The Vultures Take Wing

Banks and hedge funds get ready to capitalise on corporate misery.

Some of them look back fondly on the bursting of the dotcom bubble; others feel nostalgic about the 1990s recession. Distressed-debt traders, who buy bonds no one else will touch, and turnaround specialists, who pull companies back from the brink, operate in a topsy-turvy world, where bad times are good and corporate wreckage yields rich rewards.

The pickings have been slimmer for vultures over the past three years, however. Corporate profits have proved annoyingly robust and plentiful credit has made refinancing sickeningly easy. Except for the odd scrap of rotting meat (mainly among car-parts makers and airlines) they have had little to sink their talons into. This has led to “category creep”. Traditional distress funds have drifted reluctantly into risky, but still solvent, junk bonds and high-yield loans to keep business ticking along. Now thanks to the subprime-mortgage woes, hopes are rising that trouble is finally on its way, bringing with it outsized returns for those who trade in corporate casualties.

Investment banks, readying themselves for the expected downturn, have been strengthening their distressed-securities groups. Goldman Sachs is on the lookout for subprime bargains and recently lured a lieutenant of Carl Icahn, an ageing raider, to its “special situations” group. The investment bank, wary of the “vulture” tag, says it merely wants to ensure it can make money at every stage of the business cycle. Barclays has poached an entire team from Oaktree Capital Management, which manages distressed-securities funds. Oaktree itself is raising a new $3 billion fund.

The skills required to resurrect a fallen firm are also in fresh demand. One indication of this is the membership roll of America’s Turnaround Management Association, which has swollen by some 1,000 since 2004.

Behind this cyclical burst of activity is a deeper trend. Distress, once the preserve of specialists, is now attracting the mainstream. Edward Altman, a finance professor, counts 170 institutions that invest primarily in distress, more than ever before, with an estimated $300 billion at their disposal. The field has benefited from growing interest in “alternative” investing (which also includes hedge funds, private equity and commodities). Punting on clapped-out securities is now on many a hedge fund’s list of favoured strategies.

Vultures hope that feast will follow the recent famine. They believe the very lack of distress lately will mean the carrion is more plentiful when times eventually change. More junk bonds are being issued than ever before, more risky loans are being offered. And remarkably, this lending free-for-all continues despite a sharp drop in credit ratings, says Martin Fridson, editor of the indispensable Distressed Debt Investor. No one seems bothered that 17 percent of senior, unsecured junk-bond issues are on the lowest possible rung, compared with 2 percent in 1990.

Mr Altman, who has spent many years tracking financial junk, says he has never seen anything like today’s market. His diagnosis: “almost insane”. The “glut” will surely end dramatically, he says. Mr Fridson reckons a recession could cause defaults to jump to unprecedented levels.

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