Distressed and in need of due diligence

As enthusiasm for investing in Asian distressed debt rises, investors need to ensure they keep a firm eye on the risks as well as the rewards, says Hugo Williamson.

Investment traffic in the global financial markets dried up substantially last year as deals ground to a halt due to a lack of liquidity and a general collapse in investor confidence. However, not all investors have been in despair; distressed debt fund managers have been expanding their investments and, in contrast to many other global investment funds, many distressed debt funds have seen major returns.

This is as true for the Asian market as it is for the more traditional distressed debt markets, such as in the United States. The region has seen this behaviour before. The bursting of the Japanese economic bubble in the early 1990s, and the Asian financial crisis that followed in 1998, left a substantial number of non-performing assets with considerable distressed debt littered across Asia. Hedge funds, prop desks and other investors sought to take advantage of this and a rush of investment into Asian distressed debt followed.

Asia-focused distressed debt funds have grown dramatically in scale over the last decade and many fund managers are anticipating that 2009 will bring significant opportunities. Unlike in 1998, where many of the debt opportunities stemmed from poorly performing companies, many of these new opportunities will arise from stressed investors who, because of credit pressures, will be forced to sell debt that they currently hold in companies. Investing in distressed debt from a viable company is far preferable to that held by a non-performing one. Accordingly, funds have been rapidly seeking to raise additional capital to take advantage of these opportunities. Hong Kong-based ADM Capital, for example, has recently stated that it is seeking to raise between $500 million and $1 billion in new funds in 2009 to invest in distressed opportunities across the region, while Singapore-based Artradis Fund Management announced in October that it was seeking to raise $500 million for investment in cheap convertible bonds across the region.

Investing in distressed debt assets is not for the faint hearted, as their very nature makes the investment fraught with risk. The situation in 2009 is particularly unusual. Due to the knock-on effects of the credit crunch, many of the traditional buyers of Asian debt and equity – international investment banks and global hedge funds – have withdrawn from the market following their own credit issues.

As locals investors will testify, Asia is a highly diversified region and opportunities vary significantly from country to country. The collapse of the IPO market in Hong Kong, coupled with efforts in China to curb property speculation, has resulted in the cessation of traditional fundraising channels in the mainland. For this reason, China, and particularly its real estate industry, is being viewed as a major source for distressed debt opportunities over the coming year. Regionally, Indonesia is also viewed as a prominent source of opportunity due to the highly leveraged nature of much of its recent inward investment, while Australia and South Korea are also tipped as having significant market potential because of a stable legal system and the debt liability of the Won respectively. By sector, the finance industry and various commodity markets such as the extraction industries are seen as the areas most likely to provide distressed debt activity in the coming year.

These issues will be exacerbated by the economic slowdown in the developed world that will impact on the exportorientated economies in Asia, causing a rise in corporate defaults over the coming year as recessions in the US and Europe take hold. The impact of this is already being felt dramatically – Chinese steelmaker FerroChina Ltd in October 2008 appointed restructuring advisers following announcements that it was unable to repay $103 million in loans, while there are concerns of significant factory closures in the Pearl River Delta following Chinese New Year.

A combination of this lack of traditional investors and funds, coupled with a significant need for refinancing across the region, will create substantial returns for those who judge the market right. However, with this mass of opportunities come major risks that fund managers and finance institutions need to consider in ensuring long-term returns for the funds and their investors.

In seeking to mitigate risks, there are a number of considerations and steps that investors should consider when deciding on distressed debt opportunities. These will naturally be guided by the strategy being considered by the investor – usually whether they are seeking to liquidate or restructure and turn around the asset, and the size and duration of the investment.

“Asia-focused distressed debt funds have grown dramatically in scale over the last decade and many fund managers are anticipating that 2009 will bring significant opportunities.”

Pre-transactional business intelligence
There are a limited number of investors who have the experience, local knowledge, and patience to successfully navigate the various challenges in investing in Asian distressed debt. Initial identification of suitable distressed debt investment targets and subsequent asset valuation often require information not available in the public record. In seeking to gain a competitive edge and in protecting fund investors, business intelligence can help the fund manager identify suitable distressed targets from a number of potential options, and then seek to offset the probability of pursuing an ultimately unsuccessful opportunity through early identification of key reputational or financial issues that may influence the investment. This issue is compounded by the current speed and volatility of financial change that can rapidly render public information redundant and unreliable. Accordingly, those with access to local business intelligence and appropriate contacts can gain “real time” live information that may be crucial to a decision.

