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?
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% coupon. 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).
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
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.
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:
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.
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.
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.