5/1/2011 Print an article

Inv estors Snap Up Distressed Debt in Em erging Markets

01 Oct 2 009
Virginia Munger Kahn
The credit crunch has created plenty of distressed debt, and several money managers see the best
investment plays in emerging markets. Long-term investors are snapping up bonds or loans of troubled
companies at deep discounts.
A rebound in com m odities prices and signs of a global recov ery hav e renewed confidence in em erging-m arkets
econom ies and rev iv ed inv estm ent flows to their equity m arkets. But som e m oney m anagers say the m ost lucrativ e
em erging-m arkets prospects m ay lie in the detritus of the credit crunch: the debt of distressed com panies in these
dev eloping econom ies.
Distressed debt is a staple of recession-era inv esting. Long-term inv estors with patience and restructuring
experience can snap up bonds or loans of troubled com panies at deep discounts and negotiate new financial term s
that ensure strong returns, and often get the com panies back on their feet. Most m oney m anagers hav e tended to
stick to the U.S. and other dev eloped Western m arkets, where the legal protections afforded to creditors are well
established.
Em erging-m arkets specialists insist that the potential gains outweigh the risks in their dom ain, howev er, and
sev eral firm s hav e recently launched funds to capitalize on the situation.
“As som eone who’s been doing distressed debt in Asia for m any y ears, there hav e been only two tim es with great
inv estm ent opportunities — 1 9 9 7 to 1 99 8, and now,” asserts Robert Appleby , co-founder and chief inv estm ent
officer of Asia Debt Managem ent Hong Kong, which m anages $2 .2 billion in distressed debt. “Today is better by a
long shot. The underly ing business of the com panies is m uch better.” In August, ADM launched a new fund, Galleus
Fund II, to focus on the strategy .
Other inv estors share that optim ism . The opportunity in em erging-m arkets distressed debt is “unprecedented,” say s
Robert Rauch, director of research at Gram ercy , a $2 .3 billion Greenwich, Connecticut–based firm founded in the
wake of the Russian debt crisis in 1 9 9 8. In April, Gram ercy launched the Gram ercy Distressed Opportunity Fund,
which now has $2 00 m illion in assets.
Also in April, Ashm ore Inv estm ent Managem ent, a London-based em erging-m arkets specialist, launched a new fund
in partnership with Swiss bank UBS. Modeled on the Russian Consolidation and Recov ery Fund that Ashm ore
created after that country ’s 1 9 9 8 debt crisis, the Ashm ore Global Consolidation and Recov ery Fund is designed to
take distressed assets from banks, insurance com panies and other financial firm s in exchange for units in the fund.
Ashm ore, with its experience in restructurings and special situations, will m anage the fund to m axim ize recov ery
v alues.
“The objectiv e is to work with banks and other institutional inv estors to help them solv e the problem of getting
illiquid assets off the balance sheet,” explains Jerom e Booth, head of research for Ashm ore. “We’re looking for
inv estors who would prefer us to m anage the assets.”
The am ount of distressed debt — generally considered to be debt y ielding at least 1 0 percentage points ov er
com parable Treasuries, or about 1 3 .5 percent or m ore currently — is relativ ely m odest in em erging m arkets. ADM
and Gram ercy estim ate the eligible pool to be $2 50 billion to $3 00 billion, prim arily in corporate debt, or roughly
half the size of the m arket during the Asian financial crisis.
In the U.S. som e $3 2 billion worth of corporate debt is trading at or below 50 cents on the dollar, according to
analy sts at JPMorgan Chase & Co., but the quantity of distressed U.S. m ortgage assets is far larger. Bruce Richards,
co-founder of Marathon Asset Managem ent, recently put the v alue of eligible assets for the Public Priv ate
Inv estm ent Program , which cov ers the securitized m arket for residential and com m ercial m ortgages, at $2 .5
trillion to $3 trillion.
The play ing field m ay be sm aller in em erging m arkets, but the potential rewards are outsize, m oney m anagers say .
Bonds hav e traded with y ields to m aturity of 2 5 to 3 5 percent “without being candidates for default,” notes Rauch.
Gram ercy has already profited from a rally in what Rauch calls “distressed perform ing” bonds. In April the firm
bought the 9 .5 percent senior unsecured bonds due in July 2 01 8 from Indian m ining com pany Vedanta Resources
when they were trading at less than 7 0 cents on the dollar. In August, the firm sold the bonds when they rebounded
to its target price of 9 0 cents.
