While the current tightening of liquidity is bad news for some investors, others are positioning themselves to capture a whole range of distressed debt opportunities through innovative investment structures. UBP, for example, is launching a fund which offers the opportunity to combine both hedge funds and private equity funds in a portfolio designed to capitalise on the distressed cycle we are entering.
The basic concept behind the new fund, called DCO Distressed, is to build a portfolio capable of capitalising on different opportunities as they arise and evolve during a distressed cycle. In the first phase of such a cycle, hedge fund managers frequently focus on bank loan opportunities and stressed high yield investments, later moving into asset backed securities and capital structure arbitrage. Finally, when default rates reach anticipated new highs, they focus on true distressed opportunities.
Distressed investing is essentially value investing. It provides numerous opportunities alongside traditional distressed, including long positions in companies that have filed for bankruptcy or are in default, investing in companies which can be classified as “stressed”, leveraged loans and high-yield debt trading at attractive valuations.
Specialist distressed managers have also been known to look at investing in capital structure arbitrage, which seeks to benefit from mis-pricing of securities, rescue financing and direct lending, special situations and asset backed securities, specialty financing, and the buying of post-reorganization equity which often trades at discount due to lack of initial coverage by the sell side. There are also opportunities in shorting securities of companies that are expected to face financial or operational difficulty.
Investing in distressed papers is cyclical in nature, hence requiring investors to be opportunistic in timing their investments. The main part of the cyclical aspect is the growth of supply of distressed securities stemming from a combination of fundamental and technical factors.
The right DNA
UBP says that hedge funds are in an ideal position to be able to capitalize on opportunities within the distressed space, yet protect the downside risk by implementing a portfolio of hedges. Hedge fund mangers have “the DNA and mindset” to think in a more flexible and trading oriented manner than traditional investors. This is needed as the breadth and variety of opportunities in the upcoming distressed cycle will be wide. There are some hedge funds specializing in certain niche strategies or sub-strategies and UBP fully intends to utilize such hedge funds where appropriate.
A hedge fund investment mandate is relatively broad and allows such funds to be very agile about their investment. For instance, hedge funds will generally look to invest in securities which are higher up in the capital structure of a company, as this provides better collateral, resulting in better downside protection and higher recovery values.
However, UBP adds that there are times when junior securities end up mis-priced for various reasons, which can result in attractive valuations. During such times, hedge funds will move down the capital structure to capture the higher return potential.
On the private equity front, distressed investment opportunities across the private equity spectrum have historically generated large and consistent returns and can represent a significant return enhancement to the DCO Distressed Hybrid compartment, for those investors who choose that option.
Looking at a group of some of the most reputable private equity firms active in the distressed space during a 15 year period between 1991 and 2006, returns of an equally weighted portfolio are ranged between 30% and 40%.
A unique structure
UBP plans to invest in a wide gamut of distressed assets and has come up with a unique fund structure to achieve this. While one of the compartments of the new fund – the DCO Distressed Hedge Fund compartment - will be 100% invested in hedge funds, the other compartment - the DCO Distressed Hybrid - will be investing a minimum of 75% of the fund’s assets in hedge funds whilst a maximum of 25% will optionally be invested in private equity funds. The hedge fund portfolio will be common to both compartments.
The hybrid compartment has been structured in such a way that investors’ cash will be fully invested in hedge funds. There will be no capital call since the capital required for private equity investment will be available via the hedge fund portion which will be reduced down to 75% and a short term bridge loan which will facilitate cash management issues. Despite the bridge loan facility, which will be used temporarily to help with the private equity capital call, the hybrid fund will not be leveraged in the long term.
For DCO Distressed Hybrid, a bridge loan of 20% of AUM of the fund will be available for the initial commitments in private equity funds, subscription and redemption mismatches in hedge funds and currency hedging. The portfolio could therefore be leveraged to a maximum of 120% during the private equity investment period but does not have the mandate to be leveraged after that. For DCO Distressed Hedge Fund, a bridge loan of 5% of AUM of the fund will be available to cover the same type of situations.The DCO Distressed hedge fund will invest with up to 25 underlying managers, up to 20 on the hedge fund side and optionally a maximum of 5 on the private equity side.
UBP believes that mixing hedge funds and private equity is an efficient way to capitalize on the forthcoming distressed cycle as it will use liquid trading strategies adopted by hedge funds, as well as control and turnaround strategies exploited by private equity funds. For investors who can tolerate the extra illiquidity aspect and the side pocket structure, DCO Distressed Hybrid compartment will provide a significant return booster.
