out of the boom in junk bond sales in 2003 and 2004, notable both for its size and for the low quality of the borrowers.

"Many of the power companies were in the penalty box a couple of years ago and were able to stave off bankruptcy by doing creative financings-Calpine Corp. is a poster child for that," says Mark Brodsky a former portfolio manager at Elliott Associates who is now launching Aurelius Capital. Energy producer Calpine announced a massive $3 billion asset sale and debt reduction program in May after multiple downgrades and diminishing investor confidence limited its access to the capital markets.

"The way the credit markets looked at them [in recent years] was that their survival was a question of how much runway they were buying themselves, and whether it would be enough," Brodsky says. "Many investors figured they could clip an attractive coupon for that period, and hoped that operations would pick up dramatically in time to refinance the debt, but the needed improvement isn't happening."

Teetering under an $18 billion debt load, Calpine benefited more than most from a heady new issues junk market fueled by yield-hungry investors and low interest rates. But bond buyers-many of them hedge funds-allowed a host of problem credits to refinance themselves.

High-yield bond sales surged in 2004 to $147.2 billion, slightly more than issuance in 1998, the last banner year for primary markets, according to data from distressed guru Edward Altman, a professor at New York University. While the two bond booms square off in terms of quantity, deals executed in 2004 were of significantly lower credit quality. Bonds rated B- or lower by Standard & Poor's accounted for 42.5% of the new speculative-grade transactions completed last year, according to Altman's research, well above the 31% in 2003 and 38% in 1998.

The proverbial chickens will come home to roost in 2006 or 2007, judging by the historical two- to three-year lag between periods of high issuance and restructuring booms. Moody's Investors Service reported a 1.9% global speculative-grade default rate in May, down from 2% in April and the lowest rate since 1997. That trend should reverse slightly by the end of this year before spiking to 3% by the end of May 2006, the agency said.

As of June 22, high-yield issuance was 38% lower in volume and 39% lower in issues than during the same period last year. Meanwhile, the par amount of distressed debt-trading at more than a 10% spread over the underlying Treasury rate-shot up 79% this year as of mid-May, according to data from Martin Fridson, the former Merrill Lynch & Co. high-yield analyst who now runs high-yield research firm FridsonVision LLC.

As investors lose their risk appetite, the bottom rung of the credit spectrum suffers most. When the market hit a recent low in mid-May, triple-C credits underperformed dramatically, with year-to-date total returns down more than 9% compared with a roughly 2% loss for single-B and double-B names, says UBS strategist Stephen Antczak. "It's typical to have triple-Cs underperform, but this magnitude is rather unusual," Antczak says.

Sectors with high leverage and expenses face a clear risk in this environment. "I don't think that cable and telecom are by any means out of the woods," Brodsky says. "Charter Communications remains incredibly over-leveraged, with a complex capital structure and a spotty history. Cable companies are now spending to get into telephony, and telecoms are spending to get into video."

Cutting both ways

While tightening liquidity provides a growing supply of distressed investment opportunities, many of the fledgling vultures acknowledge that it can also hurt their ability to raise funds. Concerns about losses in convertible bonds and bets on auto makers General Motors Corp. and Ford Motor Co. cooled the investment rush in hedge funds in the second quarter. If redemptions in June spark a vicious selling cycle, that chilling effect could turn into a deep freeze.

The key to hitting commitment targets depends on the start-ups' name recognition and their ability to communicate expertise in multiple strategies. "I think the reality is that last year, if you could walk, you could raise money," said one fund manager currently pitching investors. "I accept that we are not in that reality anymore, but what that does mean is that people are going to differentiate between capable, quality managers and people who can carry a calculator."

Convincing seed capital that you are the former rather than the latter depends a lot on where you come from, says Wood Hatt & Silver's Aaron. "[For] the guys [leaving brand-name funds], money is going to come into their space no matter what happens to convertible arb," the investment adviser says, referring to a rash of closures by convertible bond funds. Fund managers that lack that type of imprimatur will suffer, he adds.

New funds can also overcome growing nervousness about the hedge fund industry by marketing a diversified investment approach, says Todd Whitenack of BBR Partners, a financial advisory firm for wealthy individuals with average assets of $45 million. "In order to have a business that survives the cycles, funds need to create a business model that allows them to be flexible," he says. Event-driven strategies that combine distressed, merger arbitrage and special situations, such as legislative or regulatory arbitrage, fit that bill, Whitenack adds.

Asset flows into purely distressed funds stood at $749 million in the first quarter of this year, totaling only 11% of total inflows in 2004, according to Hedge Fund Research. In comparison, event-driven inflows amounted to $5.9 billion, or roughly 59% of the previous year's take.

While BBR looks for diversification to mitigate risk, the recent volatility hasn't turned off the advisory firm to distressed. "What we've started to talk about internally is that if you do see a lot of fallen angels like GM, that may make the long-only side more attractive," says Whitenack. "Given the relatively large number of poor credits that got capital last year, there's going to be a lot more junk to weed through."

