By Christopher Faille
Brencourt Advisors LLC, the multi-strategy hedge fund firm founded in 2001 by William Collins, has survived some tumultuous market moves in that decades’ time. In particular it survived the harrowing experience of 2008 despite a run of investor withdrawals, and without the application of gates.
We spoke to John Zito, portfolio manager for credit opportunities at Brencourt, about some of the strategies Brencourt has employed and continues to employ in its search for alpha. He observed that one of the main investment strategies pursued by the Credit Opportunities Fund in particular is capital structure arbitrage.
John Zito: We like this strategy as it offers hedged downside with good upside optionality. Our style of capital structure arbitrage is a little different than most though as it is a fundamental approach, not a quantitative approach. One common strategy for us that works well in weak or choppy markets like current ones is buying senior debt and shorting either subordinated debt or equity – small changes in valuation can lead to significant widening in security prices. Another strategy that works well in stronger markets is buying convertible bonds and shorting straight bonds – this can often lead to free upside optionality. Our approach is to spend a significant amount of time on the capital structure of companies, their business models, and any spinoffs or bankruptcies that forcibly create valuation differentials among securities.
Q: Short-term interest rates are so low that they can only move in one direction. This must make some plays pretty obvious, and accordingly make them crowded. Are you having difficulties as a result?
John Zito: Again, our approach to capital structure arbitrage is based on fundamentals and a concrete event as opposed to quantitative measures. Therefore, we don’t need to use any leverage in this strategy. Our forecast returns in this area meet our hurdle rate without any leverage. Your point is a good one however – in a crowded market like this one leverage can often cause painful short-term dislocations for some investors.
Q: The U.S. Supreme Court has recently approved a change in the rules of bankruptcy procedures aimed at forcing greater transparency from the hedge funds actively engaged in reorganizations. How might this change affect Brencourt’s distressed debt positions and strategies?
John Zito: We would see zero change in Brencourt’s distressed debt positions and strategies. Historically, our fund has generated significant returns in times of widespread corporate default such as 2009. We do see defaults picking up in the next year or two, particularly in sectors and business models undergoing a negative secular shift. Brencourt’s strategy in bankruptcies is to invest at the low point of earnings cycles and valuation, and profit upon recoveries – or to alternatively profit from capital structure trades. Most of the new procedures forcing greater transparency stem from inter-creditor disputes. We overall welcome any procedures that make the process more visible and fair for all parties. However this will have zero effect on how we operate.
Q: Has there been a pick-up of merger and acquisition activity in recent months or is that simply an illusion?
John Zito: There has indeed been a pickup in merger activity, but understand that it has been very sector specific and generally from large strategic buyers. In the high-tech fields, as with Google’s purchase of Motorola, it is certainly the case that if you have a patent in your portfolio somebody wants to buy you up! Also, the low-growth economic climate right now presses companies who want to grow to buy competitors and eke out synergies. What is not back yet is the LBO market. This showed signs of life earlier in the year when debt markets reverted to the excesses of 2007, but now that debt is pricing more rationally, we see LBOs being the exception rather than the rule.
Q: Talk to me about the macroeconomic picture. In particular, do you believe that we’ll see a QE III in the near future?
John Zito: Europe is still the number one issue. There is no real solution, and there is a tangible tail risk of another Lehman. We do think eventually that many peripheral countries will leave the EU – but what we are really focused on is if Europe can safeguard all the banks.
In the U.S., we see slow growth for the near future. Growth will be between zero and 2 percent but it will still feel like a recession to the average American, who is still overlevered and probably underwater on real estate. Before the election there likely will be QE III or some other federal stimulus. We do think the Fed has some bullets left but the political climate makes it more difficult to expend them.
This reality makes us not want to take any market bets right now and to keep our beta exposure neutral.
Q: How do market swings, whatever their strength or timing, affect the strategies of Brencourt, and of the portfolio you manage in particular?
John Zito: Our strategies are designed to be beta neutral and market agnostic. We do however like market swings and volatility as it creates opportunities for us down the line in mis-priced securities, capital structure trades, and restructurings/defaults. While the volatility of the last two months has been startling, our team is busy doing work finding investments to drive returns in the back half of the year and into 2012.