Tuesday, 22 November 2011

Hedge Funds Positioning to Benefit from Euro Banks Spitting out Assets

"The Economist" (19th November 2011 edition) has just written about the market for assets being spat out of European banks. The article is reproduced below. For my part I see the market for leveraged loans in Europe becoming very attractive to buyers who know how to be selective, with, unlike the bank asset story, an inevitability about it. So part two of this article is my rejoinder to that in "The Economist".

Waiting to turn trash into treasure

“THIS is going to be the next great trade,” one American hedge-fund executive effused early this year. For more than two years funds have been salivating over the slew of assets that Europe’s banks will have to sell. Many have been opening offices in London and hiring to prepare for this “tidal wave” of opportunities.

Up for grabs will be distressed corporate loans, property debt and non-core businesses as European banks shrink their balance-sheets to meet stricter capital requirements. Huw Van Steenis of Morgan Stanley estimates that banks will have to downsize their balance-sheets by €1.5 trillion-2.5 trillion ($2 trillion-3.4 trillion) over the next 18 months. Funds have only about $150 billion to spend on distressed debt in Europe, he reckons, which means they should have their pick of assets.

For now the “next great trade” is not looking that good, mainly because there have been no fire sales. Most banks that are selling assets have priced them close to face value, providing little to entice buyers.

Even where sales are agreed, financing is scarce. In July Blackstone, a large alternative-asset manager, agreed to buy a £1.4 billion ($2.2 billion) real-estate loan portfolio from Royal Bank of Scotland, but has yet to raise an estimated £600m to pay for it. Worse still, many banks may not be able to sell assets cheaply even if they wanted to, because it would force them to take losses that would erode scarce capital.

"We’ve been lying in wait for this opportunity since 2008. But it will come piecemeal. It will take years and years and years,” says Joe Baratta, head of European private equity at Blackstone. Some predict that Europe could go the way of Japan’s glacial deleveraging and take a decade or more to clean up its banks. Politics play a role too. European politicians, no hedge-fund lovers, won’t want to see them buying up assets at truly distressed prices and profiting from Europe’s gloom. It may even be “politically impossible” for banks that got a government bail-out to write down assets significantly, says Jonathan Berger, the president of Stone Tower, a $20 billion alternative-asset firm.

What could turn things around? Some fund managers hope a plan to recapitalise Europe’s banks to the tune of €106 billion by next June will at last force disposals at banks. So too may the introduction of Basel 3 rules that will require banks to hold more high-quality capital. Marc Lasry, the boss of Avenue Capital, a distressed-debt hedge fund, wants to buy from these “forced sellers”, because they will offer lower prices.

Banks aren’t the only prey that funds are hunting. A wave of refinancing that will hit private-equity-owned firms over the next few years may prove profitable for distressed-debt funds. And plans by some European governments to privatise infrastructure assets may also be enticing.

In the meantime, inventive fund managers are figuring out other ways to do deals. Some, such as Highbridge, a large American hedge fund that is owned by JPMorgan, and KKR are scaling up their lending operations as banks cut back. They are able to charge high interest rates, because companies are desperate for cash.
Banks are being inventive too. Unable to sell assets, they have come up with a compromise of sorts, and have started agreeing to “synthetic risk transfer” arrangements with hedge funds. For example, BlueMountain Capital, an American hedge fund, has agreed to take on some risks on a credit-default swap portfolio from Crédit Agricole, a French bank. Another hedge fund, Cheyne Capital, has reached an arrangement with two big banks in Europe to take the first 4% or so of losses from a securitised portfolio of loans, in exchange for a very healthy return.

For those hedge funds set on playing Europe, the main dilemma they face is how long to wait before buying. Steve Schwarzman, the boss of Blackstone, insists that it is important to stay put. “It’s like dating someone,” he says. “You can say let’s wait two years. But she probably won’t be around then.”

