2.4 Credit and multi-strategy

Hedge funds are not only equity investors. Many trade corporate debt: bonds and loans issued by companies. Some specialize in companies in serious financial trouble. And some of the largest firms don't follow one strategy at all, but run many strategies, or many separate trading teams, inside a single fund.

These are the last two strategy groups in this module. Credit funds matter to administrators and auditors because their assets can be hard to value and slow to sell. Multi-strategy and multi-manager funds matter to allocators because their structure, risk controls and costs differ sharply from a traditional single-manager fund.

Long/short credit

A long/short credit fund applies the long/short idea from Lesson 2.1 to debt. The manager analyzes companies' ability to repay what they owe:

• Long positions: bonds or loans of companies the manager expects to stay healthy or improve, so their debt holds its value or rises, while the fund collects interest.
• Short positions: debt of companies the manager expects to weaken. The fund may short the bonds directly, or buy protection through a credit default swap (CDS), a contract that pays out if the company defaults and typically gains value as its credit worsens.

Some managers trade between different parts of the same company's capital structure, the layers of debt and equity it has issued. For example, a manager might buy a company's senior loans, which are repaid first, and short its junior bonds or its shares, if it thinks the market is pricing the layers inconsistently. This is sometimes called capital structure arbitrage.

Credit markets are generally less liquid than large stock markets. Many bonds trade infrequently, and prices can move sharply when many investors want to sell at once. That affects how often a fund can sensibly offer redemptions, which Lesson 4.1 discusses.

Distressed debt

Distressed debt investing means buying the debt of companies that are stressed (struggling to meet their obligations) or already bankrupt. Such debt often trades well below its face value, because the market doubts it will be repaid in full.

The distressed investor's case is that the market has priced the debt too low: the company's assets or future business are worth more than the price implies. Returns can come from:

• Recovery in price as the company's prospects improve.
• A restructuring, in which the company's debts are reorganized, either in court through bankruptcy or by agreement with creditors. Creditors may receive new debt, cash, equity in the reorganized company, or a mix.
• Taking control: by buying enough of the right class of debt, an investor can end up as a major owner of the company after the restructuring.

Distressed investors are commonly active. They may sit on creditor committees, negotiate the terms of a restructuring, and take legal action to protect their claims. That takes specialist legal and financial skill.

The risks are significant. Outcomes are uncertain, restructurings can take years, legal costs can be high, and the securities are often illiquid and hard to value. For that reason, some funds holding distressed assets use longer lock-ups or side pockets, both covered in Lesson 4.1. This lesson is only an introduction: PC201 Private Credit Strategies covers distressed debt and restructurings in depth.

Multi-strategy funds

A multi-strategy fund runs several strategies inside one fund. The same firm might run equity long/short, credit, merger arbitrage and macro teams, with a central investment committee deciding how much capital each receives.

The appeal for investors:

• Diversification: different strategies make money at different times, so the fund's overall returns may be smoother than any single strategy's.
• Flexible capital: the manager can move money toward strategies with the best opportunities.
• One relationship: the investor does one round of due diligence and deals with one manager rather than several.

The trade-offs are that investors rely on the manager's skill in many areas at once, and they can't choose which strategies their money goes to.

Multi-manager platforms

A multi-manager platform takes the idea further. The firm hires many independent trading teams, often called pods, each run by a portfolio manager with their own specialty. A platform might have many teams trading different sectors, regions and strategies at the same time.

What makes a platform distinctive is central risk management:

• Each team gets an allocation of capital and strict risk limits, such as how much it can lose and how much market exposure it can carry.
• A central risk team monitors all positions across the platform and commonly hedges out unwanted exposures, for example to the overall stock market, so that returns depend mainly on each team's skill.
• If a team loses more than its limit, its capital is commonly cut quickly, and the team may be let go. Capital is then reallocated to other teams.

The aim is to combine many sources of return while stopping any single team's losses from hurting the whole fund. Platforms often use leverage to make each team's hedged returns meaningful at the fund level.

How platforms charge

A traditional hedge fund commonly charges a fixed management fee (a percentage of assets) plus a performance fee (a share of gains), which Lesson 3.3 explains. Many multi-manager platforms work differently. Rather than relying only on a fixed management fee, they commonly pass through many of their costs to the fund, and therefore to investors. These can include trading teams' pay, technology, data, research and office costs. A performance fee is commonly charged as well.

Terms vary from platform to platform. For investors, pass-through costs mean the total cost of the fund can change from year to year and needs careful reading of the offering documents. For administrators and auditors, they mean more expense allocation work to check.

Key terms

• Long/short credit: buying debt expected to hold up and shorting debt expected to weaken.
• Credit default swap (CDS): a contract that pays out if a borrower defaults; buying protection works like a short position on the debt.
• Capital structure: the layers of debt and equity a company has issued, in order of repayment.
• Distressed debt: debt of companies that are stressed or bankrupt, usually trading well below face value.
• Restructuring: the reorganization of a company's debts, in or out of court.
• Multi-strategy fund: one fund running several strategies, with capital allocated centrally.
• Multi-manager platform: a fund with many independent trading teams under central risk management.
• Pass-through costs: operating costs charged to the fund, and so to investors, instead of being covered only by a fixed management fee.

Key takeaways

• Long/short credit funds buy debt they expect to hold up and short debt they expect to weaken, often using credit default swaps.
• Distressed investors buy debt of stressed or bankrupt companies, often take part in restructurings, and face long timelines and illiquidity; PC201 covers this in depth.
• Multi-strategy funds run several strategies in one fund, allocating capital between them.
• Multi-manager platforms run many independent teams under central risk management, and cut the capital of losing teams quickly.
• Many platforms pass costs through to investors rather than relying only on a fixed management fee, so total costs vary and need careful reading.