Also in April, Gram ercy began buy ing the 4 .7 5 percent senior unsecured notes due in May 2 01 4 of Mexican cem ent
com pany Cem ex. Fears that the com pany would be unable to refinance $1 5 billion in debt taken on for its 2 007
acquisition of Australia’s Rinker Group had depressed the bond’s price to the low 50s, where they y ielded about 2 1
percent. Cem ex reached an agreem ent with creditors in August to extend m aturities on that debt, and Gram ercy
sold its bonds the following m onth when they were trading at 82 .50.
Gram ercy anticipates a surge in em erging-m arkets bond defaults through 2 01 0. Som e $2 1 0 billion in corporate
bonds is due to m ature in 2 009, with a sim ilar am ount in 2 01 0. With banks continuing to pull back on lending, all
but the “bluest of blue chips” will face problem s refinancing their debt, say s Rauch. He expects to be able to pick up
senior debt instrum ents at 1 5 to 2 5 cents on the dollar, with ultim ate recov eries expected in the 50-to-7 5-cent
range.

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Gram ercy takes a proactiv e approach to reorganizations, ty pically as the head of an organized creditor com m ittee.
“We try to get a new piece of debt with extended m aturity and lim its on the com pany ’s ability to get cash out until
we’re paid off,” explains Rauch.
In Septem ber 2 008 the firm began buy ing the 1 0.5 percent senior unsecured bonds due in 2 01 7 issued by
Corporación Durango, a Mexican paper and packaging com pany , at about 1 5 cents on the dollar. The com pany filed
for bankruptcy the following m onth. Gram ercy headed up the creditors’ com m ittee and struck a deal in April to
restructure the debt, giv ing bondholders a sm all am ount of cash, a 6 percent equity stake in the com pany and new
bonds due in 2 01 6 that pay an interest rate rising from 6 percent initially to 1 0 percent in later y ears. Gram ercy
expects that the deal will ultim ately be worth 45 to 50 cents on the dollar, y ielding at least a threefold return on its
original inv estm ent. Durango em erged from bankruptcy in August with its debt load cut by m ore than half, to
$2 50 m illion.
Gram ercy has targeted gross com pound annual returns of 4 0 percent ov er the next fiv e y ears for its new fund. The
firm ’s initial foray into distressed em erging-m arkets debt, the $7 80 m illion Gram ercy Em erging Markets Fund,
generated gross annual returns of 3 4 .6 percent in the three y ears following its April 1 9 9 9 inception. “We think the
current env ironm ent offers ev en greater potential than what we saw in that earlier period,” asserts Rauch. He
cautions, howev er, that today ’s rich returns are not likely to last long as the global econom y recov ers: “It’ll be a
short-liv ed opportunity — m ay be two to three y ears,” he say s.
ADM takes a sim ilar approach to corporate restructurings in Asia. The firm inv ests in distressed, underv alued or
ev ent-driv en opportunities and generally seeks to buy out existing creditors and take an activ e role in
restructurings. ”We try not to buy other people’s cooking,” say s Appleby . ADM does not look to operate its target
com panies and often leav es m anagem ent in place. The goal is to recy cle capital as quickly as possible.
In August 2 008, ADM helped refinance Yingli Green Energy Holding Co., a Chinese m aker of solar energy cells,
with a $1 50 m illion senior secured loan. Two y ears ago such loans ty pically carried 8 percent coupons, and debt-to-
cash-flow cov erage ratios were 5 to 6 tim es. But when Yingli was looking to refinance, banks were not lending and
the public bond m arkets were v irtually shut. ADM prov ided the com pany with a new loan carry ing a coupon of 2 0
percent and giv ing the com pany a cov erage ratio of just 2 .3 tim es. That produced a lev erage-adjusted y ield (coupon
div ided by cov erage ratio) of 8.7 percent. “I’v e nev er seen that in m y life,” asserts Appleby . The com pany paid the
loan back in January 2 009 .
In April, ADM offered a fresh $50 m illion senior secured loan to Yingli at an interest rate of 1 2 percent; ADM also
obtained 4 .1 m illion warrants to buy the com pany ’s shares at a price of $5.6 4 . In June, Yingli raised close to $2 03
m illion in a share offering and used the proceeds to retire debt, including ADM’s $50 m illion loan. The fund
m anager retains the warrants, which are well in the m oney , with Yingli’s New York Stock Exchange–listed shares
trading at $1 3 .7 6 last m onth. “China is littered with these kinds of opportunities,” say s Appleby . “It is
extraordinarily exciting.” ADM is also looking to strike sim ilar refinancing deals in India, he adds.
