Investing in Bank Debt
Can anyone explain how hedge funds that invest in bank debt earn outsized returns?
With the informational asymmetry that exists between these hedge funds and the originating lenders, as well as the former's inability to leverage returns by funding off low cost deposits, I cannot see how the funds would consistently beat the returns of the originating lenders, let alone generate any significant alpha.
Are these funds essentially just betting on interest rates (or maybe conducting some kind of rate arbitrage) and using floating-rate instruments - leveraged loans, or bank debt - as vehicles to conduct that strategy?
Furthermore, how does the strategy for these funds differ from that of CLOs and loan mutual funds? How diverse are the strategies used by funds that invest in bank debt?
Thanks in advance for any feedback. Any and all info shared would be greatly appreciated.
These hedge funds invest ex-post, i.e. after a debtor becomes distressed, which allows for upside. Conversely, the originating lenders don't have a lot of upside potential when they lend out at par. Secondly, bank lenders are typically not in a position to take on a lot of risk ex-post, which creates pricing inefficiencies as they will sell cheaply to avoid further losses. Lastly, I think you may be overestimating the information asymmetry between the HFs and lending banks.
By investing in bank debt do you mean Nonperforming loans(NPLs) or participating in loan syndications? For NPLs, the banks are resigned to realize losses and sell their positions at discounts. The new debtor then attempts to realize capital recovery by going through the court system with judgments or informal settlement between the new creditor and the debtor, usually the combination of both approaches. As with other asset classes, the price/discount off the loan par value that the debtor is able to get is often the single most important factor in determining the success of an investment. Or, if the company still has values left, convert their debt positions into equity positions. Often in the second scenario the new creditor also needs to inject additional equity and spend more money and resources to turn the distressed debtor around/undergo restructuring.
Loan syndication is something entirely different. The funds that participate in this, usually large PE firms, are acting as participants in deals arranged by a bank who does not/ want to cannot take on such a big ticket size all by itself. This is somewhat similar to a CLO as both the CLO investos and bank loan syndication participants are doing this for the purpose of getting yields from fixed income like products. Thou there are fundamental structural differences between a loan syndication and a structured product like a CLO.
In neither case is the buyer adversarial or engaging in a zero-sum game with the bank so informational asymmetry is not really relevant here.
Could this change at all with the deleveraging going on with banks at the moment? I.E. could banks be looking to get more loans off of their books even in non distressed situations? This seems like a possibility, especially in Europe where bank debt is a more popular financing choice than in the US vs bonds
As a matter of fact, I think at this point it has become pretty clear that the Euro banks don't want "vulture" investors to make money off their losses and are not really interested to unload their NPLs at any significant discount. Sure you can buy Spanish NPLs if you dont mind paying 90% par but where is your upside if you pay that much to begin with? And then there is whole legal uncertainty aspect where local courts don't really care much for creditors rights, especially foreign vulture creditors. Avenue and KKR both took some stumble in Italy in that front. The UK, Ireland and to some extent, Germany, are the only Euro countries where distressed investors can expect similar to U.S level creditors rights and protections.
Thanks for all the responses. To clarify, I am referring to leveraged loans (revolvers and term loans to sub investment grade companies at a margin over Libor), not distressed credits. I understand the originating lenders are engaging in relationship lending and hoping to obtain peripheral revenues so can afford to lend at rates below what an investor buying for the margin alone would find attractive. They in turn lower regulatory capital by divesting or hedging against these assets in a zero sum game with solely margin investor who can take risk the banks cannot. However, the reason banks are more risk averse is because of the regulatory cost imposed by funding off of deposits. So how can hedge funds investing in bank debt without the benefit of peripheral revenues or non-interest bearing deposit base to fund off generate any significant alpha? The question stands...
People gave you the primary correct answer (leverage). Most of the loans bought by "hedge funds" are purchased via CLOs or TRS-based levered vehicles. A secondary answer is also that they are trying to add alpha via credit-picking (by avoiding bad loans and/or making loans that banks view as too risky to make).
I think you also misunderstand how these loans come into being. Most of the "bank loans" bought by these (and other) investors are not underwritten to be held by the bank-they are dedicated institutional tranches that the bank "underwrites" with the intention of immediately syndicating. So when Bank of America "underwrites" a term loan for a KKR buyout, they immediately place it with institutional investors (hedge funds, CLOs, mutual funds) and receive a fee for their services. They aren't selling at a loss or taking any capital charge against the asset. To the extent that banks DO puke out loans they underwrote with the intention of holding, they generally are doing so at distressed levels (which is the other way hedge funds make money in the space, but which you want us to leave aside).
Additionally, your model of a bank is off on both sides of the equation (assets and liabilities). On the asset side, a bank can't have 100% of its book in high-yield loans; a significant portion of any bank's balance sheet is deployed into "safer"/lower-yielding securities. For example WFC's 2012 net interest income/earning assets was ~3.4%. On the liability side, it's true that a bank funds itself partially via deposits, but not entirely-the rest is made up of longer-term debt and other forms of capital which are more expensive.
Not wholly true. Eur banks are holding distressed assets and selling boring par stuff to avoid taking the loss. There was all this hype over bank deleveraging which never happened in a flood, more a trickle.
That said, more capital should come of banks' books in the coming years. A chap from Apollo had a good slide on it at the Milken Conference.
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