Comment from Simon Kerr
The deal flow resulting from the partly state-owned  British banks reducing their assets has been slower and smaller than many expected. This is partly because the banks have effectively lobbied to have new capital adequacy regulations phased in over a longer period than first thought, and because the regulations which seem onerous in high principle on their announcement seem less so when the detail means of implementation locally  are made public. In sum, along with accumulating retained earnings, there is less risk of a capital shortfall for these banks than there was, so the pressure to conduct asset sales does not come with a visible deadline.

Arguably the same could not be said for the European market for leveraged loans. The peak of loan origination, the previous peak of bank-financed M&A, was in 2007 - see graphic 1.

Graphic 1 - European Leveraged Loan & High-Yield Bond 
New-Issue Volume

source:S&P LCD

The recovery of issuance in 2010 versus 2009 was not as constructive as it at first looks for total volume. Nearly two thirds of all leveraged loan and bond issuance in 2010 was to refinance existing debt, whereas in 2007 the proportion was approximately 20%, when new buyout and recap activity dominated.

The economic environment over the last few years for European companies with leveraged loans is reflected in the default rate. Graphic 2 shows the inverse relationship between economic growth (with a lag) and the rate of defaults amongst companies using leveraged loans as part of their balance sheet.The inference of the two graphics of default rates is that some of the European takeover deals which are above average for size that have been financed by leveraged loans are beginning to unravel. 

Graphic2 - Default Rates for European Leveraged Loans
source: S&P LCD
That recent change has been a small negative is picked up by data for companies that are seeking to renegotiate their borrowings with their lenders. Graphic 3 shows a low level of restructurings and renegotiations, but against a background of some economic growth in Europe. 

Graphic 3 -  Number of new restructurings and covenant resets – European leveraged loans

source: S&P LCD

So there has been a build of new loan issuance in Europe to a peak in 2007 and then a large falling away of new issuance, except for re-financings. However, bank loans are not permanent capital, and the companies that take out the loans intend to re-pay them within 3-5 years and replace the loans with cheaper longer-dated financing when they can. However the state of the capital markets, and the conditions of the banks have both made this intended next phase difficult to execute. The consequence is that there is a maturity wall for leveraged loans beginning in the year after next - just 14 months away, if you needed reminding. The wall is illustrated in graphic 4.

Graphic 4 - Maturity & Rating Profile of Outstanding European Leveraged Loans

Fitch estimates that of the companies they provide shadow ratings on in Europe (approximately 300 borrowers representing €240bn debt), 60% by value is due to mature between 2013 and 2015. Just over half the debt currently has a shadow credit rating of B or above with an average leverage of up to 5.4x. On the basis the high yield bond market continues to support strong rates of issuance, these loans are more likely to be refinanced in a conventional manner. The remainder, €117bn, is shadow rated B- or worse and with a current leverage on average above 6.5x represents "a significant challenge" to refinance in today’s credit markets.

PwC has commented that "The ability to refinance this wave of maturing loans is made more challenging by the fact that the majority of CLO investment vehicles (which were a key driver of market liquidity in the boom years up to 2007) will cease to be able to reinvest their funds just as the quantum of maturing loans reaches its projected peak...We expect that the majority of healthier corporates will be able to use high yield bonds and new leveraged loans to address their upcoming maturities. However, we expect there will be a significant number of companies who are forced to enter restructuring negotiations to resolve upcoming maturities."

So the European market for high yield and leveraged loans has some serious indigestion problems ahead of it. This will create some gross mis-pricings as the weight of paper needing refinancing relative to the size of the buyers is a considerable mis-match. Those buyers that are still active in the market will be able to be very selective, and they will have many opportunities and considerable work to do as the restructurings start to happen. 

