Financial Education

Investors seeking exposure to securities issued by companies in distress are typically seeking higher returns in exchange for the added risks. Success in distressed security investment requires unique skills, and typically investors participate via vehicles such as hedge funds or private equity funds. Hedge funds offer greater liquidity for the investor (and greater access to capital for the manager.) However, the illiquid nature of many distressed securities may confer advantages to the fixed term and closed-end structure of private equity funds.

There are a number of security types that relate to distressed companies:

• The publicly traded debt and equity
• Newly issued (orphan) equity of companies recently emerged from reorganization
• Bank debt and trade claims that the original creditor may wish to monetize
• “Lender of last resort” notes

Frequently investors use these securities in conjunction with a range of derivative products to hedge related risks.

The reasons distressed securities can offer high risk-adjusted returns relates to the market opportunity that arises because other investors are either unwilling or unable to participate in the market. Some funds are prohibited from owning speculative grade debt, and are forced to sell holdings that lose an investment grade rating regardless of price. Others do not wish to participate in drawn-out bankruptcy proceedings and will accept a fraction of the value of their claims in exchange for immediate cash. In other cases, failed leveraged buyouts or unduly shunned companies that recently emerged from bankruptcy may create a temporary imbalance of supply and demand for their securities.

Private equity investments typically have a low correlation to the returns on stocks and bonds, which provides a diversification benefit. Investors should understand, however, that the use of appraisals can result in a stale valuation and could partially explain the low correlation. If annual returns are used for both private equity and traditional assets, the correlations appear higher.

Although the risk reduction benefits may be modest, the expertise required to invest in private equity usually results in a higher return on investments. Therefore, a modest inclusion in the portfolio may still be merited.

Advantages

• Low correlation to developed markets is good for diversification
• Have proven resilient to financial crises and are earning investment grade ratings in many cases
• Sovereign emerging market debt in particular can:
  • respond to negative events by raising taxes and reducing spending
  • have access to lenders such as IMF and the World Bank
  • have large foreign currency reserves as a cushion

Risks

• High volatility
• Negative skewness of returns
• Lack of transparency
• Lack of legal and regulatory structure
• Sovereign borrowers tend to over-borrow and there can be little recourse for foreign lenders in the event of default

When estimating the risk and return characteristics of various asset classes, there are a number of tools available to analysts.

1. Statistical methods can be descriptive (classify past results) or inferential (used for predicting results.)
   • Sample estimators estimate the future mean and variance based on the sample’s past mean and variance.
   • Shrinkage estimators rely on judgment to weight historical estimates with other parameters in order to reduce the impact of extreme values
   • Time series estimators forecast a variable based on the lagged values of either the variable itself or other variables
   • Multi-factor models explain returns for an asset in terms of the values of a set of return drivers or risk factors
2. Discounted cash flow models express current value in terms of the future cash flows an asset will generate
3. The risk premium approach expresses expected return as the risk free rate plus a risk premium that reflects the uncertainty surrounding future results
4. Financial market equilibrium models describe relationships between expected return and risk in which supply and demand are in balance

One way to balance the costs and risks associated with portfolio rebalancing is to set target corridors for asset class weights rather than specific weights. At least five factors should be considered when setting the tolerance ranges:

1. Transaction costs – higher transaction costs should result in a wider corridor so that rebalancing occurs less frequently
2. Risk tolerance – higher risk tolerance also justifies wider corridors
3. Correlation with the rest of the portfolio – when assets move in the same direction as the rest of the portfolio they are unlikely to drift further from target weight. This, in turn, allows for a wider target corridor.
4. Asset class volatility – the more volatile the asset class, the more likely a wider divergence from the optimal weight. This requires a tighter corridor.
5. Volatility of the rest of the portfolio can also lead to large divergences from optimal weights and the need for tighter corridors.

Once a target corridor is breached, the portfolio may be rebalanced to the target weight or to some level within the target corridor. The latter methods allow for more control, particularly with regard to illiquid assets. The alignment to strategic asset allocations would be less, but transaction costs would be lower.

The risk management concept of Value at Risk (VaR) has met with wide acceptance and has spawned a number of extensions and supplements to the original concept. These include cash flow at risk, earnings at risk and tail value at risk.

Cash flow at risk and earnings at risk measure the risk to either cash flow or earnings (rather than market value) for a given risk factor. It can be useful when assessing assets that generate cash flow or earnings but are difficult to value. It can also be used as a sensitivity test for valuation models.

Tail value at risk adjusts VaR to not only express the minimum loss but also the expected loss when extreme outcomes occur. It is expressed as VaR plus the expected loss in excess of VaR. For example, the tail value at risk for a 5% VaR would be the average of the worst 5% of outcomes.

Benchmarking the returns of private equity investments is complicated by the fact that events that would indicate a change in market value (such as a new financing, acquisition, IPO, or failure of the business) occur infrequently.

Cambridge Associates and Thomson Venture Economics provide overall indices for VC and buyout funds. They typically calculate the internal rate of return based on cash flows since fund inception. Often firms are compared by vintage year for comparability across the stage of financing and any macroeconomic influences.

Since the venture capital must provide appraisals of some assets, stale valuations can result in a smoother return appearance than is actually realized.

Changes in the spread between domestic and foreign interest rates can diminish the return on a foreign bond investment. Breakeven spread analysis quantifies the amount of spread widening (W) that would eliminate a given yield advantage.

For example, if a foreign bond offers a 300 basis point yield advantage (75 basis points per quarter) adn has a duration of 5:

• The change in the price of the foreign bond would be 5 X the change in yield or 5W
• Breakeven = 0.75% X 5W
• W = 0.13% or 13 basis points

Model uncertainty is the risk that a selected model is inappropriate or incorrect for the purpose used.

Input uncertainty relates to whether the inputs fed to a model are accurate.

Input and model uncertainties make it difficult to evaluate potential inefficiencies or market anomalies.

Hedge funds are not required to report their performance, and those who voluntarily report can opt out of reporting at any time. There are at least two possible reasons a hedge fund might choose to stop reporting results:

• Poor performance, possibly including fund closure
• Very good performance has eliminated the need to attract capital

In the Fall 2007 Journal of Portfolio Management, Grecu Malkiel and Saha examine both hypotheses, and find a pattern of declining performance in the months leading up to cessation of reporting. Further the probability that a fund will stop reporting increases rapidly during the first five years of a fund’s life and then gradually declines from the peak. Funds with high Sharpe ratios, more assets and peer-beating performance are less likely to stop reporting.

The authors conclude that hedge funds stop reporting results due to poor performance, rather than strong performance.