Credit - Pod Shop/MM vs. Distressed/Special Sits HF

What's your view on industry and career outlook for all the credit folks out there?

Have never worked at a pod shop before, but my current firm does a decent amount of active trading as well as long-horizon distressed. As a younger analyst, I tended to think that deep value, concentrated distressed is where it's at. The work seemed more interesting, more involvement in headline grabbing situations, and legendary stories from the likes of Elliott.

But increasingly as I think about what kind of portfolio I'd like to run 5-10 years from now and refined my decision making processes to become more probabilistic, it seems like most distressed managers are running black box books and are long on hubris and short on risk appreciation. Hence the scarcity of "consistent" players with many former "rockstars" sinking on one too many bad trades (BlueMountain, Solus, Perry, Paulson, etc). It feels like a more diversified approach to portfolio risk is the better way to actually be a professional investor. It's like being a professional poker player - you don't go in and bet all your chips on a hand with no respect for uncertainty and luck in any individual play, but you rather seek to play hundreds of hands and over time seek to tilt the table in your favor by being the superior and probabilistically aware player. In other words, being a "grinder", although many of the best poker players are known to take some ballsy bets on consequential hands.

Any experienced folks out there who have thought about this? Do you think this is mostly a matter of personality fit/interest or is there a superior approach to investing in public credit?

Comments (18)

  • Research Associate in HF - Event
Aug 16, 2020 - 4:10pm

I think what you're saying is that distressed isn't an evergreen lifecycle strategy, therefore funds focused specifically around only that form of investing have struggled.

I don't think pod shops necessarily are the best place to perform long/short fundamental credit unless you confine yourself to the upper B/BB/crossover space and only doing liquid relval. Most people who try to take "distressed risk" on the lower quality tend to get blown up (at least from personal experience knowing a few people that went to Citadel and got blown out).

The question you should ask yourself is if your manager has the wherewithal to know when to not force himself into a situation and has the capacity/capability to invest his fund in other higher yielding products (private credit, fallen angel crossovers, stressed, highly structured investments etc.) when the distressed pond they are fishing out of is too toxic to begin with.

Most single manager, "flagship"-only product strategies where they charge ludicrous fees for "targetting 20% returns" are the ones that subsequently blew up because they flew too close to the sun. The average return in distressed over 5 years is less than 5%, yet it's pretty funny how those said managers ignore the littany of higher quality credit trading at mid 90s with a 9% yield. If you build a book of only those credits over the last 5 years and ignored all the distressed blow ups, you would have probaby doubled your performance. What that tells you is that a conflict of interest exists between a manager trying to hang onto or justify their high-fee hedge fund product by chasing higher returns that take on way more risk than they think.

That "hubris" so to speak should be solvable by aligning the industry and LPs with a minimum hurdle and bringing fees in line with the product alpha created (I think the remaining "1.5% & 15% with an undisclosed side letter hurdle with key LPs" funds will eventually transition to 1-1.25% and 15% performance above a 6-8% hurdle rate money over next 5-10 yrs).

Aug 16, 2020 - 6:28pm
Telemachus, what's your opinion? Comment below:

I think its challenging to have a diversified strategy. Most of the time there's a limited number of ideas to invest in. Credit is such feast or famine, in bad times there's too much to do and in good times not enough. It's hard to keep investors interested when you're making a low return and the NASDAQ is crushing it (i.e. last year) so you can be ready for the ripe time (March/April this year).

I find most credit funds get pulled into bad situations because of this, when times are good they invest in what's available: bad companies w/ bad balance sheets (i.e. TXU ), rather than wait for good companies w/ bad balance sheets that go through a reorg (i.e. Lyondellbasell). Which is why going into March/April so many credit funds were fully invested and got hit hard (i.e. Caesar's TL).

I'd say most long-lived successful funds tend to either be a 1) long term locked up capital w/ investors who support the PM and can ride our the volatility in distressed (i.e. Mudrick) or 2) invest in super liquid L/S credit with very tight risk constraints and strong execution (not distressed, more like the pods).

A strategy for a large pool of credits, where you are playing for the mid-teens yields with bonds that are more stressed than distressed and small allocations to distressed def makes sense...but there aren't enough of those to go around in an avg year. In good times, everything other than the broken industries is super narrow, in bad times everything is super wide and those sweet spot 'stressed' credits are hard to find.

