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Attractive debt


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  • | 6:00 p.m. August 25, 2008
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Attractive debt

Large institutional investors, including the largest pension fund in the U.S., are finding debt funds more attractive than stocks. It could be a risky, but lucrative, bet if the economy turns around.

INVESTING by Miles Weiss | Bloomberg

The California Public Employees' Retirement System is paring stock holdings and investing as much as $2.3 billion in distressed-debt funds run by Leon Black as corporate-default rates are forecast to double within a year.

The largest public pension fund in the U.S. is supplying almost all of the capital for three partnerships set up by Black's Apollo Global Management LLC to buy bonds and bank loans the firm deems cheap, according to regulatory filings. Apollo's experience with distressed debt - loans trading below 90 cents on the dollar and bonds below 70 cents - dates back to the early 1990s, when it made $2 billion with Credit Lyonnais SA on high-yield bonds acquired from insolvent Executive Life Insurance Co.

Calpers is turning to the New York-based firm to find profits amid the worst decline in credit markets in two decades, in part by acquiring buyout loans from banks such as Citigroup Inc. at prices at least 10% below face value. It's part of a three-year plan to hold fewer stocks, which returned 5.6% a year for the fund in the past decade, compared with 17.3% by its distressed holdings from 1990 to 2006, according to Calpers.

"It's logical they would be increasing their commitments to distressed," says billionaire Wilbur L. Ross, the New York- based investor who received a $400 million pledge from Calpers last year for his WLR Recovery Fund IV LP. "It's been obvious to people for a while that we are moving into a higher-default period."

Returns fall

The default rate for U.S. speculative-grade bonds rose to 3% last month from 2.5% in June, the biggest monthly increase in almost two years, New York-based Moody's Investors Service said Aug. 7. The rate may climb to 7.2% by July 2009, said Moody's, which rates speculative-grade bonds Ba1 or below.

Calpers, which has $239 billion in assets, reported last month that fund returns fell 2.4% in the year ended June 30, the first time it has lost money since 2002. A 19.6% gain on alternative investments, which include the distressed category, wasn't enough to offset a 10.7% decline on stocks. Calpers targets a 7.75% annual return to remain fully funded.

Distressed securities are mostly corporate bank loans and high-yield junk bonds that are having trouble meeting interest and principal payments. Investors can profit if the companies rebound or by swapping the debt for equity should they default and go through bankruptcy reorganization.

In addition to the Apollo funds, which were set up starting in 2007, Calpers committed at least $1.7 billion to seven other managers last year, more than doubling distressed-debt commitments to $5.6 billion, according to its Web site. Distressed investments accounted for 12% of alternative assets at March 31, up from 4% in June 2004, according to Clark McKinley, a Calpers spokesman in Sacramento, California.

"It's a matter of assessing market conditions and taking advantage of opportunities," McKinley says in an e-mail response to questions.

The California State Teachers' Retirement System of Sacramento, the second-largest U.S. public pension fund, in February raised its target for such holdings to 15% from 5% of alternative assets.

Fund managers such as Legg Mason Inc.'s Bill Miller in Baltimore and New York-based Third Avenue Management LLC's Martin Whitman lost money when they incorrectly bet that shares of financial-services companies had bottomed out earlier this year.

"Trying to catch falling knives is a risky business," says Hugh Ray, who founded the bankruptcy section of the Houston-based law firm Andrews Kurth LLP. "But if you know what you are doing, there are some real opportunities."

Many of the distressed funds are being set up by private-equity firms that are searching for deals amid a slowing U.S. economy and a lack of funding for their mainstay leveraged buyouts. Apollo, New York-based Blackstone Group LP and TPG Inc. of Fort Worth, Texas, bought $12 billion of debt in April from New York-based Citigroup.

"You have large global financial institutions that have to delever their balance sheets and raise capital," says Myles Gilbert, a senior consultant at Boston-based Cambridge Associates LLC, which helps institutions allocate assets and select money managers. "Sometimes they are selling their assets at distressed levels for liquidity reasons, even though the securities are economically intact."

Junk-bond windfall

Black, 57, established his reputation as an investor soon after he co-founded Apollo in 1990, following the collapse of Drexel Burnham Lambert Inc., where he had worked as Michael Milken's head of mergers. Using capital provided by Credit Lyonnais, now part of Paris-based Credit Agricole SA's Calyon securities unit, Black won an auction for Executive Life's junk- bond portfolio of $6.5 billion to $7 billion with a bid of $3.25 billion, or about 50 cents on the dollar.

Credit Lyonnais and a partner ended up splitting $1.7 billion in profits, while Apollo reaped $300 million to $350 million in fees, according to Gary Fontana, who served as the chief trial counsel for California insurance commissioner John Garamendi in a suit later filed against Credit Lyonnais. Garamendi was ultimately criticized for selling the junk bonds too cheaply, Fontana says.

"The economy turned around, interest rates fell like a rock and these high-coupon bonds became gold," says Fontana, who now handles financial fraud cases for the law firm Thelen Reid Brown Raysman & Steiner LLP. "These guys were unemployed investment bankers, and they went through the credit thing and hit on this amazing client."

Apollo Strategic Value Master Fund LP, which invests in distressed debt, has returned an average of 6.5% a year since inception in June 2006, Apollo co-founder Joshua Harris says on an Aug. 14 conference call to discuss results for AP Alternative Assets LP, Apollo's publicly traded leveraged-buyout fund.

Calpers first invested with Black in 1995, a $150 million commitment to one of his private-equity funds, and last year bought a $600 million stake in the firm's money-management operations.

Black forms two types of partnerships to invest in beaten- down debt, according to a registration statement Apollo filed with the U.S. Securities and Exchange Commission this week for a stock sale. His distressed funds invest in companies with stressed balance sheets that are trading at prices he considers cheap. The corporate opportunity funds look for debt securities of healthy companies that have fallen due to the disruption in credit markets.

Apollo spokesman Steven Anreder declined to comment.

Exclusive fund

Calpers initially pledged as much as $1.2 billion last year to Apollo Special Opportunities Managed Account LP. Apollo set up this fund for Calpers to invest in distressed debt, primarily in Europe and North America, according to this week's filing by the money management firm.

The pension plan also provided almost all of the equity for the $107 million Apollo/Artus Investors 2007-1 LP, created last October to help finance the purchase, at a discount to face value, of $1 billion of high-yield loans from the former Bear Stearns Cos., now owned by JPMorgan Chase & Co. In its SEC filing, Apollo says Artus was one of two funds designed to take advantage of "supply-demand imbalances" in the leveraged finance market.

Calpers agreed to provide $1 billion of the $1.2 billion raised by Apollo Credit Opportunity Fund I LP, a partnership established in April to purchase discounted debt, including senior bank loans, hung bridge loans for buyouts and publicly traded bonds.

"We were able to establish these funds with some of our largest and most loyal investors in a rapid fashion to capitalize on the time sensitive nature of the dislocation in the capital markets" that began in July 2007, Apollo says in the filing about Apollo/Artus Investors and a second fund.

REVIEW SUMMARY

Trend. Investing in distressed debt

Industry. Money management

Key. Stocks may not generate the returns investors demand, but corporate debt could if the economy turns around.

 

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