The firm ’s flagship hedge fund, Galleus — nam ed after a ty pe of shark found in tropical waters — has prov ided net
returns of 1 1 percent annually since its inception in April 1 9 99 . Last y ear it posted a 1 3 percent decline, but ov er
the next three to fiv e y ears, Appleby expects the fund to generate net annual returns of 1 5 to 2 0 percent.
Ashm ore Inv estm ent Managem ent, which m anages $2 4 .9 billion in assets, is taking a different tack by m arketing
its Global Consolidation and Recov ery fund as a v ehicle for financial firm s to get illiquid assets off their books. The
fund, which was seeded with $1 00 m illion in assets from UBS, is currently inv ested prim arily in tradable loans,
priv ate loans and conv ertible bonds from com panies in Eastern Europe and Asia. Project financings and public and
priv ate equity are also expected to be part of the portfolio. “We consider this a m ultiasset class fund,” notes Booth.
Ashm ore ty pically does not get inv olv ed in the day -to-day m anagem ent of the com panies it inv ests in, but rather
seeks to add v alue by working with local partners to consolidate assets and restructure target com panies. The
opportunities in em erging m arkets are m ore attractiv e than in dev eloped m arkets because com panies there are not
as lev eraged, say s Booth. “There is m uch m ore underly ing strength and v alue,” he explains.
Booth expects the fund to generate returns sim ilar to those of other Ashm ore special-situation funds. Its Asian
Opportunities Fund, which was created after the Asian financial crisis, generated gross annualized returns of 2 3 .2
percent from July 2 000 through Decem ber 2 005, when it was wound down. Its Asian Recov ery Fund, which is still
open, returned 1 7 .3 percent from its May 1 9 98 inception through March 2 009 . The new fund has a fiv e-y ear
lockup period.
Managers of distressed-debt funds acknowledge the risks of inv esting in em erging m arkets. Although bankruptcy
laws in som e jurisdictions, such as Hong Kong and India, are sim ilar to those in the U.S., countries like Indonesia and
Russia do not offer good legal protection to creditors. China has passed new bankruptcy laws com parable to those in
the U.S., but there is still substantial uncertainty about how the sy stem will work in practice. “The rules are on the
books, but the courts are untested,” Rauch points out.
Gram ercy learned a lesson about legal pitfalls with its inv estm ent in Asia Pulp and Paper, an Indonesian com pany
that defaulted on $1 4 billion of debt in 2 001 . Although Indonesian and U.S. courts ruled in fav or of creditors,
Gram ercy ended up hav ing to reach a priv ate deal with an Indonesian indiv idual to resolv e its claim s against the
com pany . “If y ou hav e to do a corporate reorganization in em erging m arkets, it’s highly likely y ou’re going to want
to do it out of court,” Rauch notes. He declines to disclose the details of the Asia Pulp and Paper settlem ent, say ing
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only that “it was a reasonable recov ery .” Inv estors also need to consider other factors when assessing potential
inv estm ents, including the integrity and objectiv es of the owners of the business, fund m anagers say . The key to
success is building long-term relationships and gaining knowledge of local play ers. “Our approach has been to choose
strong partners,” say s Ashm ore’s Booth.
In light of the risks inherent in em erging m arkets, m any Am erican fund m anagers are m ore than content to stay at
hom e and concentrate on the am ple supply of distressed debt av ailable in the U.S. “We like the law here and the
opportunities here,” explains Mark Patterson, chairm an of MatlinPatterson Global Adv isers, a priv ate equity firm
in New York City that specializes in distressed situations and m anages m ore than $9 billion. “The facts of this cy cle
ov erwhelm ingly fav or the U.S. and dev eloped m arkets on a risk-reward basis.”
Such v iews are m usic to the ears of em erging-m arkets specialists, though. In the U.S., distressed inv estors are
“tripping all ov er each other,” say s Rauch. By contrast, there is m uch less com petition for distressed assets in
em erging m arkets. “That’s what giv es rise to the potential for outsize risk-adjusted returns,” he notes.

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