Aug 16, 2020 - 10:02pm
Lead Left, what's your opinion? Comment below:
Telemachus:
I think its challenging to have a diversified strategy. Most of the time there's a limited number of ideas to invest in. Credit is such feast or famine, in bad times there's too much to do and in good times not enough. It's hard to keep investors interested when you're making a low return and the NASDAQ is crushing it (i.e. last year) so you can be ready for the ripe time (March/April this year).

I find most credit funds get pulled into bad situations because of this, when times are good they invest in what's available: bad companies w/ bad balance sheets (i.e. TXU ), rather than wait for good companies w/ bad balance sheets that go through a reorg (i.e. Lyondellbasell). Which is why going into March/April so many credit funds were fully invested and got hit hard (i.e. Caesar's TL).

I'd say most long-lived successful funds tend to either be a 1) long term locked up capital w/ investors who support the PM and can ride our the volatility in distressed (i.e. Mudrick) or 2) invest in super liquid L/S credit with very tight risk constraints and strong execution (not distressed, more like the pods).

A strategy for a large pool of credits, where you are playing for the mid-teens yields with bonds that are more stressed than distressed and small allocations to distressed def makes sense...but there aren't enough of those to go around in an avg year. In good times, everything other than the broken industries is super narrow, in bad times everything is super wide and those sweet spot 'stressed' credits are hard to find.

I'm wondering if this is exactly why fundamental L/S could be a superior strategy through the cycle. Because of the "feast or famine" opp set in long-only distressed, you end up basically betting on levered beta for the most part. Because distress comes in waves during recessions (or sector recessions), most funds are really just betting on a economic/valuation mean reversion and real value add is only in litigation/process edge which few funds actually possess (just participating in restructurings or having a general credit document knowledge doesn't really count, even mutual funds have that). You can get this general exposure with much less downside by levering S&P risk (when in fact the average manager in this space has grossly underperformed SPY for several years running).

If credit securities trade indiscriminately tight/wide in tandem as you say, you could construct net positive carry L/S books, adjusting net exposure to either side depending on your view of where in the credit cycle the market is in rather than sitting around on your thumb to wait for another Covid/GFC. Being able to do this correctly seems like a more sustainable and consistent skill set as it requires you to actually identify idiosyncratic alpha and mispricings at all times - and you can safely use some back leverage with this approach. I guess I am basically describing (what I understand to be) the MM/mkt neutral approach, but I'm not necessarily too hot on the short term focus and liquidity constraints there, either.

Are there any strong L/S credit funds that do this successfully, with some wiggle room on risk limits under a single manager structure? I'm not talking about all those that claim to be "multi strat credit" that is really just 90% long only/beta distressed. Open to criticism here

Ugh the FBI still quotes the Dow... -Matt Levine
  • 5
Aug 16, 2020 - 10:49pm
Telemachus, what's your opinion? Comment below:

Distressed, when done right (good company/bad balance sheets), in theory offers vastly less beta than the market. It should absolutely not be a levered bet on a sector / market. There's also an added bonus if you're controlling the process and the company merely needs to right size its capital structure, shed weak assets rather than a bet on a sector recovery (i.e. not shipping or oil/gas, but individual credit specific issues that can be resolved through a reorg / before a reorg).

Distressed debt done right can be driven by company specific issues that through the process can be resolved. The problem is when there's too much capital in the space and all these credit funds pile into the same crappy name that had issues before economic woes arose (i.e. Weatherford). How did any credit fund make money in 2018 or 2019? They didn't & found themselves investing in the worst sectors.

The problem w/ a L/S credit book adjusting exposure as you see the cycle unfold is it doesn't work. There is not enough liquidity in the asset class. Unlike stocks where you can trade it daily, when there's no bid in credit, you just can't sell your bond. This is why in March there were retail trades that drove down bids 50% on odd lots. And hedging isn't easy in credit, how exactly do you hedge a long stressed credit book let alone distressed? If you have a long stressed credit book driven by idiosyncratic factors, the biggest issue to hedge is the lack of liquidity. Not an easy thing to hedge against as it's also unpredictable on the single name basis. Some names in March/April sold off hard but others just stayed there. It was a case of who the holders were. Not an easy thing to hedge against.