UBP is aiming for returns of around 15% on the hedge fund compartment, with the hybrid compartment expected to provide even better returns of around 20%. UBP is targeting volatility of between 6% and 8% over a full investment cycle which is expected to be between three and five years.
“Given the long term nature of the distressed cycle, investors have to consider a 3 to 5 years investment horizon even if they can benefit from favourable liquidity terms after 2 years,” UBP says.
Shares in both compartments of the DCO Distressed hedge fund will be available in dollars, euros, pounds or Swiss francs. For institutional investors the minimum investment will be $5 million with management fees at 1.5%. For high net worth individuals, minimum investment will be $250,000, the management fee will be 1.5%, while the performance fee of 5% will be paid annually.
The official launch date for the fund is 1 June 2008. The fund aims to raise between $100 million and $300 million at the launch. The fund will be open only during the subscription period between 1 June and 1 August this year. UBP plans to close the fund quickly, because it wants to “make sure we can deploy effectively our initial pool of capital before accepting new inflows in DCO Distressed.”
DCO Distressed will not be a permanent fund as it has been designed to hunt for opportunities over the current distressed cycle, which is anticipated to last from 3 to 5 years, and thus must have a limited shelf life. Once the directors of DCO Distressed deem that the opportunity set has disappeared, they will return capital to investors. Also, once commitments to private equity managers are made, it will technically be impossible to let new investors in to the hybrid compartment.
Investors will receive monthly reports, estimates and monthly summary on all managers the fund invests in. Reporting will be monthly while redemptions will be on a semi-annual basis in June and December. For the first year the fund will be in hard lock-up, in the second year investors will be able to exit after a 95 day notice and for an exit penalty of 2%.
The fund will be structured as a Segregated Portfolio Company registered in the Cayman Islands, with Bermuda-based Citco Fund Services as the administrator and UBP’s Nassau Branch in the Bahamas as the Custodian.
DCO Distressed will be advised by Shoaib Khan, Senior Portfolio Manager and member of the European Portfolio management team of UBP Alternative Investments headed by Lara Sevanot-Davis. For the DCO Distressed Hybrid compartment, UBP’s Private Equity team headed by Vicenzo Narciso will contribute to the choice of private equity managers.
The basic concept behind the new fund, called DCO Distressed, is to build a portfolio capable of capitalising on different opportunities as they arise and evolve during a distressed cycle. In the first phase of such a cycle, hedge fund managers frequently focus on bank loan opportunities and stressed high yield investments, later moving into asset backed securities and capital structure arbitrage. Finally, when default rates reach anticipated new highs, they focus on true distressed opportunities.
Distressed investing is essentially value investing. It provides numerous opportunities alongside traditional distressed, including long positions in companies that have filed for bankruptcy or are in default, investing in companies which can be classified as “stressed”, leveraged loans and high-yield debt trading at attractive valuations.
Specialist distressed managers have also been known to look at investing in capital structure arbitrage, which seeks to benefit from mis-pricing of securities, rescue financing and direct lending, special situations and asset backed securities, specialty financing, and the buying of post-reorganization equity which often trades at discount due to lack of initial coverage by the sell side. There are also opportunities in shorting securities of companies that are expected to face financial or operational difficulty.
Investing in distressed papers is cyclical in nature, hence requiring investors to be opportunistic in timing their investments. The main part of the cyclical aspect is the growth of supply of distressed securities stemming from a combination of fundamental and technical factors.
The right DNA
UBP says that hedge funds are in an ideal position to be able to capitalize on opportunities within the distressed space, yet protect the downside risk by implementing a portfolio of hedges. Hedge fund mangers have “the DNA and mindset” to think in a more flexible and trading oriented manner than traditional investors. This is needed as the breadth and variety of opportunities in the upcoming distressed cycle will be wide. There are some hedge funds specializing in certain niche strategies or sub-strategies and UBP fully intends to utilize such hedge funds where appropriate.
A hedge fund investment mandate is relatively broad and allows such funds to be very agile about their investment. For instance, hedge funds will generally look to invest in securities which are higher up in the capital structure of a company, as this provides better collateral, resulting in better downside protection and higher recovery values.
However, UBP adds that there are times when junior securities end up mis-priced for various reasons, which can result in attractive valuations. During such times, hedge funds will move down the capital structure to capture the higher return potential.
