Q&A: George Schultze On His Fund's Unique Approach to Distressed Investing

Apr 16 2015 | 1:01am ET

George Schultze is a managing member of Schultze Asset Management, a long/short fund headquartered in New York that focuses on the distressed and event-driven investing. Founded in 1998, Schultze exploits opportunities in debt and equity securities of companies heading for, in, or recently emerged from bankruptcy. It has invested over $3 billion in the distressed markets since inception, and currently manages about $250 million. Schultze has a law degree and an MBA from Columbia University and was elected to the Board of Directors of the Hedge Fund Association in 2012.

FINalternatives' Steven Lord recently caught up with Schultze about his approach, the current state of distressed investing, and what he expects going forward.

Tell us a bit about the firm.

We have 11 full time employees, and we concentrate on special situation investing in financially troubled and distressed credits. We invest in any part of the capital structure and any point during the restructuring process, and try to identify when the securities of distressed firms have become mispriced relative to fair value.

We work with institutions as well as individuals and high-net-worth investors, and about 70% of our investors are offshore. We can do both liquid and illiquid investing, as well as managed accounts. Depending on the client, our offerings can be a good complement to larger funds. Our returns are generally uncorrelated with both the overall market as well as with other distressed securities managers.

What is your approach?

We have a pretty unique methodology. We use three basic trade ideas within our portfolio. We seek to short-sell the junior securities of companies headed into bankruptcy. Next, we buy long distressed debt for pennies on the dollar, and finally, if appropriate, we may invest long in the post-reorganization equities of restructured companies. Sometimes, we help with the bankruptcy process itself, by serving on creditor committees and such to help negotiate the restructuring plan and guide the company through it.  

The short aspect of what we do is very unique, and makes up a growing percentage (about 30%) of our portfolio today. It’s a very interesting element of our approach, and is an area that’s fairly capacity constrained – really large funds have a very hard time replicating this trade because they’re just too large.

How do you know which instruments to engage?

We think about a company’s capital structure like an ascending ladder. Each rung represents a different security class, and when a company goes through bankruptcy, many of the lower rungs are just plain removed. So when we’re looking at a firm heading into trouble, we short the most junior securities on that ladder. If we’re right, they’ll be removed during the reorganization process, and the return on our short position can reach 100%.

In the U.S., more than 90% of all Chapter 11 bankruptcies result in equity holders getting nothing, so it’s a good place to generate event-driven returns. From there, we might invest long in the surviving debt and ultimately in the company’s restructured equity.

On the long side, we always look for what we call the “fulcrum security”. That’s the debt component most likely to convert into equity in a new, post-Chapter 11 company. That’s the sweet spot for us. We love situations where the bankruptcy process eliminates all the junior debt, but converts the most senior secured debt into equity in the new, debt-free, freshly-reorganized company.

How long will you hold the long equity portion?

Until it reaches what we think is fair value. When a company emerges from bankruptcy, its securities can be volatile, with very odd pricing and lots of volatility that has nothing to do with the restructured company’s actual value. 

For instance, pre-petition lenders with no business owning equity suddenly become equity owners after companies unexpectedly go through bankruptcy. However, structural considerations (such as the Dodd Frank law, the Volker Rule, and Basel III) make it impossible for them to maintain equity positions. They become forced sellers, which can skew prices. And sometimes these discounts stay a while, even after the reorganization, so we’re prepared to be patient when we invest in post-reorganization equities. 

However, we will switch to an activist stance if we think management of the restructured company is being overly conservative. It happens…bankruptcy can be a pretty awful experience, and it can make managements and boards very gun shy. We help them move on, think outside the box, and pull on some levers (like debt-financed stock buybacks or special dividends) to make their newly-restructured capital structure more efficient and more shareholder-friendly. 

How would you characterize the distressed space right now?

It is getting very interesting. It’s growing, and there are lots of opportunities developing at the moment, especially within the oil sector. Higher interest rates will also offer a whole new set of opportunities once this rate cycle turns.

Is the low default rate translating into fewer opportunities?

Not at all. We’re extremely busy right now. Remember, that the financial crisis was the largest distressed cycle in modern history, and the systemic consequences are still out there. There have been lots of reorganizations and restructurings, and therefore the market for post-distressed equities has been extremely robust. 

At the same time, I think we’re nearing the start of another cycle of pre-bankruptcy opportunities. Yes, the default rate is still low, but especially among high-yield energy issuers, it’s already higher than normal, and there’s been massive new issuance. Investors have been pushed way out on the risk curve looking for yield, and they’ve paid up for capital structures they shouldn’t have purchased. Opportunity sets are starting to develop on the short side. 

So is the energy sector your primary focus at the moment?

The natural place for us to look is where stress already exists, and right now, that’s in oil and natural gas, coal, shipping, etc. The opportunity set in distressed oil and gas is obviously growing tremendously – if you’re able to short some of these firms and then pivot, we think the returns will be very attractive. 

Elsewhere, we’re watching a few global macro trends, like the dollar’s appreciation. It’s wreaked havoc with global companies’ earnings, so there’re some potentially interesting plays related to that.

Going forward, the upcoming cycle will be more industry specific than the one we saw during the financial crisis, so it is not going to be a one-size-fits-all market. You’ll have to do your homework, but you will get paid handsomely for doing it.

We’re also focusing a bit on Puerto Rico. We don’t trade many foreign positions, but if PR eventually restructures its debt, it will be 5x bigger than Detroit’s bankruptcy (which was the largest municipal bankruptcy ever). In that case, we played a lot of the distressed companies that were based in Detroit including auto companies and auto suppliers. However, we looked at many other potential investments in Detroit, including real estate, a casino, and even the local toll bridge. We plan to look for similar opportunities in PR. 

Overall, though, we stick closer to home. We’re experts in U.S. bankruptcy and restructuring, and once you go overseas, the rules of the road can be very different. But PR is starting to look interesting to us. 

How will rising interest rates affect what you do?

They will increase the investing opportunity. The Fed has really tried to telegraph what’s going to happen. We think the first rate rise probably comes later this year, but Yellen has consistently stressed that the Fed will normalize policy in a cautious and benign way. There will certainly be a reset in fixed-income markets, but it’s not clear whether that reset will result in anything blowing up. However, it is inevitable that fixed income markets will suffer capital depreciation when interest rates climb.

Can you talk about performance?

Like most alternative investment managers, we gave back a little performance last year.  On the other hand, we delivered outstanding results in 2012 and 2013.  This volatility was due to our focus on generating strong overall returns – inevitably, big returns require risk-taking.  Specifically, we’re looking for equity-like absolute returns.  

Our strategy is unique and interesting, with both liquid and illiquid components, and we think we’re on the cusp of another opportunity cycle that will potentially deliver attractive, above-average returns for long-term investors.

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