Some market participants are starting to get ready now. GSO Capital Partners, the global credit management arm of Blackstone, only last month acquired the largest manager of leveraged loans in Europe, Harbourmaster Capital. The AUM of Harbourmaster, at €8bn will be attractive to GSO/Blackstone, but the juice in the deal is the capacity to analyse the opportunities that will arise as the wall of maturities approaches. This area of investment is not one in which one can acquire the necessary understanding quickly by adding a few bodies. Having a large team (40 professionals in the case of the new combined entity) will give GSO a capacity advantage that will belong only to them and the other early movers yet to emerge. This is an excellent strategic deal on Blackstone's part.

6th December 2011:

MKP Capital Management LLC, the New York-based global macro and structured-credit hedge fund with $4.5 billion in assets, is starting a credit team in London to invest in European debt. Steven Jeraci, a partner at MKP, will relocate to the firm’s London office to hire investment professionals and build the team’s infrastructure, the hedge fund said in a statement today. The team should be in place by the end of next year, the company said.(source: Bloomberg News)
Comment - the fact that a team will be put in place by the end of 2012 says something about when the opportunity to commit capital will be ripe for exploitation, and reinforces the point that to build a quality team will take some time.

25th January 2012:
Mesirow Advanced Strategies Inc., which allocates $14 billion to hedge funds, has been increasing the amount of cash it holds in the last couple of months in preparation for potential opportunities including those in the European credit markets. “What we want to have is the flexibility that if particular things do deteriorate, we can play offense relatively quickly, being able to put capital to work in interesting opportunities,” Marty Kaplan, chief executive officer of the Chicago-based fund of hedge funds manager.

Kaplan said Mesirow may also deploy more capital to relative-value strategies such as capital structure arbitrage, which seeks to profit from mis-pricing of different securities sold by the same company. Mesirow has redeemed out of some strategies that take more directional views on the markets, such as long-biased equity and event-driven hedge funds that bet on corporate activities such as mergers and acquisitions. “As the situation in Europe deteriorates, right now you don’t see tons of corporate activities because confidence in board rooms has declined,” Kaplan said. Mesirow generally favors credit over equities strategies, said Kaplan, and prefers structured credit, which tends to be mortgage-backed, over corporate credit.(source: Bloomberg News)

Tuesday, 8 November 2011

Through the Lag - Europe's Leading Hedge Funds Add Investment Staff

One of the ways of looking at the health of a hedge fund business is in staffing levels. Like many other businesses in finance hedge funds cut back on headcount in late 2008 and into 2009, and the cutbacks in London based hedge funds continued into 2010 (see this article for data on last year). The tables here are disaggregated and show that of the 48 largest indigenous hedge fund groups under the FSA's jurisdiction 28 added staff at the level of approved persons (APs) - those carrying out partner/director/AML and compliance/investment/CEO/COO/CFO type functions- over the period from August last year to August this year.

In aggregate the top 48 hedge fund managers (by assets) in London added 6% to professional numbers over the year to August. It was noted here a year ago that headcount, as captured by approved persons registered with the FSA, was still declining two years after the original Credit Crunch of this century. So at last in 2011 hedge funds have got far enough beyond the assets under management low of late 2009 to have sufficient confidence in the stability of their businesses to add to their staff numbers.

The hedge fund management groups that have shed the most staff are given in Table 2 below. Ignoring the firms that have reduced Approved Person headcount by one or two people, which may be just frictional changes or voluntary departures, many of the firms appearing at the lower end of the Table have undertaken significant change post the Credit Crunch.

The firm that has made the largest absolute number reduction in their professional staff is Brevan Howard, which has opened up a trading operation in Switzerland so that formerly London based staff can escape the increase in taxation in the UK.  The exodus was led by CIO Alan Howard who has been followed by co-CEO Nagi Kawkabani to Geneva. Up to a hundred traders may be based in Geneva in time. However the opening of the Swiss office is not the only development. Brevan Howard has reconfigured the investment capabilities of the traders/managers employed. Specifically BH has cut back on allocations of capital to equity markets and funds resulting in staff departures, including a manager recruited specifically to launch an Indian equity fund, and the departure of Fabrizio Gallo who is returning to the sell-side. Gallo's BH Equity Strategies Fund has been closed. Instead the emphasis has been on adding to capabilities in commodities and macro trading. This repositioning has resulted in a net reduction in London-based investment professionals, but an expansion of the number of traders for the whole firm. Further Brevan Howard funds have produced good performance this year, and the firm is expected to continue to add teams in order to increase capacity to manage capital.