On the private equity front, distressed investment opportunities across the private equity spectrum have historically generated large and consistent returns and can represent a significant return enhancement to the DCO Distressed Hybrid compartment, for those investors who choose that option.
Looking at a group of some of the most reputable private equity firms active in the distressed space during a 15 year period between 1991 and 2006, returns of an equally weighted portfolio are ranged between 30% and 40%.
A unique structure
UBP plans to invest in a wide gamut of distressed assets and has come up with a unique fund structure to achieve this. While one of the compartments of the new fund – the DCO Distressed Hedge Fund compartment - will be 100% invested in hedge funds, the other compartment - the DCO Distressed Hybrid - will be investing a minimum of 75% of the fund’s assets in hedge funds whilst a maximum of 25% will optionally be invested in private equity funds. The hedge fund portfolio will be common to both compartments.
The hybrid compartment has been structured in such a way that investors’ cash will be fully invested in hedge funds. There will be no capital call since the capital required for private equity investment will be available via the hedge fund portion which will be reduced down to 75% and a short term bridge loan which will facilitate cash management issues. Despite the bridge loan facility, which will be used temporarily to help with the private equity capital call, the hybrid fund will not be leveraged in the long term.
For DCO Distressed Hybrid, a bridge loan of 20% of AUM of the fund will be available for the initial commitments in private equity funds, subscription and redemption mismatches in hedge funds and currency hedging. The portfolio could therefore be leveraged to a maximum of 120% during the private equity investment period but does not have the mandate to be leveraged after that. For DCO Distressed Hedge Fund, a bridge loan of 5% of AUM of the fund will be available to cover the same type of situations.The DCO Distressed hedge fund will invest with up to 25 underlying managers, up to 20 on the hedge fund side and optionally a maximum of 5 on the private equity side.
UBP believes that mixing hedge funds and private equity is an efficient way to capitalize on the forthcoming distressed cycle as it will use liquid trading strategies adopted by hedge funds, as well as control and turnaround strategies exploited by private equity funds. For investors who can tolerate the extra illiquidity aspect and the side pocket structure, DCO Distressed Hybrid compartment will provide a significant return booster.
UBP is aiming for returns of around 15% on the hedge fund compartment, with the hybrid compartment expected to provide even better returns of around 20%. UBP is targeting volatility of between 6% and 8% over a full investment cycle which is expected to be between three and five years.
“Given the long term nature of the distressed cycle, investors have to consider a 3 to 5 years investment horizon even if they can benefit from favourable liquidity terms after 2 years,” UBP says.
Shares in both compartments of the DCO Distressed hedge fund will be available in dollars, euros, pounds or Swiss francs. For institutional investors the minimum investment will be $5 million with management fees at 1.5%. For high net worth individuals, minimum investment will be $250,000, the management fee will be 1.5%, while the performance fee of 5% will be paid annually.
The official launch date for the fund is 1 June 2008. The fund aims to raise between $100 million and $300 million at the launch. The fund will be open only during the subscription period between 1 June and 1 August this year. UBP plans to close the fund quickly, because it wants to “make sure we can deploy effectively our initial pool of capital before accepting new inflows in DCO Distressed.”
DCO Distressed will not be a permanent fund as it has been designed to hunt for opportunities over the current distressed cycle, which is anticipated to last from 3 to 5 years, and thus must have a limited shelf life. Once the directors of DCO Distressed deem that the opportunity set has disappeared, they will return capital to investors. Also, once commitments to private equity managers are made, it will technically be impossible to let new investors in to the hybrid compartment.
Investors will receive monthly reports, estimates and monthly summary on all managers the fund invests in. Reporting will be monthly while redemptions will be on a semi-annual basis in June and December. For the first year the fund will be in hard lock-up, in the second year investors will be able to exit after a 95 day notice and for an exit penalty of 2%.
The fund will be structured as a Segregated Portfolio Company registered in the Cayman Islands, with Bermuda-based Citco Fund Services as the administrator and UBP’s Nassau Branch in the Bahamas as the Custodian.
DCO Distressed will be advised by Shoaib Khan, Senior Portfolio Manager and member of the European Portfolio management team of UBP Alternative Investments headed by Lara Sevanot-Davis. For the DCO Distressed Hybrid compartment, UBP’s Private Equity team headed by Vicenzo Narciso will contribute to the choice of private equity managers.