The need for informed business intelligence is particularly the case in Asia where opacity in public filings and other available documentation can complicate the process of selecting a target and defining the investment. Crucially, the ability through targeted business intelligence to navigate this lack of transparency and related barriers to entry can provide the investor with potential opportunities to leverage a competitive advantage in making informed and accurate investment decisions.

Due diligence of target
While this would seem an obvious early step for all investors once a target has been identified, investors often fail to conduct suitable due diligence. Investors need to understand exactly why the asset is distressed – is it for the reasons that the company is stating publicly to potential investors, or are there other undisclosed reasons that may effect the investment?

While conducting legal and financial due diligence is mandatory and usually a regulatory requirement, understanding the reputation of the company and the backgrounds of the management can be key to making a successful investment. In 2008, a lack of such due diligence in the US allowed Marc Dreier, founder of the law firm Dreier LLP, to market fake debt to hedge funds and other institutional investors which, as a result, lost in excess of US$380 million.

This need for due diligence is of particular significance in Asia, where fraud can often play a role in a company falling into a distressed state. Last year, a major private equity investor made an investment into a distressed company without suitable due diligence. After completing the investment, it was established that much of the company's stated Accounts Receivable was the product of interlinked fictitious companies. The result was that the company was not owed all of the money it had claimed. Subsequent investigations have identified that the investment is worth much less than originally supposed.

This need for due diligence is additionally important in the modern regulatory environment where a quick but underscrutinised investment may leave the investor in the sights of international regulators if the debtor they take a stake in has US Foreign Corrupt Practices Act or other regulatory concerns that are not identified.

Assessment of wider industry
Examining the activities of other companies in the industry or jurisdiction can further facilitate making an informed investment choice. Understanding whether the company is unique in the market place for its lack of performance, or if the company's issues are due to problems in the wider industry, might necessitate a different investment strategy for the fund manager and affect their decision-making process.

Legal, regulatory and political risk
The cross-border nature of modern finance and the fact that many of the most interesting distressed debt opportunities exist in jurisdictions that are politically unpredictable, and possibly unfamiliar, mean that fund managers often need to gain a good understanding of the various legal, regulatory and political risks associated with the asset they are looking to invest in and of the local investment culture.

As part of this assessment process, the investor may need to consider the integrity of the local legal system in ensuring that any intended restructuring or liquidation program is workable and that their rights as a creditor will be respected and supported. While legal and regulatory concerns are some of the major causes for discouraging investors from moving capital into Asia, the integrity and predictability of the various legal systems in the region vary considerably. Indonesia, despite ongoing reform, is renowned for having an opaque and often compromised judiciary that can undermine investments. Conversely, the predictability of the Australian and Japanese legal systems encourages distressed debt investing in those countries. Furthermore, thought needs to be given to the legal and regulatory framework at a local level within a country that may vary significantly between provinces in its requirements, application and enforcement. In China, which is continuing to reform its judicial system, inves tor s can expect much more predictable protection of creditors' rights in the primary commercial hubs, Beijing and Shanghai, compared to some of its more remote provinces. Regulations on foreign ownership of assets may also affect investment decisions.

“With the mass of opportunities come major risks that fund managers and finance institutions need to consider.”

In addition to understanding local legal and regulatory systems, having a deeper understanding of the local political system and of local political and economic policy, such as a government's appetite for bailouts, is important, as these can also have a significant impact on an investment. In Indonesia in late 2008, the Bakrie & Brothers Group controlled by the family of Aburizal Bakrie, a cabinet minister, nearly collapsed under its spiralling debt burdens in excess of US$1 billion, which caused a meltdown on the Jakarta stock market. Discussions of government bailouts were ultimately rejected by the finance minster. Eventually, private investors, including Australian hedge fund Brentwood Ventures and TPG subsidiary Northstar Pacific Partners, bought much of the debt.

Similarly, understanding local political and security tensions, such as the recent transitions of power in Thailand, may give investors advance warning of political upheaval and/or legal and regulatory reform that will impact investments.

While opportunities for buying distressed debt look set to grow in Asia in the coming year, and as the jurisdictions where funds go to find those opportunities expand, so too will investors' exposure to potential risks increase. While this will inhibit some from entering the market, for others it will provide great opportunities and financial rewards. Thus, ensuring that suitable risk considerations have been made, prominent issues identified, and potential problems mitigated are all essential steps for investors to take full advantage of the various possibilities.

Hugo Williamson is a director in the Hong Kong office of risk consulting company Kroll.