Why Does Capital Raising for Distressed Debt Hedge Funds Remain Particularly Challenging Despite the Recent and Anticipated Positive Performance of the Strategy?
Hedge Fund Law Report
For hedge funds with distressed debt strategies, 2009 has been a good year. As of August 2009, the HFRI distressed/restructuring index was up 15.3 percent for the year, and the HFN Research distressed index was up 18.4 percent, with August gains of 4.3 percent. Corporate default rates have been at historical highs, and the prices of distressed bank debt have been at historical lows. In short, 2009 appears to have been a golden era for distressed investing, and according to some sources interviewed by the Hedge Fund Law Report, the medium- and long-term prospects for the strategy are attractive. One would expect investor money to be piling into the strategy. And indeed, for a handful of the bigger players, that appears to be the case, as evidenced by reports of a recent commitment by China Investment Corp. to place approximately $1 billion with funds managed by Oaktree Capital Management LP. However, for other distressed debt managers, and especially for new managers seeking to launch funds with such a strategy, anecdotal evidence suggests that money-raising has been a challenge. Numerous explanations have been proffered for this phenomenon (if indeed it is a phenomenon and not just a series of isolated instances). The illiquidity of distressed debt is the most often cited explanation. But private equity funds – funds that invest in shares of private companies and thus are at least as illiquid as distressed debt funds – have raised money of late, so illiquidity cannot be the full story. Perhaps it the perception that distressed debt is a counter-cyclical strategy, and the worst is behind us? But the historical evidence suggests that distressed debt strategies do best in the years immediately following a crisis, so now would appear to be an ideal time for allocations to the strategy. Perhaps it’s a perception that the strategy entails more risk than other strategies? But that’s also insufficient as an explanation. The risk in distressed debt, like in other strategies, can be mitigated via prudent risk management; and in any case, much of the debt in which distressed funds invest is secured by real assets. So what accounts for the money raising challenges faced by existing and new distressed debt hedge fund managers? This article seeks to answer that question, and in doing so describes: what a distressed debt strategy involves; the opportunity set over the short-, medium- and long-term; lock up terms; examples of the difficulty raising money for the strategy and potential reasons for the difficulty; and what managers can do (and what they should avoid doing) in an effort to address the difficulty.