There is an imminent opportunity for hedge funds in Asia to earn outsized returns in distressed credit over a roughly three-year period, provided investment risks are better analysed and fund structures are improved.
A panel of hedge-fund managers from Hong Kong and Singapore discussed yesterday whether the industry was capable of applying lessons about credit risk learned the hard way to take advantage of the current environment, at the Distressed & Troubled Asset Investing Summit co-organised by AsianInvestor and FinanceAsia magazines.
Moderator Simon Osborne, senior reporter at AsianInvestor, challenged managers' ability to absorb lessons about credit risk, from both the Asian financial crisis of 1997-98 as well as the current financial crisis in the United States.
George Long, CIO at Lim Advisors, says a distinction should be made between Asian banks and financial institutions that have indeed remembered the painful lessons of 1997/98, but Western banks are now being forced to learn the same lessons. For investors, he says, "We know what the lessons are, but do we know how to apply them?"
Justin Ferrier, managing director at Myo Capital Advisors, says the credit assessment capabilities of Asian banks have improved but, flush with liquidity, continue to make questionable lending decisions.
A recent rally in high-yield prices in Asia has allowed some hedge funds to already make money this year, particularly as other funds have been forced to pull out of the Asian debt and distressed markets, Ferrier adds.
The real opportunity to make money in Asian credit has yet to come, however, argues Eugene Kim, CIO at Tribridge Investment Partners. He predicts the second half of the year will see the "real" distressed space emerge, as Asia experiences a rising level of corporate defaults and foreign banks are forced to sell Asian assets.
Hedge fund managers agree that now is a good time to invest—but later may be better. Bid/offer spreads are enormous but a huge amount of distressed supply has yet to come to the market. They speculate that late 2009 or early 2010 may see deals begin to accumulate.
"In 2008, the trick was to go to cash," George Long says. "Any legacy positions turned into a trap, and many high-yield and distressed funds were hurt. Now it's time to be invested," despite recent rallies in convertible bonds and high yield.
Investors will become more wary of hedge fund structures in illiquid plays, however, on the heels of last year's sour experience of gated assets and liquidity mis-matches.
Many of these distressed assets will take several years to recover, which requires a more private-equity like structure to be put in place; offering quarterly liquidity against such investments, as was the case in funds launched in recent years, will be rejected by savvy investors. Instead, hedge funds in this space need to place distressed high-yield credit into lock-ups over a period of years.
"We are transitioning some of our assets to a private-equity type of vehicle," says Jeff Tolk, principal at 3 Degrees Asset Management. "October 2008 was a wake-up call for the industry to realise its liquidity terms are not realistic." He adds that investors now understand the need for longer lock-ups for certain assets.
As far as assessing country risk in Asia, these managers say deals that turned problematic in places such as China, India and Indonesia have not surprised them; transactions that looked secure on paper have not proven so in practice, especially if local trustees aren't keen to exercise collateral rights. And local court systems are as cumbersome as ever.
George Long quips the current longest-running court case is in India and began in 1200AD. "800 years is longer than a lock-up period," he says.
Foreign investors with experience of the Asian financial crisis do, however, know what families are likely to pay their debts, Jeff Tolk adds. "Investors know what tricks borrowers have played, and continue to play." Hedge funds' best defence is to really understand the business, the people running it, and the ownership structure.
Looking down the road, hedge funds see an eventual opportunity in bank non-performing loans, particularly in China, where the government is pulling out all the stops to get banks to lend. George Long suggests the Chinese government may also be brewing trouble for itself by failing to recognise how much foreign direct investment is in the form of credit, not equity, and if foreign creditors are treated badly, it could have an impact on FDI.
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