Investor Monitor Archive

By some estimates, almost $1 trillion of high-yield debt and leveraged loans will mature and need refinancing between 2012 and 2015. Distressed and special situations funds will be able to help fill this need by injecting necessary funding into capital hungry firms. In a report on its outlook for the 2010 private equity market, a prominent asset manager proclaimed: “Distressed situations, with a focus on the U.S. and Europe, should continue to be available throughout the economic recovery given (i) the ongoing difficult operating environment, characterized by depressed demand, low capacity utilization and restricted pricing power; (ii) negative pressure on recovery from relatively high unemployment and ongoing issues in the real estate market; (iii) historically high default rates; and (iv) a looming non-investment grade debt refinancing overhang.”1

Distressed and special situations investment firms often get a bad rap for preying on the weak and feeble. However, by investing in companies facing bankruptcy or other serious financial strains, these firms can help support job retention, or at least slow job loss, at a time when unemployment is at its highest levels since 1982-1983. In fact, before the current economic downturn, unemployment of at least 9 percent has happened only twice in the U.S. since World War II: May 1975 and from March 1982 to September 1983. Today, unemployment stands at 9.7 percent and has been more than 9 percent since May 2009.2

Combing through the countless firms in financial peril is the first step in the process of identifying a viable investment with a sustainable business model. As one industry professional said at a Harvard Business School Private Equity conference, “the key to [distressed private equity investing] is determining between the train wrecks and the company that is just underachieving but has lots of potential.”3

With so many companies currently unable to finance day-to-day activities and operate efficiently, there are many firms which fall into the “underachiever” category. If these businesses do not receive financing of some kind, they will file for bankruptcy or close their doors. This is where the distressed and/or special situations investor enters the picture. By providing long-term plans and necessary capital to promising firms, distressed funds infuse stability and help retain jobs.

BHA analysts have seen a sizable increase in demand for distressed funds in the past months. During the fourth quarter when unemployment was at or slightly above 10 percent for three consecutive months, 44.5 percent of all private equity leads were for distressed or special situations funds. In the first six weeks of the first quarter, that number jumped to 47.4 percent. Finally, during the week of February 15, 50 percent of all private equity leads were for distressed or special situations funds. It is clear that private equity investors are increasingly turning to this type of fund to fulfill their private equity commitments. This is due to the vast opportunity within this investment realm.

Many critics believe that distressed and special situations funds are poachers that invest in promising businesses when they are most vulnerable and are at the mercy of their creditors. However, to those critics one can say, What would happen if these funds never made the investment? Most likely, the companies would continue to struggle until they shut down or filed for bankruptcy, neither of which are desirable outcomes.

Rather, with commitments from distressed and special situations funds, these companies are able to keep doing business and retain jobs in a time when every job counts. Furthermore, because these businesses are not closing their doors today, they provide added potential for economic output in the future.

In a time of widespread economic uncertainty, it seems these occasionally mislabeled villains should be lauded. Whether or not distressed and special situations funds get the appreciation they deserve, however, look for these funds to retain investor interest throughout 2010.

1 PEHub.com, NB Alternative Advisers, “2010 Private Equity Outlook,” January 2010.

2 U.S. Department of Labor, Bureau of Labor Statistics, “Unemployment Rate (Seasonally Adjusted.”

3 Harvard Business School Working Knowledge, “Distressed Private Equity: Spinning Hay into Gold,” February 16, 2004.

The second half of 2009 proved to be successful for equity markets around the globe. Many investors have expressed satisfaction with their portfolio’s exposure to stocks and are looking to gain access to sectors that offer low correlation to equity markets.

For the first two months of 2010, BHA analysts have seen increased investor interest in the energy and commodity sectors. Approximately 18 percent of investors looking at sector-focused funds cited energy and commodity related strategies. Of these investors, some are researching funds that concentrate on physical and hard commodities, expecting them to have the lowest correlation to equity markets.

A consulting firm based in Switzerland that specializes in energy and commodities sees great opportunity in these sectors. It believes that the current gap between supply and demand will lead to higher prices. The firm also anticipates emerging markets to have abundant energy opportunities since these countries are some of the largest producers in the world.