L/S is a vastly easier strategy to execute, which is why its also easier to launch a L/S equity fund. Unlike credit, anyone can buy equity but with credit the price on your screen isn't always the real price.

The only successful credit funds I'm aware of have long term locked up capital that take large distressed positions and are active in restructuring (Avenue, Mudrick, etc..) and the MMs that do rel val credit basis trades.

Personally I find the event driven strategy that invests across the capital structure to be the best for investing across the cycle. You can have a few time intensive distressed names, your stressed names and your carry credit trades and catalyst equity names with equity shorts to remove the beta. The biggest risk here is the liquidity risk in a mkt correction, near impossible to hedge against even if you keep your market correlation to a low. This can be countered by running a book w/ low concentration, but the more you do this, the more you look like the market and more time it takes up. There's also the risk of being over hedged on the short side if you lean into hedging mkt risk w/ equity shorts.

Aug 17, 2020 - 3:58pm
ke18sb, what's your opinion? Comment below:

I disagree with the statement that its really just a industry / beta bet of mean reversion.

What distressed is, in large part, is a liquidity provider that takes advantage of large bid/ask spreads due to market dislocations. For a variety of reasons, a traditional investor will sell out of distressed positions (ratings, timing, processes, hassle, etc) often times at prices that are no where near inline with intrinsic value - of course this is predicated on the underlying business having a reason to exist. Good distressed investors can filter through a good vs bad business, effectively deploy capital and help facilitate the turn around process.

*edit - often time a long only manager might believe in the business through cycle, even like the terms of the restructuring but is not allowed to participate based on fund specific mandates. Just because someones sells, and sells low, does not always imply they are happy about dumping the position nor think its a bad buy.

Aug 16, 2020 - 8:27pm
tmike425, what's your opinion? Comment below:

In a similar position, my fund does a mix of active trading rel val stuff and longer term distressed. Have pretty similar views, but am also finding that the exciting super litigious bankruptcy process distress trades take up a lot of time, energy and resources and often aren't even our most profitable trades. I've come to understand pure directional distress as more of a complement either event driven/ SS cap structure agnostic, a HY, or a rel value fund strategy (or some combination of the three)

I think long term distress is a strategy I would like to remain active in but only if the fund was putting money into distressed ideas out of a drawdown style fund. Couldn't imagine having to try and play through a BK process out of a quarterly liquidity vehicle and would hate to feel forced into shit co bankruptcies to meet an investment mandate.

Aug 17, 2020 - 2:40am
DistressedInvestor, what's your opinion? Comment below:

Approaching this from a different angle.. but its worth really calling out the types of capital used in credit.

  1. I think if you are 100% 2/20 (with 20%+ targets) you end up forcing yourself into hairy stuff that can be pretty binary and as someone else noted.. can be a time and resource suck. I also find these things to be much more MOIC focused
  2. "Stressed" and Credit Opps that like 10 - 15% game thats generally a pull to par or rel val thesis.. nothing wrong with it but its really hard to throw meaningful exposure into the full on distressed names since there aren't a ton of 1.6x trades here to offset a loser... YTE and IRR much more common.
  3. Par or Par-Adjacent. Could be senior loan funds, CLOs, etc... entirely credit, yield, rel val, spread, etc. Portfolio construction matters.

I generally think any one of these in isolation can create problems for a fund manager. Having pockets with return bogeys that are more "all weather" are likely to have better performance on average.. there are also a lot of synergies in having capital to invest across the yield curve.

Bluemountains problem was they went from being a BOMB structured credit manager to trying to be a $20bn multi-strat that blew up a ton of money in PG&E equity (if I remember).

Sole distressed managers have to be ready to take binary bets or let capital sit on the sidelines like the last 4 - 6 years (binary bets being retail and energy for the most part). Stressy guys aren't stoked that the market has been like 5 - 10 pts high on a lot of interesting things in their universe. Par guys just hope the wheels come off.

Interestingly.. guys like Crescent who had done a ton of private 2Ls and holco loans in the past 5-7 years are just seeing $0s.. risk/reward can be scary when most sponsor backed deals went loan only cap structures and because of wacky lopsided tranches there are a lot of 2Ls (and some bonds) sitting behind disgustingly huge 1Ls that are basically buying a ticket to write a check.

