VARIOUS degrees of upheaval and widespread deleveraging in the global financial system since 2008 have left no shortage of interesting opportunities for hedge fund managers who know where to look.
Banks and traditional middle-market lenders continue to roll back lending activity in response to deteriorating balance sheets and tightening regulatory restrictions. Traditional sources of capital have largely gone out of business or substantially reduced their activity.
Investors also continue to display a fragile confidence in markets, leading to volatile "risk-on, risk-off" periods and a strong preference for liquidity.
Changes in banking rules such as the Basel III capital standards and the required increase in US bank deposit insurance are making lenders conservative on their decisions to lend. Large European banks, for example, are expected to shrink their balance sheets by as much as two trillion euros through the end of 2013, or 7 per cent of total assets. A quarter of this reduction will probably come as a result of lending less and the rest from sales of securities and non-core assets.
Meanwhile, borrowers shut out by banks - particularly smaller businesses and firms in cyclical industries - are in need of alternative sources of capital.
Also, finding enough buyers for large-scale sales of complex structured securities is difficult, now that investment bank proprietary trading desks have been downsized. Origination and market-making activity by traditional lenders and prop desks has been greatly diminished in the post-crises world, creating a supply-demand imbalance.
Enter hedge funds. Some investment managers have opportunistically been able to bypass securitised asset markets and effectively taken on the role of a middle-market lender, providing capital directly to underserved businesses in a variety of industries.
Other hedge funds have managed to isolate potential value within a pool of illiquid assets and have used long and short positions to realise gains as liquidity conditions change.
Hedge funds involved in these types of directly-sourced investments have faced few competitors, especially for small deals where complexity is high, sourcing difficult and liquidity may be thin.
This has enabled smaller, highly specialised funds to target deals that have the potential to produce double-digit returns, often over two to three years.
Over the past two years, these kinds of highly specialised hedge fund strategies that capitalise on financial system dislocations have a relatively low beta of 0.12 against the S&P 500 Total Return Index.