In mid-March, global asset manager Blackstone announced that it would be shuttering its $3 billion GSO Special Situations Fund, a distressed debt hedge fund that offered investors quarterly redemptions. Interestingly, Blackstone didn’t take this step because returns were necessarily that bad – the fund returned an annualized average of 6.5% since launch in 2005, according to a March 16 Bloomberg article on the decision – but because it wanted to shift the fund’s investors to other GSO credit vehicles that lock up investor capital for longer periods.
This seems counter-intuitive, but the move highlights a core facet of many asset-backed, high yield and distressed lending activities: liquidity is scarce at best and nonexistent at worse. Accordingly, if those activities are housed within a vehicle that offers anything close to frequent redemption periods, a mismatch can easily occur between the liquidity of the fund and the liquidity of its various portfolio components. As any veteran of the financial crisis can attest, this mismatch can quickly place managers in the unenviable position of becoming forced sellers of infrequently-traded securities, which by any definition will mean they will be unlikely to do so at favorable prices. Even worse, they may have to dump well-performing positions in order to avoid sparking a fire sale on the others.
This can cost real money. The Bloomberg article made note of two Blackstone credit vehicles, both similar to the GSO fund in question and offering longer investment horizons, which booked net annualized returns of 17% and 13% respectively. The message? For the more liquid investment option, the aforementioned mismatch resulted in significantly lower fund returns over time.
Blackstone’s step raises broad questions about the wisdom of putting a liquid wrapper around what are fundamentally illiquid investments. Hint: It may not be a good idea.
Furthermore, Blackstone’s move speaks directly to the value that can be created – the premium, if you will – that can be obtained through illiquidity. While the GSO fund in question deals primarily with traded credit instruments like junk bonds, the takeaways are the same; all else being equal, illiquidity in private debt transactions can create the situation whereby investors can capture an illiquidity premium. There is a reason why the AUM of the $600 billion private debt market has quadrupled since 2006 and booked its tenth consecutive year of growth in 2016.
When the nature and horizon of the investment is clearly understood beforehand, illiquidity is simply not the four-letter word it is traditionally made out to be. On the contrary, when properly utilized, illiquidity can deliver excess return without commiserate increases in actual risk.
Granted, our type of approach requires proper due diligence and structuring expertise in order to fully understand our borrowers and the likelihood they will ultimately default on our loans. However, that is a risk we can at least mitigate through the level of effort we put into our process and research; contrast that with the portfolio manager, who is dealing with fund-level redemptions that routinely forced the closure of long-term, illiquid positions before they had a chance to fully work.
In our mid-2016 Review, “Seizing Illiquidity” (for a copy, put a link or a request) we wrote at length about the liquidity deterioration that has increasingly developed in traded credit markets since the crisis. Resulting in broader bid/ask spreads and higher volatility, this decline is the result of many factors, but chief among them is reduced market making activity by financial institutions due to regulatory constraints on their capital. Therefore, despite an explosion in the total stock of corporate bonds issued by firms trying to lock in rock-bottom coupon rates, investors are in the perverse position of having less liquidity actually available to them. As we wrote last summer, this situation was more or less tolerable as long as U.S. interest rates remained in the cellar; the test would come when rates began to move materially upward and the “great unwinding” began.
Well, we’re there…
Instead of a statement about the risks of illiquid investing, therefore, the Blackstone decision is actually a tacit endorsement of private debt in general and what we do at Old Hill Partners in particular. Not only will the liquidity “discount” offered by traded credit markets prove illusory should everyone head for the exits at the same time, the additional risk-adjusted yield investors can earn – modeled by Old Hill’s analysts to be 400-700 basis points – for agreeing to place their capital into longer-term structured private debt transactions can be significant.
In a March 20 follow-up article discussing the Blackstone decision, Bloomberg columnist Lisa Abramowicz concluded, “many investors have sacrificed returns for liquidity, perhaps more than they realize.” We couldn’t have said it better ourselves, and would only add that the traditional, outdated view of illiquidity being a disadvantage is literally costing investors money every day in lost yield. Moreover, when the next rush for the exits occurs and they learn the market liquidity they’ve been paying for has evaporated, they’re apt to lose a lot more than that.
In moving investors in its GSO Special Situation Fund from a fairly liquid environment to a more illiquid one, Blackstone – which manages than $367 billion and is one of the most sophisticated asset managers on the planet – seems to agree. In augmenting or replacing a fixed income allocation, the illiquidity premium inherent in private debt transactions is best earned through similarly illiquid alternative investment pools like those offered by Old Hill Partners.