Another Swiss investor, a large family office, told BHA analysts that it is seeking global macro funds focused on emerging markets, specifically Asia and Russia that have exposure to energy and alternative energy, mining, infrastructure, water, agriculture, raw land, and hard commodities. The firm believes that these types of funds offer low correlation to equity markets.

With the current stability in equity markets, many investors seem to be seeking uncorrelated investments, and funds focused on energy and commodities are at the top of their lists.

In recent months, China has been taking measures to slow its growth trajectory. This past Friday, the country raised its bank reserve requirements for a second time in a month. This is due in part to economists’ fears of a speculative bubble. Investors, however, are reacting with indifference to these proclamations. BHA has tracked investor interest in Asia-focused hedge funds and, from the mandates received during the past six months, interest has held steady at about 20 percent. It seems investors are undaunted by the maneuvering of China’s central bank.

China, the continent’s largest economy, grew by 8.7 percent in 2009. Meanwhile, just south of China, India’s economy grew by 6.6 percent. Although there may be some evidence of a slowdown throughout the year, these healthy numbers indicate the economies were resilient enough to post solid gains despite reeling developed markets. This is one reason why investors have indicated to BHA that they believe these emerging economies can still bring strong gains to their alternative investments portfolios. For example, a wealth advisor based in Chicago said he sees great upside potential in the Asian continent for years to come and mentioned that his firm was making a long-term investment at this point.

Investors interested in Asia-focused funds include family offices and funds of funds among others. These institutional investors have mentioned their interest in event-driven, relative value, and distressed strategies specifically. They are looking not only to benefit from the potential upside inherent in the Asian markets but also from the regional diversification added to their portfolios.

Currently, there may be problems underlying the markets in Asia. However, alternative investors can benefit from the strong potential for long-term growth and the advantage of diversification. Hedge funds that focus on the Asian markets possess real opportunity even in our troubled times and remain attractive options.

Long/short equity funds have long been the preference for institutional and private investors active in the alternative investments space. This trend is one that is not stopping anytime soon. Despite that the LAB Long/Short Index dropped 1.46 percent in January, investor demand for the liquid strategy increased significantly.

The increase in demand for long/short funds since January 2009 is staggering. During January 2010, BHA’s team of analysts spoke with 181 investors that indicated an interest in researching and reviewing long/short equity funds. This is striking when compared with investor sentiment a year ago when 87 investors expressed interest. Even the comparison between December 2009 and January 2010 is significant: the number of investors interested in long/short equity funds more than doubled in one month’s time.

Granted, these investors are quite different from one another in terms of the funds they will choose for allocations, but one thing remains the same – long/short equity funds allow for redemptions and transparency that are favorable in this recovering market. Just ten days into February, the BHA team has spoken to more than 45 investors looking for long/short equity funds. It will be interesting to see how these funds perform over the next few months, but as the market continues to rebound, it is safe to say that demand for long/short funds is not going away.

Since January concluded, many investors and fund managers alike have been anxiously anticipating results from the first month of the year. Over the past week, many funds and indexes have tallied their month-end numbers, and it appears global macro fund investors have reason to smile. The Credit Suisse Global Macro Liquid Index, LAB Global Macro Liquid Index, finished up 1.18 percent for the month.1

January saw a major uptick in the number of investors that expressed interest in global macro funds. During the month, 118 investors expressed interest in researching and allocating capital to these funds. That figure represents a sizeable increase from January of 2009 when only 67 investors were actively looking for global macro funds. January’s interest also represents a significant increase from the 73 investors that BHA spoke with in December of 2009 that indicated an interest in the strategy.

From their daily phone calls with institutional investors, BHA analysts reported hearing interest in global macro strategies from a wide array of investors across the globe. Some cited the potential for positive performance as driving their interest; many others cited diversification of assets combined with the potential to provide for uncorrelated returns.

A family office based in California currently has a unique approach to a potential fund investment. Although it is in the early stages of evaluating funds, and is very much still framing the particulars for its search, the family office is pursuing diversified macro funds that are trading a variety of underlying assets using a discretionary approach. The family office is especially interested in funds trading in developed yet off-the-radar markets, such as Australia, New Zealand, and Norway. Because each of these markets sees far less activity than the United States, Western Europe, or Asia, it believes the potential for a fund to provide uncorrelated returns is high.

