The future of special situations / distressed?
Accepted an SA offer at a brand name special situations HF last spring. They invest opportunistically all across the capital structure, and do both equity and credit. I hope to go back full time.
At the time, I chose special sits because I found it more intellectually stimulating, thought I was a better personality fit with the industry and my team, and just was more interested in the type of work compared to banking/PE and other types of HFs. I also thought that exposure to this style of investing would help me grow and develop into the best investor possible. However, looking at the returns funds like mine have posted over the past few years, I’m worried about longevity and viability of this industry. Many funds are struggling and low DD returns are considered phenomenal for the asset class by allocators right now. I’m expecting this to change over the next 5 years as we enter a new economic environment but I’m still worried about LT prospects.
Keeping this in mind, I was curious about a couple of things. For one, if a junior has a distressed/special sits HF background, how possible is it to career switch as an associate/VP into other investing roles, whether private markets special sits / distressed or other HFs, especially considering that I will get significant exposure to equities in my current role. I feel like I would automatically be ahead in development compared to most IB analysts since I would have 2 years of actual investing experience at a brand name after an analyst stint, but I may wrong. My thinking is that special sits experience may be transferable to a private special sits strategy and public markets / equities investing experience may be transferable to different HF strategies, but again I may be wrong. On the mention of banking, my second question is whether folks on here would recommend re-recruiting for PJT/EVR RX full time (which I believe is very possible in my situation), as that would give me a brand name of a bank on my resume as well as the greater optionality of banking, as RX analysts tend to exit into pretty much anything.
I really appreciate any insight you guys have. Really I’m just looking for any info that can be provided about the future of the special sits industry, so please feel free to steer the conversation in any direction you want, discuss specific funds, etc.
WSO really needs to impose word limits starting now.
Having been on the other side of the table for a few years, my thoughts are that distressed strategies as an asset class for LPs will continue to grow both as a function of just how big the levered credit market has become and how, as the other poster noted, the potential opportunity set in the near term is seemingly very large if rates remain elevated. That being said I still think the old traditional distressed HF model is probably not going to come back with any permanence outside of certain outperformers like Mudrick and maybe ones that launch opportunistically in the right time such as next year (but would still be skeptical of these funds being able to meaningfully grow AUM past a certain point).
All weather distressed still doesn't seem like a scalable strategy and there still is a huge advantage in having large scale in credit/distressed vs being a $2-5bn single fund manager in terms of being able to drive processes / participate in some of the more economically beneficial deals. Imo the next 12 months or so will see significant LME activity particularly from sponsors like Clearlake who seem to have tons of topical names in the sector just given the multiples they paid for some of these businesses. But it does seem like for the first time in over a decade (excluding COVID) there is the prospect of actual good or at least decent businesses becoming distressed as many of these LBOs with huge floating rate exposure will likely see a lot of FCF erosion due to interest expense almost doubling from when base rates were at 0 (or 1% if you're looking at the floor in many of the loans) with a potential drop in top line on the horizon.
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Ehhh... I think you partially get it right, but it's not the full picture.
I worked at both $200B+ megafund and now at ~$1B single hedgefund, I choose $1B single fund with a gifted PM for through-the-cycle performance. You may think it's cool that Oaktree or Apollo gets to cut billion dollar checks and muscle people out, but there is no free lunch. You may "win" on that single deal that get a lot of press (but more likely net lost money) and include those case studies in investor day materials that is causing you availability bias (i.e. why you are bringing up Hertz/APO), but across the house you are ultimately a long-only beta exposure to the market (Hertz is <50 bps of Apollo Credit AUM, no needle-move). Across the house, the mega fund will never do better than index +100-200 bps, they are just destined for benchmark tracking. You may point out "oh but what about this XYZ fund vintage that killed it". That's not how you get paid at these shops - you look at the overall AUM and performance - nobody really "owns" a single performance data point at a single fund and get rewarded as such.
On the other hand, being at a $1B HF you can definitely get crushed on large cap situations where those mega funds leave you behind. But that's not our game at all and we actively avoid or short those situations. For every Incora and Envision, there is a plethora of double-digit return oppty out there on both long/short credit, converts, structured product, and reorg equity, especially today. The problem is there isn't enough liquidity for more than $25-50M positions in a lot of attractive trades. Understandably, the mega funds have no use for a $25M ticket. As a matter of fact we've struggled to borrow even $10M on certain shorts where we really want to short as much as possible. So we play and harvest those risk premiums in the secondary. On the flip side, we look at large structures with loose docs where somebody is obviously going to get primed through an LME, we just go short and capitalize on mid-sized people stampeding out when the inevitable bad news arrive. There are maybe 10-20 shops that play this way, across asset classes, equally comfortable long and short. Trying to compete on accumulating a blocking stake in deep distressed is just not the game here.
Given how press coverage works, there is some perception that doing these large new money deals is the most attractive opportunity set in stressed/distressed credit today and you must be in them to be successful. Having done both, I have to disagree with this and say the real reason that the megafunds do this is because their AUM base has gotten to a point where trading in the secondary has just become unviable due to liquidity constraints. So the only way to put on $100-500M position becomes to just offer par primary dollars to a company. And you basically become a long-only because isn't anything that you could short $500M of, other than like the top 10 liquid CDS names.
