Distressed credit could exert a gravitational pull as US managers launch opportunistic vehicles
The hedge fund industry recorded USD33 billion of redemptions in Q1 according to HFR, making it the highest figure since the second quarter of 2009, as investors de-risked their portfolios. But this redemption figure could arguably be even higher come 30 June, as the full impact of Covid-19 becomes clearer.
This is now an interesting period, as some managers consider imposing gates to prevent further redemptions, while at the same time, other managers are launching new vehicles to tap into distressed valuations.
Expect to therefore see a push and pull effect over the coming months, as capital moves from liquid strategies into longer term, illiquid strategies.
“You have some managers who are having liquidity and valuation issues, and facing significant redemptions ahead of 30 June,” comments Kevin Neubauer (pictured), Partner, Investment Management Group, Seward & Kissel LLP. “And on the other side of the coin you have some managers raising funds, in particular managed account money, to take advantage of those same valuation opportunities that didn’t exist six weeks ago.”
Eurekahedge’s figures for net investor redemptions are slightly higher for Q1, totalling USD47.1 billion, which they suggest has been compounded by USD132.6 billion of performance-driven losses. This echoes what the industry went through in the wake of the ’08 financial crisis.
If those losses end up being worse for Q2, investors with diversified portfolios who need cash will once again go straight to their liquid investments, irrespective of how well those investments might be performing.
Neubauer is not necessarily of the opinion, however, that redemptions will be higher.
"Given the timing of the pandemic and the fact that people didn’t start working remotely until early March, for most funds it was too late to make a redemption request for 31 March. I think it remains to be seen whether there will be more redemption activity come 30 June.”
Opportunistic distressed credit funds launching
In the ’08 crisis, hedge fund managers suspended redemptions in their funds when the level of redemptions exceeded their ability to generate the cash to pay out investors.
Whether managers choose to impose gates will depend on the level of liquidity in the marketplace over the next couple of months. “There are a lot of depressed valuations. However, I haven’t yet heard about widespread use of suspensions, thankfully. We will have to wait and see what the world looks like in a couple of months,” suggests Neubauer.
As the contours of the crisis become clearer, there will likely be a secondary wave of redemptions. But there should not be too many comparisons made with ’08 for two principal reasons: 1) The investor profile today is significantly more institutional. 2) Although clearly serious, the economic slowdown this year has not been the result of a systemic failure in the financial system, and whilst it might be a slow grind, the global economy will recover.
As such, even if redemptions tick higher in Q2, this is not a crisis for the industry. Indeed, it provides an opportune moment for investors as managers seek out discounted investments for their portfolios. Today’s volatility is a time for hedge funds to make money, in contrast to recent years when it was harder to outperform the bull market.
Neubauer confirms that at Seward & Kissel they are already seeing several funds with a distressed credit focus being established in light of recent events.
Another variation of this is hedge fund managers owning distressed assets in existing vehicles. This will require them to take a page out of the distressed credit playbook, getting involved in creditors committees, potentially negotiating the exchange of debt for equity etc.
Commenting on distressed credit opportunities, Neubauer says, “We’re seeing both pooled funds and segregated managed accounts being launched.
“One manager was planning to launch a pooled fund but, precisely because of the lack of in-person communication with investors, decided to use a managed account platform instead.
There is typically less diligence required for an investor to open up a managed account than there is to make a commingled fund investment.
“Others that have longstanding investor relationships are able to more easily launch new commingled funds because the investors can rely on previously conducted due diligence.”
Virtual due diligence
With remote working still firmly in place, he says the big question right now is, ‘How does the market move in terms of due diligence expectations?’
In Neubauer’s opinion, investors might eventually become more comfortable with a virtual due diligence process, if the lack of in-person communication prevents them from making attractive investments.
"Will there be challenges? Of course. But managers and investors will figure this out. Institutional investors will be thinking long and hard about the value they are getting from in-person meetings and whether they can get comparable value by doing virtual due diligence; and seek comfort from other approaches, like having more extensive discussions over the phone and through video conferencing and requesting additional documentation.”
According to Murano, a research-driven platform that connects global investors with alternative fund managers, family offices, wealth managers and boutique investment managers (at the smaller end of the hedge fund allocator spectrum) are particularly interested in distressed and opportunistic credit strategies, to take advantage of near and mid-term dislocations in the private credit markets.
In its latest Murano Allocator Note on 5th May 2020, Murano pointed out that the demand for distressed credit “was primarily seen from US-based institutions, although family offices in Canada, Europe and Asia “all expressed similar searches.”
It further added that whilst distressed corporate credit strategies were the most often discussed strategies this week, “opportunistic credit and specialty lending strategies were also popular”.
TALF program guidance
Neubauer confirms that as part of the CARES Act, some US managers are looking to take advantage of the TALF (Term Asset-backed Securities Loan Facility) program, which was similarly introduced by the Federal Reserve in 2009. Under this program, the Fed will make credit available to US companies which will be backed by newly issued, highly rated asset-backed securities.
A number of funds were set up in 2009 and 2010 to take advantage of this program and proved successful for managers, investors, and ultimately US taxpayers.
“There is some uncertainty based on the limited guidance issued by the Fed whether investment funds will be eligible borrowers but the industry is expecting clarity on that point soon.
“To the extent they do become eligible, I think you’ll see some managers setting up dedicated TALF funds, where they borrow money to buy ABS and collect income yield on those for the life of the program. Many managers are already fundraising for these funds with the expectation that the guidance will be clarified.
“Credit managers might utilise borrowing to buy ABS as part of an existing fund strategy, or establish a new fund solely to take advantage of the TALF program; we saw both approaches in ’09,” confirms Neubauer.
Recovering value from distressed assets will take time. If redemptions continue out of liquid strategies, into new distressed credit funds, which act more like private equity, drawing down capital over an extended period of time, investor will know their capital will be locked up for years.
Expect distressed credit to exert a gravitational pull among some investors over the course of 2020.