Cezary Salad

On Tuesday night the Penn Club of New York held its 10th annual Hedge Fund Panel, sponsored by the Club’s Hedge Fund Intra Club, during which six hedge fund managers shared their views on everything from where they see distressed investment opportunities to whether speculation is driving up oil prices (emphatic no). I attended the panel to benefit from their perspective and thought I would share some of the take-aways so that others may benefit as well.

The panelists included Arif Joshi, portfolio manager at Halbis Capital Management (the asset management arm of HSBC), Jed Hart, senior managing director of Centerbridge, John Khoury, portfolio manager at Wesley Capital, Aaron Cowen, managing director for Karsch Capital Management, Jerry Cudzil, managing director at DAC funds, and Leslee Cowen, managing director of the Drawbridge Special Opportunities Fund at Fortress Investment Group.

Obviously, with the economy in a downturn, opportunities to invest in distressed assets were a big focus of the discussion. Asked where they see the opportunities in their respective asset classes, the panelists seemed in agreement that the best (or worst, depending on how you look at it) is yet to come since corporate distress is at the lagging - not the leading end - of defaults. However, the panelists noted that this cycle is different from anything we’ve seen before in several respects. For one, Mr. Hart - who helps manage a credit opportunities fund at Centerbridge - mentioned that “it’s just much bigger” since there’s been about $2 trillion of high yield debt securitized in the last few years. So if corporate default rates, which he said are still incredibly low, start to tick-up to a rate even half the default rate of last credit downturn in 2002 (about 12-15%), there will be “plenty of dollars of default securities to look at and invest in,” with consumer cyclicals leading the charge.

Ms Cowen, whose group within the Drawbridge fund focuses on distressed debt and special situations investing, seconded those thoughts but added that this cycle is also unusual in that defaults are being led by the mortgage markets, not corporate defaults - as was the case with the last cycle. One reason for this, of course, is the downturn in the mortgage markets following the subprime meltdown. But Ms Cowen added that corporations have “a lot of extra cushion” this time around since many of them refinanced their debt in 2005-2007, before the fallout from the credit crunch materialized, and thus have some leeway in terms of liquidity and covenants on their debt. So give it another quarter or two before we start to see some real activity in corporate defaults.

(Meanwhile, of course, the smart money is already well-positioned to take advantage of this trend: earlier this year, the Blackstone Group paid $930 million for GSO Capital Partners - a fund that is now raising money to invest in distressed opportunities).

Taxes were another hot topic during the panel since it looks increasingly likely that Congress will pass the carried interest tax this year, which would tax carried interest - the share of a fund’s profits that goes to the partners - at the rate of ordinary income instead of capital gains. This would effectively mean that that hedge funds and private equity partnerships would have to go from paying 15% to 40% of their profits in tax. The panelists seemed resigned to this development. “It was good while it lasted. If it’s going to end, it’s going to end,” Mr. Hart, commented, adding that he sees this as part of a normalization of tax codes taking place in the U.S. since “there’s no reason why a doctor should be taxed more heavily than an investment analyst.” However, Mr. Hart mentioned that he doesn’t foresee hedge funds shifting operations abroad in response to this - which makes sense since MPs in Great Britain are also spoiling to tax carried interest at a higher rate.

Besides tax strategy, though, operational efficiency and cheaper labor provide additional incentives to shift operations abroad - notably to places like India. Asked whether hedge funds would follow investment banks in taking advantage of this trend, the panelists shared mixed opinions. Mr. Khoury of Wesley Capital, whose hedge fund focuses on real estate securities, noted that “hedge funds get paid for research at the end of the day” and that includes going out to meet management and look at assets. “I just can’t see what part of our investment process you could take outside of the office or outside of the team and outsource it in a way that adds value to it,” he concluded. However, Mr. Cudzil noted that his hedge fund does employ a service that gives it access to six analysts based in India who help it with routine analytical work that has to be done on a daily basis, such as dollar price tests, earnings tests and updating models for annual reports. “We have found it helpful,” he said. So it outsourcing may be less relevant for funds that invest in something tangible like real estate and more important for funds that analyze less tangible investments, like structured credit.

Two other areas that panelists were asked to comment on - the SEC’s restrictions on short selling and the impact of speculation on commodity prices - yielded unsurprising responses. The panelists viewed short selling as a healthy function of the capital markets. One of them opined that short sellers provide a service to investors who might otherwise be buying shares of companies at the wrong price and that restricting short-selling is un-American and akin to socialist restrictions on a free society. And when asked - by me, given my interest in this topic - to comment on whether speculators are driving commodity prices higher, Mr. Cudzil seemed to speak for the panel when said that he believed that global commodity markets are too big to manipulate. “Short-term manipulation in the markets driven by speculators will quickly be corrected,” he said, and supply and demand fundamentals will ultimately drive the markets.

Other trends the panel touched on would also not surprise those who follow the hedge fund world: the big funds will likely keep getting bigger, emerging markets provide some compelling valuations (esp. places like sub-Saharan Africa and South America) but also bigger risks, and it’s as important as ever for investors to do their homework and research their manager before they invest.