Also.. more of a personal view but the proliferation of private credit and more stressed/distressed draw down credit funds means that funds with low- to mid-teens return targets can afford to pay more for credits that a distressed guy is starting to do work on. And because that is drawdown/long-dated capital it doesn't have the same forced selling triggers or baskets and is likely "okay owning a business".. the distressed market as you think of it is just different than it was in 07 - 09.

Long winded way of saying.. credit markets are wonky/scary in general right now. Too much dry powder chasing yield.. only rational thing in my mind to do is pull an Ares, Apollo, Oaktree.. raise capital across the yield and product spectrum to diversify. Athene's compliment to Apollo credit in terms of cheap capital is hard to beat... and even if its a crap distressed market.. par guys are likely turning and burning. At some point that will flip and then you just turn from one to the other.

Aug 17, 2020 - 3:39pm
ke18sb, what's your opinion? Comment below:

You can't really do true distressed in an overly diversified manner for a variety of reasons, unless, I suppose you had a massive capital base and a huge team. Its just a huge time suck on a per deal basis. Distressed is much more akin to PE in this regard. Its why you don't have a PE fund that wildly diversified.

Aug 17, 2020 - 10:00pm
DistressedFund123, what's your opinion? Comment below:
ke18sb:
I disagree with the statement that its really just a industry / beta bet of mean reversion.

What distressed is, in large part, is a liquidity provider that takes advantage of large bid/ask spreads due to market dislocations. For a variety of reasons, a traditional investor will sell out of distressed positions (ratings, timing, processes, hassle, etc) often times at prices that are no where near inline with intrinsic value - of course this is predicated on the underlying business having a reason to exist. Good distressed investors can filter through a good vs bad business, effectively deploy capital and help facilitate the turn around process.

*edit - often time a long only manager might believe in the business through cycle, even like the terms of the restructuring but is not allowed to participate based on fund specific mandates. Just because someones sells, and sells low, does not always imply they are happy about dumping the position nor think its a bad buy.

ke18sb:
You can't really do true distressed in an overly diversified manner for a variety of reasons, unless, I suppose you had a massive capital base and a huge team. Its just a huge time suck on a per deal basis. Distressed is much more akin to PE in this regard. Its why you don't have a PE fund that wildly diversified.

From personal experience, a single person (+/- their jr) can manage between 3-5 processes while still getting home in time to have dinner with their family (or walking downstairs in COVID world). That's within the context of (sometimes) having a few other friendlies in the steering committee and also having input from lawyers/advisors doing the heavy lifting (i.e. a Feltman or Dunne-type person). PE is not like that because PE is always a jam job with trying to win the auction, fussing over the model and having too many layers between the analyst/associate to the partner negotiating the deal.

Where a lot of disillusion comes from is a lot of us work at "tip top" funds yet we see poor returns and poor compounding of LP capital from the core distressed strategy our funds pursue. Funds that went all in on your large-cap restructurings typically lost money except for a select few investments like PCG bonds at 80-90, the 2-3 guys that bought up FirstEnergy HY market is fundamentally a different place than it was 10 or 15 years ago.

I'm not entirely doom and gloom about my own industry (rather think of us as event-driven credit oriented guys than "distressed guys"), I just think we'll eventually have to evolve like many other facets of other industries and find the next best thing to do that justifies our existence which may take form of large funds controlling lion's share of RX processes, doing more Owl Rock like private financings, building out expertise in structured credit to complement fundamental L/S credit and using anciliary products like CLOs and CDOs to build mgmt fee streams that stabilize GP P&Ls.

Most Helpful
Aug 18, 2020 - 10:01am
Lead Left, what's your opinion? Comment below:

This.

It seems like the only thing that hasn't changed about this market is the so-called "distressed guys" egos. You can also notice on this board distressed folks are quick to get defensive on how this "misunderstands" what they do or why all other investing approaches are so much dumber and more inferior to their craft. When the question posed was not even about that... It was bigger picture than that: namely, Where Is the Durable Alpha (in credit)?

I'll unpack this by going over what is happening to the broadly accepted 3 factors that explain most of any durable alpha:

  1. Informational Edge: Distressed investing has historically thrived on opaqueness and lack of transparency. This informational edge has been masquerading as analytical edge (i.e. people thinking they are smarter than the market, when you really just happen to know where to look), but this field is leveling quickly with cheap resources like Reorg and maturation of the HY/loan market where all market participants are significantly better informed than in any prior period. You cannot reverse or stop informational proliferation in a given marketplace once it's set in motion.

