Open Question

Blackstone Sends Warning to Illiquid Debt Funds

Revolving-door policy for investors hurts returns and invites turmoil.
At Closing, April 23rd
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Blackstone Group just sent an ominous message to many debt-fund managers: They are promising their clients too much.

Since the 2008 financial crisis, asset managers have pledged they could both invest in risky, infrequently traded assets while allowing clients to withdraw their money whenever they wanted. This was a supremely attractive feature for investors who had just been stung by a credit seizure that challenged people's faith in "safe" assets. But this structure doesn't work over the long term. It will either lead to lower returns, or, in a worst-case scenario, a complete breakdown.

Blackstone, the world’s biggest alternative asset manager, just closed a $3 billion distressed-debt hedge fund that allowed periodic withdrawals. It gave clients the option to transfer their money to Blackstone funds that lock up capital for longer periods.

The New York-based firm highlighted a rather stunning bit of data as a reason for its decision: The fund returned an annualized average of 6.5 percent since its launch in 2005, compared with a 17 percent net annualized return in a 2007 mezzanine credit fund with a longer lockup period and 13 percent in a similar 2011 pool.

Lagging Behind

Distressed-debt hedge funds have struggled to outperform broader indexes

Source: HFR, Bank of America Merrill Lynch index data

Blackstone's decision should serve as both a warning and an example for some open-ended funds that may bill themselves as high-yield bond strategies but are in truth distressed-debt funds. 

For example, more than half of the rated assets in the Highland Opportunistic Credit and Fairholme Focused Income funds are CCC and lower, meaning they're the closest to default and ripe candidates for restructuring. While these bonds may occasionally trade frequently, they can suddenly freeze up just as investors want to withdraw their money. (See Third Avenue Management.)

Bottom of the Barrel

Some high-yield debt mutual funds focus on the lowest-rated bonds

Source: Bloomberg, Morningstar, regulatory filings

About 11% of the Fairholme fund's assets weren't rated by either S&P or Moody's, while about 20% of the Highland fund's assets weren't rated, according to Bloomberg portfolio analysis data

Even hedge funds often give their clients the option of withdrawing cash every few months, which could force them to sell assets at undesirable prices. (See 2014 and 2015, when oil prices crashed, bringing several distressed-debt hedge funds down with them.)

Blackstone's move makes sense for the firm, which oversees $367 billion and focuses on private-equity and longer-term investments. But it also spotlights the stark reality of this type of investing, which makes it less compatible with an open-ended fund structure.

Big Growth

Blackstone's assets roughly tripled in six years as investors sought larger returns

Source: Company filings

Value often comes from hanging into the bonds through a reorganization, when other investors can't afford to wait out the often lengthy process. This takes patience and faith that your investors won't leave during scary times. 

Many investors have sacrificed returns for liquidity, perhaps more than they realize. It's a good time to rethink that approach before another crisis hits.

Peter Grauer, chairman of Bloomberg LP, the parent of Bloomberg News, is a non-executive director at Blackstone.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

    To contact the author of this story:
    Lisa Abramowicz in New York at

    To contact the editor responsible for this story:
    Daniel Niemi at

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