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Contents
Acknowledgments
CHAPTER 1 Hedge Funds and the Credit Market
CHAPTER 2 High Yield Bonds
CHAPTER 3 Stressed and Distressed Investing
CHAPTER 4 Bank Loans
CHAPTER 5 Convertible Bonds
CHAPTER 6 Sovereign Debt
CHAPTER 7 Legal and Structuring
CHAPTER 8 Operational Due Diligence Program for Credit
Hedge Fund Investing
CHAPTER 9 Risk Management
CHAPTER 10 Financing
Notes
Key Takeaways and Questions
Index
Acknowledgments
I have been fortunate to be able to work alongside some of the most exciting
and brilliant minds in the investment arena. My work as a credit strategist
and portfolio manager has placed me in the driver‘s seat through different
investment and economic cycles, and I am profoundly grateful for the
opportunity to get to know so many thoughtful and dedicated men and
women. I would like to express my deep appreciation for the individuals
who have in one way or another been teachers, mentors, colleagues, and
friends. Their generosity with their advice, time, thoughts and expertise
regarding the credit market and the hedge fund industry has influenced this
book as well as my journey and growth as an investor. Errors and opinions
expressed in the book are my own.
A most emphatic thank you goes to the following individuals:
Steve Blauner at Solus Alternative Asset Management, LP for his advice on
distressed investing as well as for some of the most fascinating stories on
bankruptcy cases. Christopher R. Hebble at Cerberus Capital Management,
LP for sharing his expertise and thoughts on less liquid and distressed
investment opportunities. Gunther Stein and Jenny Rhee at Symphony
Asset Management for their candid advice on the credit market and
hedging techniques. Joseph Naggar, Ted Roosevelt V, and Vanitha Milberg
at GoldenTree Asset Management for sharing their thoughts and market
savvy regarding the bank loan, high yield, and structured products markets.
Richard D. Holahan, Jr. at Caspian Capital Partners, LP for sharing his
wealth of legal and operational experience with credit and distressed hedge
funds. John Zito at Apollo Global Management, LLC for sharing his
investment acumen as he navigates through the complexities of the credit
world. Alicia Sansone and Meredith Coffey at the Loan Syndications and
Trading Association (LSTA) for their tireless work on behalf of loan
investors. Cathleen M. Rittereiser, Co-Author, Foundation and Endowment
Investing and Top Hedge Fund Investors for her advice on the writing
process and keen observations on the hedge fund industry. John Dyment,
Mike Carley and Paul Greenberg at Lutetium Capital for their comments
and thoughts regarding financing method as well as on trading and
investing practices in the credit market. Ioana Barza at Thomson Reuters
LPC for her work in the leveraged credit market. Wingee Sin at State Street
Global Advisors for her friendship and sage advice regarding the alternative
investment world. Bryan Dunn at MidOcean Partners for his insights on
relative value strategies and hedging techniques. Tad Flynn at Houlihan
Lokey for his thoughts regarding valuation and liquidity management
techniques. Andrew Gordon at Octagon Credit Investors, LLC for sharing
his years of experience as an investor in the leveraged credit market and his
expertise in the CLO market. Aditya Divgi at New York City Retirement
Systems for educating me about investor priorities and concerns. Sabrina
Callin at PIMCO, LLC for her advice on the writing process as well as her
thoughtful comments regarding the investment management industry.
Craig Ruch at Matlin Patterson for his insights on liquidity, trading,
hedging and credit risk in the credit market. Shawn Wischmeier, CIO, and
Rodney Overcash, Director of Credit Strategies, at the Margaret A. Cargill
Philantrophies, for sharing their astute observations and candid
perspectives on investing throughout the cycles.
I would like to thank the partnership at PAAMCO for their vision,
leadership and continuous support. Thank you for letting me join in the
adventure! My colleagues for sharing their wealth of knowledge, in
particular Philippe Jorion, Ronan Cosgrave, Sam Diedrich, Josh Barlow,
Marc Towers, Leslie Macdonald, Charlie Nightingale and Max Rijkenberg.
Most of all, a personal and deeply heartfelt thank you goes to Rodrigo
Pascualy for his never ending support, love and friendship.
CHAPTER 1
Hedge Funds and the Credit Market
Hedge funds have often been classified as an asset class. This definition is
changing as many investors are becoming more familiar with hedge funds
and recognize hedge funds as a specialized breed of active asset managers.
Hedge funds provide investors with ways to access various asset classes and
are not restricted to a specific asset class. Some hedge funds are focused on
one or two specific asset classes such as convertible bonds, while others
invest in a wide range of assets. A multistrategy hedge fund provides a good
example, as it may invest in interest rates, sovereign and corporate bonds,
equities, and currencies.