  2. Analytical Edge: This comes down to your investment and valuation framework, and ultimately "variant perspective". All fundamental investors are capable of having this (but hard to come by true edge), I'd guess intra-class variance within distressed, performing, L/S credit investing classes among individual firms/PMs is greater here than any inter-class level differences. Distressed funds may be positioned to build a superior institutional cumulative knowledge set over time in specific domains as they simply spend more time trafficking in those situations that other classes of investors don't spend as much time on (assuming you have a thoughtful system of knowledge accumulation and implementation). But edge is relative - the goal is not to be the most absolute correct thinker everywhere and every time, but rather to be superior to your counterparty/competitor. In performing L/S credit, you are often competing with a less sophisticated and less price-sensitive set that are happy to earn the market return, more or less, and view carry as primary source of return. Thus, there should be some white space in extracting alpha from relative value when they are not fully calibrated to the last 25 bps. With the amount of capital and well-resourced firms involved in distressed today, you are arguably fishing in the most competitive pond - sure something probably looks statistcally cheap to you at $50, just know that Oaktree, Apollo, Silver Point, Elliott have all taken a look and decided not to price the risk there and that this is actually a very efficient price. It is on you, then, to prove why the consensus tacitly implied in the price is wrong - you cannot outperform by running some static waterfall and telling people that it's covered.

  3. Trading Edge: This was also one of the reasons distressed funds could consistently capture alpha a decade ago. Other funds simply couldn't traffic in their playground. This has changed permanently. Just go watch Eaton Vance mutual funds taking a giant dump on Apollo and Angelo Gordon's faces with Serta Simmons. Sure, there was Ascena (pyrrhic victory for those that "stole" this turd of a business from original lenders?), but CLOs are amending their indentures to be able to put up new money in rights offerings - this change will be the permanent new market standard, meaning the 2/20 distressed capital is now also competing with capital whose hurdle rate on an unlevered basis is ~5% in restructurings. On the other hand, if you want to become the best L/S relval alpha extractor in credit, there is still a lot of green space - as many commenters point out, this is largely difficult due to the trading cost and bid/ask still present in the HY market, especially as you go down to the smaller size liquidity spectrum. If you can figure out how to execute well against this backdrop relative to everyone else, this will be a source of durable alpha for a while until the market catches up.

This is what is fun about our markets. It is a continuously evolving, complex organism. It is not static and the axiom of yesteryear is today's history. If you don't believe this and think there is some overarching universal truths about the market that will never change, just look what happened to value equity guys that kept shorting Salesforce or NFLX and buying "cheap" energy stocks. Again, I don't know which way is which, I'm just laying out some devil's advocate arguments because a lot of people came to defend distressed strategies pretty quickly while not giving any consideration for alternative methods of outperformance.

Ugh the FBI still quotes the Dow... -Matt Levine
  • 10
  • Research Associate in HF - Event
Aug 18, 2020 - 12:50pm

The lead creditor that is running the 50% carveout contested DIP circus in Ascena has lost a boatload of money in that credit. To be honest, I'm not sure many if any funds have come out significantly positive in P&L contribution continuously investing in retail & energy (not talking about one or two bets here or there) except those that may have had a significant short position in CMBX as their active hedge. I'm sure there's situations here or there but I personally am not close to figure out how much the winners can truly offset the bagels.

Canyon's Josh made a good point about this recently in one of his public talks when asked if he sees opportunity in retail or energy: those funds who are now carving out coercive economics (DIPs / equity split cramdowns / covenant stripping / uptiers) that seem very attractive on the face aren't really reserved as much for new guys to the capital structure. It's typically for the guys who rode the loan down who are making up for the lost ground (sure you didn't buy at par per se, but if you bought a stressed loan at 70-80 and it now trades at 40 well great that you think the DIP economics get you to a 60 cents recovery package but don't forget over two years you still lost money...and don't even get me started on unsecured recoveries in this cycle vs. historically).

Aug 24, 2020 - 2:05am
BoJackBackpack, what's your opinion? Comment below:

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