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| Kate Kutasi |
Kutasi is a portfolio manager at Kellner, DiLeo Cohen & Co. in New York, which manages $550 million in distressed/ high-income, special situations merger arbitrage and convertible arbitrage investments. She joined in January and was formerly head of high-yield, distressed and private securities at Alliance Capital Management.
What's your view on default rates?
They have bottomed out. I don't think they are going any lower than here. We're seeing some high-profile filings with the likes of Winn-Dixie and I think we'll see a slight increase in the default rate through the latter part of the year.
Where do you see opportunity in the distressed market?
In the smaller to middle market companies, which tend to be less widely followed. [Part of that is] as a smaller fund we can take a bigger position there. And I think there will continue to be distressed supply there. Smaller companies have fewer alternatives available and less access to the traditional source of capital.
Which sectors are you currently focusing on?
One obvious sector everybody is looking at is the auto parts industry. Most recently, in the middle market, any industry that is having a margin squeeze. Every manufacturing or industrial company that is sensitive to commodities prices, rising food prices, input prices; the key thing to look at it is liquidity. There's a fear over the amount of liquidity in the market right now. It's a question of the quality of earnings and the ability to pass through prices. I hate to generalize, but some companies have been more successful than others at passing along price increases. It's really on a case by case basis.
What names are attractive?
There do remain some attractive opportunities. I like the Land O'Lakes issue; the capital trust security is attractive. Land O'Lakes is showing improvement in its operating performance and its numbers. It's an interesting situation with strong brand name recognition, though there are some structural issues with it.
I also think supermarkets are interesting. The pressures Winn-Dixie faces [are not limited to it.] I expect to see some filings in the industry. As I'm working on positions at the moment, I'd prefer not to highlight any names.
Do you think pension reforms could spark distressed supply?
The pension reform issue is still a big one. I think the likelihood is something will happen with that. As for its impact, the auto suppliers have the biggest issue. They're the ones that really need the most flexibility. Any additional call on their cash could absolutely spark defaults, this could have a huge impact. Also, if the [Pension Benefit Guaranty Corp.] is successful in getting its claims secured, that could have also have a huge impact on when people do their recovery analysis. [The PBGC's claims] could become senior if something happens, which would depress recoveries.
Do you think the influx of hedge funds has changed the distressed market?
This has made valuations extremely high in many cases. There's a tremendous amount of momentum in trading, a lot of price movement on rumors, which has been increasing over the last several years. And to some extent the recovery process has sped up. Companies have been able to refinance because there's so much capital looking for a home. There have been a lot of rescue financings.
When and how do you think the turn in the credit cycle will unfold?
The cycle will change some time in the next 12 months, though it's hard to predict what will trigger it. But there's been a trend in high-yield issuance for lower credit quality deals through 2004. It's now the beginning of '05 and there's a continued rise in triple-C issuance and less and less is for refinancings. From 60% last year to 50-55% so far this year in refinancings of low quality issuance. And there's an increasing amount of issuance to fund shareholder activities, which in many cases leads to downgrades. Nevertheless these deals keep coming to market. The refinancings are fine, but it's more the shareholder dividend deals, where companies are levered up to fund distributions. These are troubling especially in conjunction with downgrades.
There are players in the market that don't understand what they're investing in. A perfect example is with the second-lien paper issued. People look at it as generic second-lien paper and in some cases don't understand what they're buying. Second-lien paper could be a source of dramatic fallout. Aside from that, I think people that have not been through a downcycle before don't understand how ugly it can get. There will be a real differentiation between funds when the cycle turns.
I think what's going to happen is the default rate is going to slowly creep up and then there will be an accelerated rise. Any time liquidity dries up, easy access to capital dries up and we'll see a dramatic increase in the default rate. Liquidity is masking some real operating problems and we'll see these come home to roost. At which point there will be some natural fallout with some investors exiting the market.