Corporate reorganisations have played a role in the appearance of other firms in Table 2. The Approved Person  headcount given for *HSBC Halbis Capital Management was up to June 2011. At that point HSBC Halbis, the alternative asset management business of HSBC, was merged into HSBC Global Asset Management, and as ever in such a merger there was duplication of staff resulting in voluntary departures and redundancies.

Polygon Investment Partners has moved from a multi-strategy approach to running a series of funds dedicated to specific investment strategies. The flagship Global Opportunities Master Fund was finally closed earlier this year, after a two-year-plus wind up process, and the residual illiquid holdings are now in the Polygon Recovery Fund. The reduction in approved persons at Polygon took place in Aug-Sept 2010 as six people left in a short period, and head count has been stable amongst the professional staff since. 

At Rubicon Fund Management the spat between returning head honcho Paul Brewer and the two men who deputised for him as CIO for two years, Timothy Attias and Santiago Alarco, has led to the change in numbers. The former co-CIOs left in January and April this year to set up their own firm Sata Partners.

Altima Partners had its peaks in assets in mid 2008 and its peak headcount in early 2009. Asset under management were $4bn three years ago and are now thought to be around $1.9bn. The count of APs has followed a similar path, though with a lag as one would expect. 38 staff members were registered with the FSA in January 2009, and the present number is 23, down from 28 in August of last year. 

The third Table here ranks the firms amongst London's largest hedge fund managers that have added the most Approved Persons with the FSA  over the period August 2010 to August 2011. In percentage terms Henderson's takeover of Gartmore has increased the Approved Persons count in a step-change by 45%, or 29 individuals.  In hedge fund terms there was some overlap in the geographical areas invested in by the two companies when separate, but the styles used to run the European equity funds, for example, were very different. This has allowed Henderson to keep most of the Gartmore investment staff, though there are bound to be some who lose out in jockeying for position in such a takeover.  

There are more themes at play in the Table listing those firms expanding than in the Table ranking those firms with declining investment and senior staff. Losses of staff numbers may be for idiosyncratic reasons, but firms add to their payroll when they have been growing their revenues for a while. In the hedge fund industry that growth in revenue can come from performance fees, based on better investment returns than a previous period, or, more likely, from higher assets under management (from subscriptions plus investment growth on existing assets). So the firms adding investment staff in 2011 would be expected to be those that have performed well enough to attract new assets.

The investment strategies that are represented in the list of expanding firms are clustered. The first cluster is in global macro/CTAs/commodities -  Capula, Man AHL, BlueCrest, Armajaro and Clive Capital. There are some multi-strategy winners - Mako Investment Managers, Arrowgrass and CQS, but perhaps a less obvious winner is in credit management. The third cluster consists of Finisterre Capital, James Caird Asset Management, and Chenavari Financial Advisors/Credit Partners - all with a considerable credit aspect to their investments.

The increase in staff numbers at Europe's largest hedge fund groups over the year to August 2011 is far from dramatic at 6%. It does come after nearly three years of decline. The strategic thrust of the global hedge fund industry has been to expand in numbers in Asia and/or emerging markets rather than Europe (or even the United States). So it is good to observe some growth in headcount in the London-based part of the industry. The fact that the owners and managers of those businesses have shown caution in adding to their cost base via the headcount in the last year should serve the industry's employees well, as tricky times have returned from the middle of this year. Although there are the highest level of redemption notices for the year in place for the end of this quarter, I don't expect even a majority of them to be acted upon. And consequently I expect the employment levels in the London hedge fund industry in the first half of next year to be similar to those we are seeing now. Some stability would be be very welcome.