As corporate financial distress swells for the first time in years, both funds and bankers who work with companies in trouble are gearing up.
The business of investing in "distressed" companies is poised for a surge in activity, says Allan Brown, portfolio manager and co-head of global distressed-debt trading at hedge fund operator Concordia Advisors LLC.
Market participants believe that massive leverage on corporate balance sheets is about to push more and more debt-laden firms to the breaking point. As a result, says Brown, "There's going to be a lot to do (in this niche), and there's going to be a lot of demand for talent."
After years of giving risky borrowers a free pass, institutional investors have begun shying away from the leveraged loans and "covenant-lite" bond deals they'd been snapping up just a few months ago. As credit becomes more expensive and less available, companies with low debt ratings could find themselves unable to roll over outstanding debt when it comes due - a recipe for bankruptcy. Recently, Investment Dealers' Digest reported that $415 billion in leveraged loans and approximately $41 billion in high-yield bonds are set to mature over the next 18 months. As a result, corporate default rates are widely expected to climb from 1.4 percent in this year's second quarter to three percent or more next year.
Hiring in the sector is on the rise, even though the aggregate amount of distressed debt remains scarce for now. A month ago, Jeff McDermott left UBS, where he was co-head of investment banking, to start a new distressed-investing private equity firm backed by turnaround tycoon Michael Heisley. Two months ago, global search firm Heidrick & Struggles said it was placing more distressed-debt bankers in London than at any time since 2002, in corporate restructuring groups at firms like Goldman Sachs.
Qualities Candidates Need
Distressed securities shops buy into companies about to default or already in default, but whose assets or long-term business prospects promise good returns to those who buy the debt at deep price discounts. When a company restructures, equity investors' holdings typically are wiped out and control passes to various classes of creditors.
To prosper in this niche, Brown says an analyst or portfolio manager needs a reliable "gut feel for how things are going to evolve" for any target company. Candidates also must be able to think on their feet, stand behind their decisions, and then confidently pitch their ideas to a portfolio manager or trade a position.
"We find the skill-set is best developed at a sell-side proprietary (trading) desk - which is essentially a buy-side shop on the other side of the street," says Brown.
Other important qualities are a contrarian mind-set and an eye for the big picture. "Seeing the forest through the trees, as an analyst, is what I look for," says Brown. The analyst must figure out whether a troubled company is basically a good business hampered by a bad balance sheet - and thus a promising buy for a distressed investor - or is "on the wrong side of history," stuck in a business that's destined to shrivel or lose money regardless of how it's financed.
Analyze Legal Documents
Unlike stocks or investment-grade bonds, the value of a distressed-debt investment ultimately depends upon the specific wording of its indentures or loan contracts. So Brown, who teaches a distressed-investing course at New York University, devotes most of his class time to helping students decipher debt-related legal documents. The critical step is extrapolating from contract terms to market prices - determining where a particular security should trade, given the range of possible workout scenarios consistent with the loan documents.
Besides proprietary trading, other useful backgrounds include working for a restructuring advisory firm, high-yield securities, any type of credit analysis, value investing, and event-driven investing.
"If this is the field you want to get into, you should be aggressive in trying to accomplish that goal. You need to have a passion for this business," says Brown. "I want you to show me that you're spending time actually investing your own money and making decisions."
Candidates also should keep tabs on relevant developments both in the overall market and individual restructuring situations, and should conduct their own case studies of companies going through workouts.
As is typical for hedge funds, base salaries in distressed investing tend to range from $100,000 to $150,000. But most compensation is in the bonus, which is highly variable and determined by fund performance and a few other factors that differ with each firm.