Western economies are flirting with recession and stock markets threaten to sink conditions that hedge funds typically benefit from. Graham Buck asks whether charity trustees should overcome their qualms and learn to love them

After four years of fair winds in the stock market, conditions once again turned choppy in 2007. While the blue chip FTSE 100 managed to stay aloft, closer inspection reveals its buoyancy relied on a handful of stocks, such as mines. Shares in sectors such as banking, property and retail sank as the US subprime problem broadened into a credit crunch and the ripples spread to other sectors of the economy.

Analysts were unusually united in agreeing that this year could present even more of a bumpy ride for investors, as the crisis continues to unravel. A portent of what this may entail for equities came in January, when a disappointing Christmas trading statement from Marks & Spencer triggered a one-day slide of nearly 20 per cent in the share price.

If harder times lie ahead, as seems likely, the more turbulent conditions could be to the advantage of hedge funds. According to Francois Barthelemy, a partner at F&C Partners, the subprime crisis has produced a number of attractive opportunities, particularly in distressed assets.

Barthelemy points out that as subprime contagion has spread, many banks and insurance companies have been left with the burden of distressed assets on their balance sheets. Accumulated losses have destroyed large chunks of capital and restricted their ability to write further business.

In order to raise fresh capital, they are resorting to selling impaired assets to investors able and willing to nurse them through bankruptcy or restructuring. Only hedge funds have the legal and investment expertise to buy that type of asset and they are likely to do really well as a result of it, predicts Barthelemy.

He adds that with economies on both sides of the Atlantic nearing a recession in 2008 after several strong years in which the way to make money was all about growth we are moving into a very different environment. In a recession, corporate capital comes under pressure while cashflow can turn negative for many companies, so they are no longer a going concern.

Pryesh Emrith, hedge fund and structured products analyst at Charles Stanley stockbrokers, cites as an example the casualties of the telecommunications boom and bust at the start of the decade. Some telecoms companies buckled under the strain of their huge capital expenditure requirements and went under, yet at the same time many owned very valuable assets.

As the economy slows down, credit spreads increase and more companies file for bankruptcy or, in the case of US companies, file for Chapter 11 protection to gain breathing space and the opportunity to restructure.

It also offers hedge funds the opportunity to gain control of the distressed company. A typical move presaging a takeover would, for example, involve the fund buying bonds in the company at a deeply discounted price of, say, 17 cents to the dollar, then swapping the bonds for equities to gain control.

Distressed managers are those providing liquidity in tough market environments and are remunerated for doing so, says Emrith.

The strategy by which they buy stocks or bonds in troubled companies, with the aim of getting an improved price following a subsequent liquidation or reorganisation, is not always risk-free.

Take the recent case of Northern Rock. When the mortgage banks problems became evident last September and its share price slumped, hedge fund RAB Capital raised its stake in the conviction that the banks underlying value remained intact. Undaunted by the Rocks worsening prospects, it bought more shares in December but now faces heavy losses if, as is a possibility, the bank is eventually nationalised (At time of press, the bank had not yet been nationalised).

Time to move in?

So what are the prospects for hedge funds that target distressed assets for their portfolios? And if they are poised for such a stellar performance should charity trustees, who have often been wary of the sector generally, overcome their reluctance and move in?

On past form, the potential rewards are enticing. Much depends on how credit spreads evolve, but in the 1991-92 recession the returns from distressed funds were as much as 30 per cent plus, while even the less depressed conditions of 2004 produced a figure of 18 per cent.

For Philip Pearson, deputy head of alternative investments at fund manager Morley, which is owned by insurance giant Aviva, the outlook for investing in distressed assets is one of cautious optimism. As he points out, the problems experienced by the subprime part of the credit market have started to spread to other sectors, but the extent of the contagion is not yet clear.

