Market ripe for distressed investing

(December 2007) “Buy low, sell high” is pretty much the mantra for everyone in the financial industry, but that doesn’t mean people should scoop up companies that are about to go bankrupt.

Or does it? In today’s financial climate — with a number of businesses taking heavy losses, especially in the housing industry — some managers are hoping to find success by buying distressed investments.

“We’re starting to see a number of companies involved in financing houses or building them, [and] their volume of business is falling away,” says Keith Tomlinson, director of research for Arrow Hedge Partners, owners of the Arrow Distressed Securities Fund. “They might be perfectly good companies, but good distressed investors are looking for good companies with lousy balance sheets.”

Essentially, distressed funds will buy companies that are near bankruptcy, and therefore, the value of their shares has been significantly reduced. The hope is that a fund manager can help turn around the business and then sell its stock at a much higher price.

On the downside, it’s more than possible for the company’s downward spiral to continue, rendering their shares worthless. Needless to say, a distressed investor likes risk.

“This requires somebody who is able to really assess the real risk and to get behind the numbers and understand what’s going on. There will be some instances where the market will identify some riskier opportunities,” says Kevin McElcheran, partner with the national Bankruptcy & Restructuring Group at McCarthy Tétrault. “Someone who can assess risk more effectively will be able to make money out of that.”

A major upside for distressed investing is that this option has a low correlation to what’s happening in the markets. It’s true that down markets will bring more opportunities, but a drop in the TSX shouldn’t have much bearing on the stock prices of the companies in a distressed investments portfolio.

“There is the ability to extract value in large parts, independent of broad market swings,” says Dwayne Dreger, director of corporate development at Arrow Hedge. “It’s a very effective way to diversify portfolio properly in spite of its narrow mandate.”

However, because of the risk, an investor wouldn’t want his or her portfolio to consist of too many distressed securities. Dreger says these types of investments should make up about 5% of a portfolio at the most, though it really depends on each investor’s propensity for risk. Still, Dreger mentions that “we’re really talking relatively low exposure.”

Getting in on the distressed investments game isn’t easy, though. It’s generally an option for high-net-worth clients who invest in hedge funds. It takes a minimum investment of $25,000 to invest in the Arrow Distressed Securities Fund. “Naturally, it leans toward people who have money, but it’s hardly for the super rich,” says Tomlinson.

Just like how distressed investing isn’t for the retail stock picker, it’s also not a good business for the average fund manager. For distressed investing to work, extensive research and legal expertise are needed.

“There is a skill set required to really understand the way distressed securities work. The ones that are [in this market] are specialists in that area,” says Dreger.

“A manager has to be a good financial analyst to spot critical securities, and the whole thing is a giant legal battle, so you have to be a good attorney,” adds Tomlinson.

With a good manager in place — Arrow Hedge outsources the management of its fund to an American company — the potential to make big bucks is there. Tomlinson says a good manager can find a company and, for example, buy its bank debt, which has declined to 20 cents. After turning around the company, that debt could be worth a buck, and the investor will walk away with five times his or her money.

But, of course, it’s not as easy as it sounds. “There are all kinds of stakeholders,” says Tomlinson. “Investors, employees with benefits, pension plans — they’re all fighting. It’s a monumental legal battle that’s very unpredictable.”

And even if the analysts think things will go their way, the bankruptcy judge could rule otherwise. “Then you get nothing,” he adds.

The promise of large returns, though, is turning more people onto distressed investing. Tomlinson says that right now, the space is pretty small in Canada — Arrow Hedge, a billion-dollar company, values its distressed fund at $60 million — but it’s on the verge of exploding.

He says more people are seizing opportunities in the volatile marketplace and that’s making them more aware of distressed securities. “Unfortunately, it’s going to be big, if you catch my message. Because that means more companies will be into a lot of trouble, and that’s kind of too bad.”

Filed by Bryan Borzykowski, Advisor.ca, bryan.borzykowski@advisor.rogers.com

(12/14/07)

Bryan Borzykowski