On their own

And there will be a lot more vultures to do the weeding.

Samii and Thorton were among the first to decamp to start their own shop late in 2004. The pair teamed up with Lutz Stoeber, also from from Huff, and Shane Larson of Credit Suisse First Boston to launch Pardus Capital, a European distressed and special situation strategy that grew out of the international approach Samii brought to Huff from CSFB in 2001.

Large funds like Cerberus Capital Management L.P. and Oaktree Capital Management LLC established beachheads in Europe years ago to purchase nonperforming loan portfolios that were being liquidated by banks to conform with standards from the Basel II accord. Instead of competing with these big fish, Pardus will focus on individual credits in the middle market with an emphasis on control equity stakes. "In Germany, there are a lot of middle-sized companies that need capital, from retail to travel to utilities to telecoms," Samii says.

The pace of departures picked up early this year as more high-profile fund managers took flight. Brodsky left Elliott Associates-the fund famous for beating the government of Peru in court-in February. A member of Elliott's management committee and a former bankruptcy lawyer, Brodsky spearheaded an aggressive and lucrative legal strategy for the fund in Owens Corning's asbestos-related bankruptcy. Daniel Gropper, who engineered another of Elliot's large distressed positions in bankrupt utility Mirant Corp., also left to start up an activist distressed fund.

Brodsky teamed up with Adam Stanislavsky, a portfolio manager at John A. Levin & Co., to form Aurelius, a multistrategy distressed and event-driven fund that borrows a motto from its Roman namesake: "Claim your right to say or do anything that accords with nature, and pay no attention to the chatter of your critics. If it is good to say or do something, then it is even better to be criticized for having said or done it."

Angelo Gordon's head of distressed investing, Jeffrey Aronson, left his fund at roughly the same time as Brodsky. Aronson joined the firm in 1989 and controlled half its assets under management as recently as 2003, making all-in bets on Adelphia, MCI/Worldcom, Owens Corning and Telewest Communications Plc, among others.

In 2004, Aronson began returning funds to investors because of declining supply in the distressed space. Expectations of a pickup in 2006 and the lure of independence spurred him to leave Angelo Gordon in February, although a noncompete agreement will keep him from launching a new venture until October.

The defection epidemic also hit DE Shaw in February when Max Holmes, the head of distressed securities who recently oversaw the acquisition of high-end toy retailer FAO Schwartz Inc., resigned. Holmes is now running a global multistrategy fund with Joseph Bencivenga, who recently left Guggenheim Capital and previously ran global high yield for Barclays Capital and fixed-income strategy at Salomon Brothers.

Holmes will employ the same market-neutral strategy he used at DE Shaw to mitigate risk in his new distressed portfolio, Plainfield Asset Management LLC, utilizing currency and interest rate hedges, among other mechanisms.

Friendly business

Some of the new shops grew from friendships forged at the bargaining table, in the market and even in court during complex restructurings that dragged on for years.

After taking a gardening leave from Satellite Capital, where he ran the distressed investment desk, David Ford is teaming up with David Sabath, the former head of credit proprietary trading at JPMorgan. Stephen Blauner, a former partner in Milbank Tweed Hadley & McCloy's bankruptcy practice, will serve as chief operating officer for the pair's new distressed and event-driven fund, Latigo Partners.

The decision to go into business for themselves follows years of talk about the idea and numerous workouts they tackled together. "Without intending to be comprehensive, all three of us have worked on Owens Corning"-still in bankruptcy after four years-as well as Mirant Corp., working on its third year in Chapter 11, Sabath says. He and Ford also worked on Toys "R" Us Inc., which was recently purchased by private equity investors.

Mark May, a former partner at Sagamore Hill Capital, helped build the fund's assets under management to $2.8 billion from $50 million. Early this year, May cast off to launch Azura Capital with Eagle Rock's Lupoff. Mark Luongo, who worked for four years at George Soros's Quantum Fund as comptroller, will serve as chief financial officer at Azura.

Sagamore's managing partner, Steven Bloom, and then-investor relations manager Gabby Bockhaus introduced Lupoff to May in 2003. Shortly thereafter, the two collaborated in the brawl-cum-restructuring of Mexican telecom Alestra. Through the course of subsequent investments, they mulled starting their own event-driven, multistrategy shop that would allow them to create equity without the cult of personality that characterizes many vulture funds.

In January 2004, Bloom-one of three investment partners with May and Scott Roth-exercised his right to change the management agreement with the other two. Roth decamped immediately while May, who had longer tenure at the fund, cast off last June and began working on Azura Capital earlier this year, once his noncompete had expired.

(c) 2005 Investment Dealers' Digest Magazine and SourceMedia, Inc. All Rights Reserved.


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