Hedge fund managers are rummaging through the world's vast debt opportunities, looking for undiscovered sources of alpha in an overheated market plagued by high volatility and correlations that are much too close for comfort.
Managers are meticulously combing through odd, obscure, complicated, often tainted securities. Also, those hedge fund firms with the sophisticated skills needed to exploit these opportunities are taking their ideas to institutional hedge funds-of-funds managers.
Hedge fund performance has been challenged so far this year, with the July 31 year-to-date return of the HFRI Fund Weighted Composite index return at just 1.55% and the HFRI Fund of Funds Composite index flat at 0.37%.
“The bad news is that it's very dangerous to be invested in traditional asset classes in a market like this that's drowning in liquidity. The good news is that because there's so much funky debt around, skilled hedge fund managers can find deals that will yield hundreds of basis points of return in excess of traditional securities,” said David Ben-Ur, co-chief investment officer, Corbin Capital Partners LLC, New York.
Corbin Capital managed $2.7 billion in hedge funds of funds mostly for institutional investors as of July 31.
Most of the creative alpha sources that hedge funds managers seek are in the debt arena, observers said. They range from troubled asset-backed securities to ways to short European sovereign debt to potential deals between hedge fund managers and European banks that are looking to trim their balance sheets by offloading structured credit portfolios.
The common characteristics of these vastly different kinds of debt deals include extreme complexity, opacity, illiquidity and fairly small investment outlays. These deals frequently involve a stressed seller who has to get rid of debt securities quickly at bargain prices.
“These forced sales tend to create a pawn-shop dynamic,” said a hedge funds-of-funds CEO who asked not to be identified. “The buyer gets to set the price, because there usually aren't a lot of buyers looking for these kinds of very complex securities. And the price usually is well below what these assets are worth,” the CEO added.
Structure is important
The illiquidity of many of these investments means that “the vehicle structure is very important. It can't be the typical evergreen hedge fund structure,” said Mary Bates, senior consultant and credit specialist in Hewitt EnnisKnupp's hedge fund group, Chicago.
Ms. Bates noted that most hedge fund managers create a hybrid vehicle for their credit and debt investments with a lockup period of between two and five years — less than a private equity fund, but longer than most hedge fund lockups.
But accepting the longer lockup period should bring rewards, said Robert Kaplan, CIO of Permal Group, New York.
“Hedge fund managers need time to work through these illiquid assets, but that's the price of the opportunity. Many institutional investors have been very focused on maintaining ready liquidity since the 2008 and that means they are missing a lot of opportunities,” Permal managed $23 billion in hedge funds of funds as of July 31.
Veteran credit hedge fund manager Peter L. Briger Jr. stressed that for his team of 350 credit specialists at Fortress Investment Group LLC, the best pickings are in “the busted structured finance servicers and capital structures in the world that have yet to be worked through. We are looking at all of the illiquid areas now. If you have the capital to put to work, the best opportunities right now are there. But you have to make sure you get paid for the liquidity risk.”
Mr. Briger is co-chairman and principal of New York-based Fortress, which managed $43.8 billion in hedge funds and private equity as of June 30. He also is co-chief investment officer of Fortress' Drawbridge Special Opportunities hedge fund strategy, one of the industry's longest-running credit opportunity funds, having launched in 2002. The onshore and offshore versions of the fund totaled $5.3 billion as of June 30. The onshore fund returned a net 7.2% year-to-date June 30 and a net 25.5% in the year ended Dec. 31. The funds offer annual redemptions.
Executives at BlueMountain Capital Management LLC, New York, are looking at a wide range of debt opportunities, including both subprime auto loans and the non-agency option arms of residential mortgage-backed securities and relative value trades in dividend swaps that are performing well because of volatility on the dividend curve.
Stephen Siderow, founder and president, also is looking “prospectively” to acquire structured credit portfolios from banks in the U.S. and Europe that likely will have to trim their holdings in order to meet regulatory requirements.
“We believe we can buy these relatively inexpensively and manage down the risk over time. These are ... complex portfolios and there are few hedge fund managers with sufficient experience and size to handle these kinds of investments. The European banks are looking very carefully at potential buyers because they have to remain a counterparty to these portfolios,” Mr. Siderow said.
BlueMountain managed $6.7 billion in hedge funds and other alternative investments as of July 31.
Institutionally oriented hedge funds-of-funds managers are capitalizing on their close relationships with hedge fund managers, who are coming to them more and more frequently with good ideas for debt and credit investments.
For example, Blackstone Alternative Asset Management, Corbin, Permal and Benchmark Plus Management LLC all have struck co-investment deals with some of their managers in diverse areas such as auto loans and residential mortgages, event-driven and activist situations, microcap equity and long/short structured credit.
“The key to finding these opportunities is through strong relationships with hedge fund management and then being able to quickly act and set up the investment,” said Permal's Mr. Kaplan.
Blackstone Alternative Asset Management has set up a partnership with Bayview Asset Management LLC to invest in whole mortgage loans and mortgage-backed securities. To date, Bayview manages $2 billion in the strategy for BAAM's hedge funds of funds as well as in separate accounts for some of BAAM's larger institutional investors.
BAAM managed $40 billion in hedge funds of funds and customized hedge fund portfolios as of July 31 for institutional investors.
Support for new strategies
Investcorp International Inc., New York, uses its hedge fund seeding business to support creative new hedge fund strategies.
Deepak B. Gurnani, CIO and head of hedge funds, said Investcorp seeded Prosiris Capital Management LLC in July because of founder Reza Ali's long/short approach to monetizing structured credit investments.
“Institutional investors love the asset-backed securities space because it's so big and deep - about $17 trillion in the U.S. - but it's very opaque and complicated. It takes the kind of skill that Prosiris' investment teams have,” Mr. Gurnani said.
Investcorp also is readying a strategy to debut this fall that will short European sovereign debt.
“Every institution that we talk to is very worried about the impact on the markets and on their portfolio of the European sovereign debt crisis. They are interested in shorting their exposure. We think this is going to be a really good play for hedge funds,” Mr. Gurnani said.
Investcorp managed $5 billion in hedge funds of funds as of July 31. As of the same date, $1.6 billion was invested in single-manager funds on the firm's investment platform.