Hedge funds also have the flexibility to invest across geographical areas and
in various markets around the globe ranging from developed to developing
and frontier markets. Hedge fund managers‘ investments may cover a wide
range of investment and trading styles, such as fundamental bottom-up,
trading oriented, macro, and relative value. Hedge funds also invest in
instruments across different markets—exchange traded and over-the-
counter—as well as in cash and derivatives.
The inefficiencies in and across different financial instruments and markets
provide opportunities for hedge funds to add value through active
management. We will point out particular inefficiencies that are unique to
the credit market. These inefficiencies provide both challenges and alpha
opportunities to select credit investors that are able to differentiate among
different credits.
BERNIE MADOFF—HEDGE FUND MANAGER?
―Mr. Madoff was not running an actual hedge fund, but instead managing accounts
for investors inside his own securities firm. The difference, though seemingly minor,
is crucial. Hedge funds typically hold their portfolios at banks and brokerage firms
like JPMorgan Chase and Goldman Sachs. Outside auditors can check with those
banks and brokerage firms to make sure the funds exist.
―But because he had his own securities firm, Mr. Madoff kept custody over his
clients‘ accounts and processed all their stock trades himself. His only check appears
to have been Friehling & Horowitz, a tiny auditing firm based in New City, N.Y.
Wealthy individuals and other money managers entrusted billions of dollars to funds
that in turn invested in his firm, based on his reputation and reported returns.‖
Source: Alex Berenson and Diana B. Henriques, ―Look at Wall St. Wizard
Finds Magic Had Skeptics,‖ New York Times, December 12, 2008
HEDGE FUNDS—HISTORY AND INDUSTRY GROWTH
Alfred Winslow Jones, a journalist, was credited with founding A.W. Jones
& Co., the first hedge fund, in 1949. He formed a limited partnership with
four of his friends to invest in common stocks using leverage and short
selling. The structure was exempt from registration under the Securities Act
of 1933 and the Investment Company Act of 1940; the partnership shares
were offered as a private placement.
In the late 1980s and early ‘90s, the managers of the endowments for
universities such as Harvard, Yale, and Duke started looking into hedge
fund investments. These managers were banking on the idea that better
risk-adjusted return could be achieved by managers who have fewer
investment restrictions than managers who are subject to the ‘40 Act.1
In 2002, the California Public Employees‘ Retirement System (Calpers) and
Pennsylvania State Employees‘ Retirement System (PennSERS) were two of
the first state pension plans to invest in hedge funds. Their motivation was
to diversify their investment portfolio beyond the traditional asset
allocation mix of bonds and equities.
In the two intervening decades since Calpers and PennSERS started their
foray into hedge funds, the industry has changed dramatically, and some
hedge fund managers have become household names. George Soros became
―the man who broke the Bank of England‖ in 1992 through his short bet on
the British pound. John Paulson was known by his short subprime trade in
2007 and 2008. Unfortunately, another household name related to hedge
funds is Bernie Madoff and his $50 billion Ponzi scheme. After the fraud
was uncovered in 2008, the ripple effect was felt across the hedge fund
industry, and investors went back to the drawing board to reassess the risk
management process—both internally and of their asset managers. As of
the time of this book‘s writing, much of the hedge fund assets are
concentrated in the world‘s largest hedge funds. Figure 1.1 shows the
world‘s top 20 largest hedge funds, which collectively manage 25 percent of
the total estimated $2.25 trillion total assets managed by hedge funds.
Figure 1.1 Top 20 largest hedge funds
Source: PAAMCO, Hedge Fund Intelligence
PORTABLE ALPHA
Portable alpha investing is a strategy where the investor separates the alpha and beta
exposure of the portfolio. Alpha is the portfolio return achieved over and above the
return resulting from the correlation between the assets in the portfolio and the
broad market (beta). The investor usually obtains beta exposure through a swap and
separately obtains alpha through investing in absolute return investments such as
hedge funds.
During the same time period, there have also been many changes to
institutional investors‘ attitudes about hedge funds. Over time, many other
state and corporate pension plans have overcome their initial reservations
about hedge funds as the hedge fund industry started to implement better
practices on governance and transparency. Institutional investors such as
large corporate and state pension plans have also introduced some
innovations into the alternative investment landscape such as portable
alpha investing.
The rapid growth of the hedge fund industry as measured by the assets
under management and number of funds can be seen in Figure 1.2. The
chart reflects estimated data, as hedge fund managers have not been
required to report the amount of assets they manage. Since 2000, the
amount of assets invested in hedge funds is estimated to have grown from
$491 billion to $2 trillion in first quarter 2011, and the number of hedge
funds has been estimated to grow from 3,800 to more than 9,000 in first
quarter 2011.
