A review of third quarter reports from hedge funds finds that, at least as of September 30, many event-driven managers continue to seek much of their equity-like exposure through positions in distressed or discounted but still performing credits. The extent to which this is a deliberate choice based on strategic considerations is not in all cases clear.
Strategies of seeking equity-like exposure through the credit markets has had much to recommend them over the last couple of years, and dedicated investors in distressed situations are likely to continue to seek such exposure. But returns on these investments tend to be slow to develop and “lumpy.” It could be that, in many cases, the continued predominance of credits in event-driven portfolios simply reflects the fact that investments made a year or two ago have yet to achieve their return targets. Retention of a bias toward credits could also be a matter of liquidity: even at the best of times, most such instruments are fairly illiquid, and if the prospect that they will achieve their return targets are fading, demand for them is likely to be even less. Managers who might otherwise allocate away from them may be deterred by the necessity of having to accept steep discounts in order to liquidate them.
Distress and discounted performing credits are always with us, but their supply varies, as does their inherent attractiveness. The opportunity to acquire the paper of sound borrowers at steep discounts occurs only during times of crisis – the credit spreads on such paper have narrowed since the Credit Crunch, and where liquidity allowed, most such positions acquired at that time have probably been realized. There is always new supply of distressed debt, as previously healthy firms encounter difficulty, but the quality of a borrower that enters into distress at a time of relative economic calm is rather different from that of a borrower whose distress results from global macroeconomic dislocation. Widespread distress offers opportunity to hedge funds that are not distressed debt specialists. As the new supply of distressed debt arises increasingly from firms that fall into distress for idiosyncratic, firm-specific rather than macroeconomic reasons, fewer managers other than distressed debt specialists will be attracted to it.
All this suggests that many hedge funds’ allocation toward credits will decrease over time, almost certainly in favor of an increased allocation to equities. The credit positions they have built over the last few years will either attain their return targets and be liquidated or gradually be abandoned. Specialists will continue to plough the debt furrow, but the majority of event-driven managers are likely to find more opportunity in trades employing equities rather than equity-surrogates. Other factors support this trend – most notably the high levels of liquidity on corporate balance sheets. This encourages corporations to create opportunities for merger arbitrage, a tendency that is already clearly in place, and in an environment where arbitrageurs face less competition from private market buyers than they have in the recent past. Where they are not used to finance acquisitions, cash hoards invite corporate activism, in which many event-driven managers delight. The U.S. environment for activism will improve next year, thanks to changes to proxy rules. In the next year or so, strategies involving equities can be expected to bulk larger in event-driven portfolios than they have recently.