Credit managers all dressed up, nowhere to go

Credit managers are awash in cash from institutional investors, but markets aren't making it easy for them to put it to work, especially bigger bets.

Executives at larger firms — who asked not to be identified — report their credit weightings are down significantly, or are completely gone. Some have parked billions in cash as they wait for volatility, disaster or some other catalyst to roil credit markets and create pricing inefficiencies they can exploit.

Credit managers are nostalgic about the heady days after the 2008 financial crisis. Panic, mispricing and frequent fire sales made it much easier to invest billions in lots of deals at rock-bottom prices.

“In 2009, you could pick up anything and it would make money,” said Erik A. Falk, member and co-head of leveraged credit, Kohlberg Kravis Roberts & Co. LP, New York.

Of its $83.5 billion in assets as of June 30, KKR managed $19 billion in credit hedge funds and long-only funds.

“In 2009, credit spreads widened to an exceptional level,” said Michael Barnes, managing partner, Tricadia Capital Management LLC, New York. The U.S. Troubled Asset Relief Program “gave credit traders a measure of confidence and all of the credit markets rallied together.”

Halcyon conditions extended into 2010, as directional beta within the credit markets continued to buoy up many deals, Mr. Barnes said. Since then, ever-tightening spreads have forced “credit managers to move back into what they do best: apply an opportunistic, fundamental approach to source the best alpha opportunities,” he said.

Tricadia managed $3.4 billion as of Sept. 30, all in credit strategies.

Despite the lack of blowout opportunities and lower expected returns — projected at 12% in 2013 compared to 25% annualized between 2009 and 2012 — institutional investors continue to direct large allocations to opportunistic credit strategies as an alternative to traditional fixed income. Public pension funds that have made recent, good-sized allocations of $100 million to $200 million include the $42 billion Los Angeles County Employees' Retirement Association, Pasadena, Calif.; the $7.2 billion Sacramento County (Calif.) Employees' Retirement System; and the $69.2 billion Ohio Public Employees Retirement System, Columbus.

The tight credit spreads that are a hallmark of the current market mean that there isn't a lot of price disparity to generate bargain buys.

“My view is that credit is fairly valued, and we don't buy assets that are fairly valued,” said Clint Carlson, president and chief investment officer of multistrategy hedge fund manager Carlson Capital LP, Dallas.

“This is not a very exciting market, but there are credit deals to do, just not very large ones,” Mr. Carlson said. Carlson Capital managed $7.5 billion as of Sept. 30, of which about $2 billion was invested in credit strategies.

Ironically, inflows from institutional investors might be keeping credit prices close to their fair value levels.

“We don't like the risk-reward represented by broad credit markets, especially in high-yield and investment-grade securities. My suspicion is that because there is so much capital sitting on the sidelines, credit prices may not drop soon and therefore, we are focused on smaller and more idiosyncratic deals,” said Craig Bergstrom, partner and CIO at hedge funds-of-funds manager Corbin Capital Partners LP, New York.

Mr. Bergstrom added that deals today will, by necessity, be “smaller tickets — $10 million, $20 million, $30 million, which will favor smaller credit managers. A large hedge fund would have to write a much larger ticket, say $150 million, to make a difference in performance.”

Corbin managed $3.7 billion as of Sept. 30 of which $1.6 billion was managed in credit strategies, primarily through co-investments with underlying hedge fund managers.

Consultants are wary about larger credit funds these days.

“We have misgivings about very large corporate distressed funds. We wouldn't be comfortable (with) a $5 billion fund in the U.S. or a $1 billion to $2 billion fund in Europe,” said Jennifer O'Leary, head of fixed-income hedge fund research at Towers Watson & Co. in London.

“We like managers to be able to exploit corporate distressed deals when they can, but we don't want a dedicated strategy that sits on cash when there aren't opportunities,” Ms. O'Leary added.

Said alternatives consultant Stephen L. Nesbitt, CEO, Cliffwater LLC, Marina del Ray, Calif.: “It is a wait-and-see game for most institutional investors. At 2% (management fee) and 20% (performance fee), patience will wear thin sooner rather than later. It already has with some credit/distressed hedge funds with high cash positions.

“Some (investors) are seeing enough deal flow to stay invested, others not. At this point, I don't see a clear direction,” Mr. Nesbitt added.

Still, some larger and many smaller money managers are finding interesting credit deals, mostly in the U.S. and Europe.

KKR's Mr. Falk said his credit team is finding more opportunities coming from Europe than the U.S., especially in private rescue financing and in bank balance sheet sell-offs. Private credit deals in the U.S., particularly in the middle market, are becoming easier to strike since banks have stepped back from their previous role as financiers, he said.

Long/short credit strategies are working well in both Europe and the U.S., Mr. Falk said. “It's becoming easier to find relative value in companies based on their fundamentals. And that means you can make money on both the long and the short side.”

Executives at both CQS (U.K.) LLP and III Associates LP, agree with Messrs. Falk and Barnes that the current market requires fundamental analysis of individual companies to find idiosyncratic deals.

Michael Hintze, founder, CEO and senior investment officer of London-based CQS, said there are greater relative value opportunities in European asset-backed securities, particularly commercial mortgage-backed securities, residential mortgage-backed securities and senior secured loans.

CQS recently moved a meaningful portion of the firm's U.S. ABS portfolio into selected European ABS, Mr. Hintze said but declined to give the weighting change.

CQS managed $12.5 billion as of Sept. 30 in multistrategy hedge funds, mostly in credit and credit-related strategies.

Garth Friesen, principal and co-CIO of Boca Raton, Fla.-based III Associates, also is looking at European structured credit, although he said he is seeing “individual lay-up opportunities in the U.S. to make midteen returns.” III Associates managed $2.6 billion as of Sept 30, of which $1.4 billion was invested in credit or credit-related strategies.

Pine River Capital Management LP, Minnetonka, Minn., is focused on direct lending, said Brendan McAllister, partner and portfolio manager. “This is a way for us and our investors to take advantage of what the banks aren't providing any more, which is lending to entities against assets that are hard to value, such as warehouse financing for securitization deals,” Mr. McAllister said.

Mr. McAllister said credit managers have an advantage in sourcing and structuring loans because of the complexity of the deals and their familiarity with the complicated debtor structures.

Pine River managed $13.6 billion as of Sept. 30; about $1.5 billion was managed in credit strategies.