So only the hedge funds that specifically focus on subprime-backed Collateralised Debt Obligations (CDOs) have so far seen a significant upturn in distressed opportunities. Default rates and distress elsewhere is still fairly low, meaning that most distressed debt hedge fund managers have yet to see the opportunities enabling them to significantly increase the size of their funds.

But I believe that the problems created by subprime are set to spread more widely, he adds. The areas next to be affected are likely to be corporate entities that have been heavily dependent on cheap debt for example, large private equity transactions and retail firms that may be exposed to cutbacks in consumer credit and expenditure.

Also vulnerable are many retail firms that are exposed to cutbacks in consumer credit; particularly those selling big ticket items, such as furniture and electrical goods.

Look beyond these sectors, however, and the pain could be more limited. As Pearson points out, corporate balance sheets elsewhere generally remain strong, and many companies may be able to withstand a period of tighter credit.

But opportunities will undoubtedly arise now that the credit spread is rising, says Charles Stanleys Emrith. Investors need to be ready to take advantage of the right conditions and those fund managers with the biggest cash chest will be best placed to take advantage of the opportunities. He expects these to begin accumulating in the latter part of 2008 and to continue into early next year.

Charity trustees evidently have an increasing awareness of these opportunities. Emriths colleague Nic Muston, an investment manager at Charles Stanley, says that an increasing number have demonstrated an interest in investing in hedge funds over the past couple of years, and there have been in-depth discussions on whether they should take the plunge.

Trustees caution is understandable, because its not their own money being invested, he observes. But more are beginning to consider hedge funds as part of a well diversified portfolio.

Distressed investing is only part of a wider picture, Emrith adds. A hedge fund portfolio should be well diversified including, for example, commodities and currency strategies. Distressed is nonetheless an interesting asset class; the source of risk is very specific and there is only a low correlation with equities, which means it tends to perform well during recessionary periods when more opportunities arise.

A cocktail of assets

Like other institutional investors, charity trustees must assess whether they have the level of expertise necessary to make a direct entry into the market. Choosing the right timing is essential, with capacity and prospective returns depending on the number of available opportunities, and these vary greatly over time.

Selecting the sectors and the individual companies within them that offer potential for recovery is an exacting science, involving a lengthy due diligence process. And, later on, deciding when to make an exit is equally challenging.

For several years, UK commercial property has provided a favourable diversifier to UK equities, but in recent months its attractiveness has rapidly faded.

This is likely to prove overly daunting for trustees who only serve their charity on a part-time basis. The alternative is to pay for the services of an adviser able to demonstrate expertise and a sustainable strategy.

Market timing is always the hardest part, observes Emrith. Its therefore advisable for charities to start increasing their exposure to distressed investing via funds of hedge funds which target these strategies.

In addition to F&C, both FRM Credit Alpha and AcenciA are among those following distressed strategies; AcenciA being a listed fund of hedge funds that specifically invests in distressed hedge funds.

However, he stresses that distressed investing is only one of many hedge fund strategies, as many trustees tend to put all hedge fund strategies in the same basket. However good a strategy may appear, charity trustees like any investors should diversify over several strategies and limit their exposure to each. His recommendation then? Leave the allocation of the single hedge strategies to the experts.

One major advantage of multi-strategy funds of hedge funds is a correlation between the various asset classes, dubbed the cocktail approach, with much depending on how skilfully these different components are mixed.

Among the best-regarded multi-strategy fund of hedge funds are Signet, Liongate and Dexion Absolute. These are suitable for first time investors with a limited capacity to perform due diligence, even if the performance of a multi-strategy fund is likely to be less impressive than distressed investing.

Finally, what if charity trustees have qualms with the ethics of distressed investing? Emrith agrees that the ethical question is a tough call, but suggests as it is very deal specific, much depends on the restructuring proposed.

Given that the companies are in survival mode it is quite hard at this stage to make ethical priorities rank high among other decisions, he adds.

There is also the issue of transparency. Most hedge funds try to remain secretive about the deals they are involved with. This would apply not only to distressed but to other strategies as well.

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