My view is that there are attractive <$5B hedge fund teams out there that has capability across long/short, move fluently across event-driven asset classes (IG, HY, convert, options, equity, US, Europe, EM) and can construct trades intelligently (not just going long something beaten down). I agree you're fck'ed if you are a $3B HF manager and your only skill is buy-and-hold distressed (a lot of old school prop desk spinouts). But I think the real squeeze is on the mid-sized guys who are clumsy long-only strategies but not big enough to always be in the room (think $10-50B "multi strategy" credit shops). I would either want to be $100B+ and run the room always (but personally don't really get paid for it) or be <$5B and have ability to trade any market where there is an opportunity being missed (and have P&L ties to my trades).
Sure, I was giving an example, not dead set on $1B. I think there can be great setups anywhere $1-10B, it just depends.
Lot to unpack on the spectrum you mention. It would depend on what that "$7B fund" is composed of. It is vanishingly rare to see a shop with pure 2/20 flagship HF that is $7B in size - maybe Silver Point, Elliott, Diameter? The mix is more like $3B master fund, $0.5B drawdown, $1B long-only SMA variation with lower fee, $2.5B CLO, and $0.5B private credit effort that hasn't taken off the ground. I'm making these numbers up but you know what I mean.
The problem is the topline is most certainly not $200M+ now given margin compression and the expenses start to bloat if not careful about how you build these other functions. Suddenly there is a lot more marketing and ops people to support each strat. Suddenly there is a separate CLO team. Suddenly there are more PMs/"Head of XYZ" to feed. Suddenly you need more traders. Suddenly you're opening up a West Coast/London office. Now the headcount is 50-100 people.
For a $1-5B fund, I think there are a variety of ways to play it. First of all, I'd look for IP count 5-15 max. No layer cake "deal team" structure, no deadweight legacy older people. P&L producers only and ideally with some zigzags in skillset (hardcore legal guy, a plugged-in trader that can put in a call anywhere, random FIG/structured nerd, a Europe/EM guy, etc). Then, you can potentially look for setups with separate P&L for your team but tucked under a broader umbrella for infrastructure/stability/marketing. Might mean ownership under a multi-strat event-driven umbrella alongside uncorrelated strats (some merger arb, some convert arb, some L/S equity, etc), BUT definitely NOT Citadel type. Might mean sponsorship and captive dollars from a larger AM platform, but with 100% autonomy in operation and the parent just provides marketing relationships and trade/tech infra. This way, you give a cut to the mothership but the mothership is usually also looking at it as GP value and market intelligence/synergy play, not just trying to harvest cash flows from GP fees. So there is usually more than enough to go around between like 5-10 IPs if you're really generating $40-80M fees p.a - which would be very good outcome (then average down expectations to the inevitable drawdown years through cycle)
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To each their own, but in general, that's just not the case - look at all the HH market reports. "Market" cash comp is different for a carry fund vs. hedge fund. In particular, "market" does not exist for senior analysts at hedge funds that have idea generation responsibilities. Your personal experience may be different, but there's a variety of factors that could affect that, such as if you moved from a smaller hedge fund to a large MF special sits team where your cash comp stayed the same+higher and you got carry on top of that. If you are going from being a senior analyst at King Street to a Principal at Apollo Hybrid Value or this Ares Special Sits vehicle, I can guarantee you in a good year - like reasonable, non-tail case year (both up and down), the KS analyst will get significantly more cash comp. I went from large carry fund to one of these blue chip credit hedge funds and just quit to go back to another large carry fund, and my cash comp went up a bunch (b/c good,not-tail performance) and then down a bunch when I left. No one on earth was going to give me $1.2MM in cash comp excl. carry for my level. It's not as black and white as you make it seem or literally no one would want to go to hedge funds. I agree if you're getting carry in a fund being raised right now, the timing is great (which is why i'm making a "business decision"). But if you joined in the last 2-3 years, its probably a different story. At the same time though, carry funds more or less are just levered long the market, and there's less prudent investing vs. capital deployment, and the latter is certainly what makes more money at this stage in the cycle. Only time will tell if I made the right move, because the way I look at it is any extra cash comp I would've got from the HF I would've plowed into levered long equity exposure as well to mimic the "carry" part that funds provide.
Dude are you for real? This is literally the best times for distressed firms right now
Every single bond out there trades in the 80s
In the UK after the massive screw up by the now defunct government who lasted 44 days, pension funds had to dump all their liquid assets and distressed / credit hedge funds filled their boots
On top of that, the more aggressive hedge funds are becoming active in restructuring situations to buy out the companies for whom they own the bonds rather than get crammed
Energy crisis in Europe is not going anywhere so long as the situation with Ukraine does not improve (which my crystal ball tells me “not anytime soon”), rates just went up 4-5% in the UK so the average household is going to be squeezed and all these overly levered consumer exposed businesses will become stressed
Next x years are going to be the best time for credit distressed