A family office based in Hong Kong similarly expressed interest in global macro funds, but it has a different reason: it wants to see a fund that is exclusively trading assets it can evaluate fundamentally. As part of the firm’s search, it has included discretionary macro funds that have a history of providing consistent returns when trading throughout the United States, Western Europe, and China. The family office feels that funds experienced in trading in and out of major markets are poised to provide strong returns over the next couple of years.

Although global macro funds started off the year with a strong month of performance, it will be interesting to monitor how the strength of the returns in the short term affects investor interest over the next quarter. In all likelihood, investor interest will be closely tied to economic growth, the stabilization of global markets, and the ability of individual funds and managers to trade in and out of specific markets effectively. It is undoubtedly a trend that BHA analysts will continue to monitor in the weeks and months ahead.

1 FINalternatives, “Global Macro Advances, Long/Short Declines in January,” February 2, 2010, http://www.finalternatives.com/node/11220.

BHA estimates that there are about 10,000 hedge funds in the world. Of those, there are thousands that fall into the emerging manager category: funds that have a track record of less than two years or less than $100 million under management. The question for many of these emerging managers is, How do I get to the point where I am no longer considered ”emerging” and can legitimately market my fund to institutional investors? The short answer to that question is, raise $100 million and run a profitable business for at least three years. But, there are other bridges to cross in order to be able to effectively market to institutional investors.

Building a solid infrastructure around the fund’s management team is extremely important. Institutional managers almost never invest in a fund run by a few brilliant traders and a Bloomberg terminal, regardless of the fund’s AUM, performance, and track record. These types of investors need to see strong risk management capabilities and individuals dedicated to handling investors’ needs, among countless other compliance and operational officers.

This is even truer today after the meltdown of 2007-2008. During that period many firms’ invested assets plummeted in value by 20 to 25 percent. Therefore, institutions need to feel comfortable with a fund before making an investment. Having the confidence and trust of any investor is the path to an investment.

The first place most fledgling fund managers turn to raise capital is their personal and professional networks. Here, the relationships have already been built. All a manager needs to do is convince these friends, family members, former colleagues, and business acquaintances that he has a good, profitable product. Once this network has been exhausted, however, the fund manager has to begin tapping new resources to find investors. Sadly enough, the days of sitting back and waiting for an onslaught of investors clamoring to give you their hard-earned dollars is long gone (especially for emerging managers). Managers looking to raise capital need to engage in outbound marketing.

Established managers with a significant revenue flow from management fees often look to capital introduction services or third-party marketers for outbound marketing support. However, these options often come with large price tags or an asset sharing structure that is less than ideal for a fund that needs to keep every dollar it raises in pursuit of the illustrious $100 million mark.

Other managers may turn to a service like BHA’s that is more affordable and doesn’t take a cut of allocations gathered. However, for emerging managers still building their internal infrastructure, a simple contact database or list is perhaps the most cost effective means for identifying new investors.

Some of these contact lists come from fellow managers trading data sets; others are purchased online from third parties. However, the problem with many contact lists is that their information is either out of date or very out of date: at least 12 to 18 months out of date. This means that the fund’s marketer has to spend valuable time verifying contacts instead of building relationships. BHA analysts estimate that it takes five to ten phone calls (spanning the course of two to three weeks) to gather the relevant information about who the proper contacts are and what the firm is currently looking for. Thus, with a standard contact database, the fund’s marketer has to make those verification calls before a legitimate introduction can be made.

Everyone knows the old adage that time is money, and here, clearly, time and money are being wasted due to the stale data that the marketer is using. What emerging managers need is a product that provides fresh, accurate data about investors and their search preferences. This way, marketers can effectively target investors interested in their funds, and get in touch with the right people at those firms without having to make five to ten verification calls.

With an effective and targeted marketing process in place, emerging managers can focus on their performance. With a marketer targeting legitimate prospects, and the fund putting up respectable numbers, productive relationships can be built with investors. From these relationships stem new allocations, whether the investment is in the near term or at some point down the line. After these allocations push the fund above $100 million, larger institutional investors will consider the fund. From there, it is up to the marketer to correctly locate these new investors while the manager complements those efforts with impressive performance to keep the process rolling.