Candlewood Hedge Fund Plans Fund to Buy Puerto Rico Debt

Candlewood Investment Group LP, the $3 billion hedge-fund firm run by Michael Lau, plans to start a fund to profit from Puerto Rico’s debt market, as the commonwealth and its agencies struggle with $73 billion of obligations.

The Candlewood Puerto Rico SP fund will target securities including general-obligation bonds, debt of public corporations and the monoline-wrapped space, the New York-based firm said in a presentation obtained by Bloomberg News. Market prices are offering unadjusted yields of 8 percent to 10 percent and U.S. tax-equivalent yields of 16 percent to 20 percent, it said.

Candlewood joins hedge funds including Brigade Capital Management LLC, Fir Tree Partners, Monarch Alternative Capital LP and Perry Capital LLC in investing in Puerto Rico as the island seeks to boost its economy, which has contracted by 20 percent since July 2005. About 45 percent of the island’s 3.6 million residents live in poverty, according to U.S. Census data.

Security selection will be important as certain segments of the market may retain “significant value” and others may “suffer full impairment,” Candlewood wrote.

The fund’s size could reach about $400 million midway through capital raising, according to a person familiar with the matter, who asked not to be identified because the information is private. Janet Miller, general counsel and chief operating officer at Candlewood, declined to comment.

Puerto Rico securities have been trading at distressed levels for a year on concern that the commonwealth and its agencies won’t be able to repay debt on time and in full. The three largest-rating companies slashed Puerto Rico’s debt to speculative grade in February.

Tax Base

Candlewood wrote in the document that Puerto Rico’s “underground” economy has been estimated at 25 percent to 50 percent of total gross domestic product. The commonwealth may be able to broaden its tax base to generate higher revenues and reduce individual and corporate levies.

Candlewood is starting the fund as Puerto Rico’s Government Development Bank, which works on the island’s debt sales, aims to sell notes maturing in June 2015, according to a posting on the Electronic Municipal Market Access website. Lawmakers are working on a bill to approve $900 million of short-term borrowing.

The $900 million of short-term debt would be the first borrowing for the island since a March issue of $3.5 billion of general obligation bonds, most of which was bought by hedge funds. It would also follow a new law approved in June that allows some public agencies, such as the Electric Power Authority, to ask bondholders to take a loss.

Utility Restructuring

Puerto Rico bonds have rebounded from record lows set in July following passage of the law allowing some agencies to restructure obligations. Prepa, as the electric utility is known, picked New York-based turnaround firm AlixPartners LLP last month to help repair its finances. It must file a debt restructuring plan by March 2.

A Prepa debt restructuring would be the largest ever in the $3.7 trillion municipal-bond market. Puerto Rico securities are held by about 57 percent of U.S. muni mutual funds because the debt is tax-free nationwide, according to Morningstar Inc. Prepa is the biggest U.S. public power utility by customers and revenue.

The tax-exempt general obligations sold in March and maturing July 2035 traded Oct. 1 with an average yield of 9.2 percent, or a taxable-equivalent yield of 15.3 percent for top earners, data compiled by Bloomberg show.

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