In Depth

Q&A: Distressed Debt In Bloom

Mar 24 2008 | 7:49am ET

Times are tough for the hedge fund industry, which is coping with the collapse of Bear Stearns, the ongoing credit crisis and the recent slide of the commodities market after a strong two-month rally. But while some firms are looking for markets to put their cash to work, others say it’s never been a better time to get into the distressed debt market.

FINaltenatives recently spoke with Geoffrey Gwin, chairman of New York- and San Francisco-based Group G, a $200 million distressed-debt hedge fund shop, who is savoring every moment of this historic market for distressed players and shares his thoughts on the industry.

FINalternatives: How would you compare the current credit crisis with past ones involving other high-profile blowups, such as that of Long-Term Capital Management in 1998?

Gwin: This market is different from any high-yield market that anybody’s every faced before. I was involved in leveraged finance during the summer of Long-Term Capital Management, and the bank loan market was not nearly as affected as this time because it was much smaller then. The period when competitive local exchange carriers went bust and Enron and Worldcom filed for bankruptcy is probably the closest thing to what we have today.

We’re in a period in which distressed investing is going to be extraordinary, and it’s already happened with some distressed corporate names. But what’s going to surprise people is how fast this distressed market is going to develop. Historically, in other distressed cycles, capital inflows tend to take a while and the distressed market begins to develop.

FINalternatives: What are some of the drivers that are causing so much fear and uncertainty in the market?

Gwin: There are synthetic index arb strategies that have tremendous amounts of leverage hitting points where they have to unwind their positions. There are bank loan vehicles that have large amounts of leverage and they're facing the issue of having to reduce positions. We haven't seen cash flow collateralized loan obligations unwind, but we're definitely seeing the stress on them by the mere fact that nobody's able to build these things anymore. The bank loan market is shrinking and the investment-grade market is really facing some difficult times. So those two areas of the credit markets have been really dysfunctional and they've created more problems in the financial markets because they've been placed in the hands of investors who thought they were buying something a lot safer.

Credit derivative players are at a disadvantage because there's not a lot of transparency in what the outstanding exposure is in those indices. You don't know how much has been written, where it's been written and who wrote it, or when it's trading, and you only see that reflected through the dealers, but you have no idea of the size and scope of the direction. So dealers have a huge advantage over the secondary market.

It's the way high-yield used to be 10 years ago in that the way you discern price is by watching movement in markets. Today, in high-yield and other corporate bonds, you have transparency just like equity markets in terms of levels and volumes. So there's a tremendous amount of fear of the unknown that's driven things wider.

FINalternatives: How has the demise of Bear Stearns impacted the market for smaller dealers?

Gwin: Interestingly, Bear Stearns was rather active in making markets in smaller stressed and distressed companies in high-yield. Their departure will certainly have a positive impact on smaller broker dealers like Miller Tabek, Imperial Capital and Jefferies, which have gotten a larger share of trading volume—not huge but enough to ensure their survival. A number of these firms were shriveling over the last few years, but their fortunes have now turned.

FINalternatives: What are you seeing in terms of opportunities in the bank loan and bond markets?

Gwin: There are a lot of companies that are going to have difficult situations because the bank loan market is so challenged. Typically, companies pay down debt by just refinancing it so it's unlikely that companies with very highly-levered balance sheets are going to actually be able to deliver, and they're going to have to hope for a refinancing event.

But just because there are going to be more restructurings doesn't mean that the market is going to underperform. Some parts of high yield are probably going to do very well. If you're looking at just the double-Bs and triple-Cs right now, I'd say they're going to underperform as default rates widen and we have more companies going through restructurings.

You’re going to have investors very quickly put together larger amounts of money allocated to distressed, and it might initially go into other forms of distressed such as mortgage and structured products.

FINalternatives: You think that bigger funds, specifically multi-strategy hedge funds, are going to have a tougher go at it than funds like yours. Why?

Gwin: Big multi-strategy funds are at a disadvantage because when they go into the market, they have to actually engage in the market, which is one of the more difficult execution areas to participate in and there's a lot of intermediaries you have to go through involving a tremendous amount of trust. We have found larger institutions that haven’t participated in high-yield trading are sloppy in their execution and reveal too much information. So their access to the market is going to be more limited than a firm that's wholly engaged in high-yield for years.

Size is a huge disadvantage so large distressed funds have to engage in much larger situations than they want to. Historically, the better opportunities (on a risk- and complexity-adjusted basis) are smaller distressed situations. So if you have multiple billions to put to work it's going to be hard to put together $50 million worth of distressed bonds in one name, so you're going to have to look for the larger-cap companies going into distress. Right now, smaller managers have a vast number of opportunities because there are a lot of $200 million companies with bonds trading at 50 cents on the dollar.

By Hung Tran


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