Hennessee Says Investors Over-Invested In Distressed Debt

Investors Offshore, London

11 July 2002

The Hennessee Hedge Fund Advisory Group, a global hedge fund investment consulting firm, which advises individuals and institutions on over $1 billion in assets, believes that many hedge fund investors made a mistake by investing too aggressively in distressed managers. Specifically, many investors have allocated too much money to the asset class in an attempt to find returns in excess of the equity markets, especially when distressed managers have difficulty hedging.

"It was apparent to us that distressed hedge fund managers were going to have a problem when we heard that most fund-of-funds were making a tactical decision to over-weight distressed assets," said Charles Gradante, Managing Principal of Hennessee.

Following the difficulties of WorldCom, the Hennessee Hedge Fund Distressed Index fell -1.77% in June, leaving the index at +1.67% for the year.

According to the Hennessee Hedge Fund 2002 Annual Manager Survey®, assets invested in distressed hedge funds increased nearly 100%, to $17 billion during 2001. Most investors were looking for a replication of 1991 when the economy pulled out of a recession and distressed hedge funds returned an average of +34.75%, according to the Hennessee Hedge Fund Index. However, the widening of credit spreads in 2001 was primarily due to heavy high yield issuance in the late 1990s.

According to Mr. Gradante, "Companies with bad business models were able to raise capital via the high yield markets with relative ease in the late 1990s. Many of these companies currently have little to no net asset value, making them poor distressed investments with low probability of coming out of bankruptcy alive."

While most investors hoped that an improving economy would bail them out of tight credit markets, high yield bonds performed poorly in June, primarily due to problems at WorldCom. The Merrill Lynch High Yield Index lost -7.75% in June, its worst month ever, including the Drexel Burnham junk bond debacle in 1990.
Because of the increased flow of money in distressed hedge funds, managers of these funds have been forced to put money to work in sub-par distressed credit, such as WorldCom. Typically, distressed managers analyze the real assets of a company and the likelihood of bonds having sufficient asset coverage, should the company liquidate. WorldCom presents a particular problem since its senior debt was a particular favorite of hedge fund managers who now believe that they may be wiped out. By most accounting, WorldCom has $3 billion of assets against $43 billion of debt.

Mr. Gradante believes that many investors, especially fund-of-funds, will redeem all or a portion of their investments from distressed debt funds. "This could pose problems to all distressed managers, even those that have stayed clear of telecom. The selling pressure caused by these redemptions will ultimately cause the asset class to be marked down by the credit markets and generate lower returns than were originally expected," concluded Gradante.

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