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These Hedge Funds (and Madeleine Albright) Are Betting on a Debt Crisis

Bradley Keoun

There could be a big debt crisis brewing in places like China, India, Latin America and Africa -- and a growing number of investors are amassing war chests to cash in on the distress.

Albright Capital Management, a Washington-based hedge fund backed by former Secretary of State Madeleine Albright, has raised about $75 million in recent months to buy up bonds of debt-strapped companies in places like Latin America, Africa, India, Russia and Asia, filings show. Other hedge funds betting on distressed emerging-market bonds include Los Angeles-based Oaktree Capital Management, New York-based Greylock Capital and Gramercy Funds Management, based in Greenwich, Conn.

A casual glance at global markets reveals little of the distress, where optimism over economic growth and higher oil and raw-materials prices has driven developing-country stocks up an average 12% this year, more than double the gains for the S&P 500 Index .

Yet Greg Bowes, managing principal at Albright Capital, says that corporate debt in emerging markets has risen so rapidly over the past decade -- partly fueled by low interest rates in developed markets like the U.S. and Europe -- that a crisis on the scale of Latin America's in the 1980s and Asia's in the 1990s has become increasingly likely. Some $100 billion of corporate defaults are plausible, or roughly 15% of the wall of emerging-market corporate debt scheduled to mature in the next four years.

One catalyst could be rising interest rates in the U.S., which would drive up the value of the dollar, in turn making it harder for foreign companies to afford their dollar-denominated debt.

"This corporate credit crisis could be a particularly big opportunity," Bowes, also Albright's son-in-law, said in an interview. Given the deep discounts historically afforded on distressed debt during a credit crisis, investors could triple or even quadruple their money as prices recover, he says. Albright, started in 2005, manages about $500 million overall.

Corporate debt in emerging markets has more than doubled since 2008 to at least $18 trillion in 2014, according to an International Monetary Fund research paper in December. As a share of gross domestic product, the debt now represents more than 70%, up from less than 50%. Things look equally bleak based on metrics typically used by investors to evaluate a borrower's ability to make payments: In Asia and Latin America, companies' debt now represents roughly four years of operating profits, up from fewer than two years prior to the financial crisis of 2008.

According to Standard & Poor's, about 40 emerging-market bond issuers were on the brink of default as of year-end 2016. And a raft of credit-rating downgrades is likely this year in Latin America, Eastern Europe and Africa, given that oil prices remain well off their 2014 highs above $100 a barrel and that geopolitical uncertainty remains high.

Among the hot spots: political turmoil in South Africa and Turkey; corruption investigations in South Korea and Brazil; rising tensions between the U.S. and Russia; and the potential for Donald Trump to impose import restrictions on places like China and Mexico. 

So far, the wave of defaults has been more of a ripple. According to analysts at JPMorgan Chase , there had been only one corporate default in emerging markets this year, as of April 7, representing about 0.1% of total junk bonds from the countries. At this time last year, the rate stood at 1.8%.

A continued hunger among investors for high-yielding bonds has helped emerging-market companies to refinance their maturing debt, especially given the improvement in their finances due to the rebound in oil prices from last year's low around $26, according to the bank. Overall, JPMorgan forecasts a 2.1% default rate for all of 2017, less than half of the 2016 rate.

But Gramercy, a $6.1 billion hedge fund headed by former Lehman Brothers executive Robert Koenigsberger, published a report in January 2016 declaring that a "potential perfect storm" was brewing in emerging-market corporate debt.

Part of the story stems from the increasing reluctance of large banks -- partly due to stiffer regulations enacted in recent years -- to absorb big slugs of debt from desperate sellers.

The firm has raised about $1 billion of capital over the past year and a half to pursue credit opportunities in emerging markets, according to a statement in February.

Some 5.7% of corporate junk bonds from emerging markets are trading at prices below 70 cents on the dollar, more than double the rate for higher-risk U.S. bonds, according to JPMorgan.

The diciest borrowers include China's Shanshui Cement; Croatia's Agrokor, a manufacturer and distributor of mineral water, ice cream and mayonnaise; and Ukraine's UkrLandFarming, an egg, meat and sugar producer. The only defaulter so far this year from emerging markets is South Africa's Cell C, a mobile-phone provider that missed an interest payment on 400 million euros ($425 million) of bonds.

For most of the hedge funds, the strategy is pretty simple: First, buy a distressed company's bonds for cents on the dollar. Then, work with executives to get them to pay the debt back, or else swap it for a big equity stake that can eventually be liquidated at a profit.

That's the theory, anyway. Distressed-debt investors risk being left in the dark on a company's true financial state, getting ripped off by management and becoming embroiled in bankruptcy proceedings. There are also hazards specific to emerging markets, such as rapidly changing political and economic conditions, high inflation, currency devaluations and ad-hoc trading restrictions.

Greylock, a $990 million hedge fund run by Willem J. "Hans" Humes, says in a filing with the Securities and Exchange Commission that international junk bonds are "generally considered to be predominantly speculative with respect to the issuer's capacity to pay," and that defaulters sometimes end up shielded by "principles of sovereign immunity."

According to a bio on Greylock's website, Humes started the firm in 1995 after working as a banker and trader for Lehman Brothers and Manufacturers Hanover, including stints swapping debt for equity in Latin America and restructuring government debt for the Philippines and Yugoslavia. He has lived in Nigeria, Morocco, Canada, Chile, Mexico and Belgium and is fluent in Spanish.

Albright Capital, which invests in distressed debt as well as private equity, plans to raise another $125 million for its emerging-markets fund, according to filings. 

"It's a very difficult landscape and terrain," says Bowes, who previously worked at Greenwich Capital Markets and Bankers Trust. "There's a small club of investors who have that kind of experience and are licking their chops for another bite at the apple."

Editors' pick: Originally published April 18.

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