In the world of hedge funds, distressed mortgage funds are suddenly hot, but it is unclear whether the strategy will live up to the marketing hype.
Donald R. Mullen Jr., the manager of Goldman Sachs’ subprime mortgage trade during the housing bubble, is raising $1 billion for a fund to be managed by his investment firm, Pretium Partners. Deepak Narula’s Metacapital Management also plans to start a fund to invest in delinquent mortgages, said a person briefed on the matter who was not authorized to speak publicly.
Both Mullen and Narula are jumping into an increasingly crowded space. The hedge funds Ellington Management Group, One William Street Capital, and Angelo, Gordon & Co. are either already in the market or planning their own funds. Other institutional investors that are active in the so-called nonperforming loan market include the Blackstone Group, Oaktree Capital, and Lone Star Funds. Bloomberg News first reported about Metacapital, which has traditionally invested in mortgage securities and a few years ago was one of the top-performing hedge funds, moving into home loans.
The appeal of the distressed mortgage market is understandable for managers looking to generate above-normal returns for their wealthy investors. Even though home prices have rebounded, some in many areas hardest hit by the housing bust, there are still more than 4 million loans on which borrowers are delinquent. Hedge fund managers are wagering that after buying some of these troubled home loans at a substantial discount, they can reach an agreement to restructure the loans in a way that allows borrowers to resume payments — generating sufficient cash flow and decent returns.
A marketing document for Mullen’s distressed mortgage fund projects some stellar performance. The fund, depending on the firm’s rate of success in restructuring troubled mortgages, expects to generate a net internal rate of return of 7 to 20 percent. A person close to the fund but not authorized to speak publicly said Mullen’s firm estimates returns at the higher end of that range, after paying fees and expenses.
But the performance of a 6-year-old distressed mortgage fund managed by Selene Investment Partners suggests that investors looking to sink money into a nonperforming-loan fund might want to temper their expectations a bit. The Selene Residential Mortgage Opportunity Fund 1 has posted good, but not eye-popping, returns.
The Selene fund, managed by a firm led by Lewis S. Ranieri, one of the early pioneers of the mortgage-backed securities market, has generated a net internal rate of return of 8.3 percent as of the end of 2013, according to a March investor letter.
An 8.3 percent internal rate of return after fees and expenses for a credit-oriented fund is not bad given the current 2.7 percent yield on a 10-year Treasury note. But the Selene fund was actually performing even better a few years ago. A July 2011 memorandum from a pension consulting firm reported that the fund had a net internal rate of return of 11.4 percent. The fund’s gross return, before fees and expenses, was 19.8 percent.
An investor in the Selene fund said its performance had declined because the discount at which distressed mortgages can be purchased has narrowed. The performance has also suffered some as the fund has shrunk in recent years with the sale of restructured loans and other assets.
But an executive with another firm that invests in delinquent mortgages said a realistic rate of return for such a fund in the current market was in the “high single-digit, low double-digit” range. Selene, which is winding down its Selene 1 fund, declined to comment.