Third Avenue Focused Credit Abruptly Shuttered

On Dec. 10, Third Avenue Management abruptly announced that it had shuttered Third Avenue Focused Credit and placed the fund's remaining assets, less a roughly 10% distribution to be made later this month, into a liquidating trust. The trust will make distributions to the fund's shareholders as income is received and assets are sold. Third Avenue expects the liquidation to take up to a year or more to complete.

This is highly unusual. Normally, when a fund company liquidates an open-end mutual fund, it provides advance notice to shareholders, who are given the opportunity to redeem their investment up until the liquidation date. During this interim period, the fund's manager will typically sell the portfolio's holdings to raise cash, using the proceeds to pay out shareholders who redeem their investments. On the liquidation date, the fund company makes a final pro-rata cash distribution to any remaining shareholders.

Third Avenue was unable to follow this protocol because it mismanaged the fund. Specifically, the fund's management team, led by Tom Lapointe, invested heavily in illiquid bonds. Then, when the fund's performance deteriorated and shareholders asked for their money back, the team found itself unable to sell those bonds without unloading them at fire sale prices. This liquidity crunch is what apparently prompted Third Avenue to "gate" most of the fund's remaining assets by placing them in a liquidating trust.

There are two issues here. First, there are the decisions that, taken together, decimated the fund's performance and left the portfolio in its current illiquid state. In our view, this reflects a profound management failure. Second, there is the subsequent decision to gate redemptions so as to prevent a run on the fund and catastrophic losses as illiquid holdings were sold at fire sale prices. We think this decision is prudent, as it will help shareholders salvage whatever value the bonds can fetch in a more stable high-yield climate at a later date.

Here we address some of the questions that have arisen in the wake of Third Avenue Focused Credit's failure. Before we do so, it's worth underscoring that the fund's unusual makeup--in particular, its focus on distressed debt and concentrated portfolio--made it especially vulnerable to a liquidity crunch. It's unlikely that other, more broadly diversified and higher-quality funds will meet a similar fate, as they don't invest in illiquid fare to the same extent as the Third Avenue fund. We do not believe this will prove to be the first in a series of similar failures that sweep high-yield funds.

What Happened? According to Third Avenue, the decision to liquidate the fund was driven by investor redemptions, which have accelerated as the fund's losses mounted. The fund, which had experienced a total of $1.3 billion in estimated net outflows for the year to date through November 2015, had lost 27% for the year to date through Dec. 9 and was down 6% in the opening days of December alone. The fund's losses are among the worst in the high-yield Morningstar Category compared with a much more modest 2.9% average decline across the group for the year to date through Dec. 9.

With redemptions evidently continuing, Third Avenue came to the conclusion that it would not be able to meet them without being forced to sell the fund's holdings at punishingly low prices. The firm then decided to stop accepting redemptions and to transfer the fund's assets to a liquidating trust.

Why Isn't the Fund Allowing Remaining Shareholders to Liquidate Their Holdings Immediately? With a year or more to liquidate, the firm can unwind the fund's holdings gradually. As a result, it should be able to get better prices for the bonds in its portfolio than if forced to sell them under the crushing pressure of redemptions into an increasingly volatile credit market. As we approach a likely Fed rate hike next week and the holidays, market liquidity could well take a hit. Meanwhile, the market's knowledge of the fund's holdings and struggles would have put the fund in an extremely weak position to bargain for fair prices.

Has This Ever Happened Before? There is some precedent for what happened at Third Avenue Focused Credit, though in the past the problems have been centered in the municipal-bond market. Lower-quality muni bonds tend to be illiquid because there is little research and the issues can be quite small. When issuers of low-quality bonds encounter problems, it can be particularly hard to find a buyer.

Two Heartland muni funds were shuttered by the SEC in 2001 after massive losses over the course of one day caused people to question the validity of the fund's pricing. In 2008, during the height of the credit crisis, Schroder Municipal Bond and Schroder Short-Term Municipal Bond, both of which held floating-rate debt hard-hit in the crisis, halted redemptions in 2008 and slowly sold off their portfolios. Manager David Baldt was later charged with insider trading.

Is This Likely to Be a Prelude to Similar Failures at Other High-Yield or Bank-Loan Funds? It seems unlikely. The majority of high-yield and bank-loan funds are far more diversified by issuer and hold substantial stakes in the higher-quality, and typically more-liquid, tiers of the junk-bond markets. As a result, they're much less likely to be forced to embark on a yearlong liquidation like the one planned for Third Avenue Focused Credit, even in the event of large redemptions. Indeed, in 2008, the vast majority of high-yield and bank-loan funds were able to meet shareholder redemptions, even during a period of extreme market distress, as market liquidity evaporated and fund outflows surged. Investors were left with sizable losses but were ultimately able to redeem their investments.

What Was so Different About the Third Avenue Fund? Third Avenue Focused Credit stood out for its large, concentrated allocation to distressed and other low-quality fare. As of July 2015, management had invested half the fund's assets in bonds rated below B and another 40% in nonrated fare. The portfolio's largest individual holding was a nearly 5% stake in troubled Clear Channel Communications (now IHeartMedia), which was recently trading at roughly 30 cents on the dollar.

Lower-quality and distressed debt can be particularly illiquid, and the fund's concentrated positions have likely made it more difficult to unload its holdings. The fund took some steps to mitigate these risks, including holding a net 10% allocation to cash as of July. It also had a line of credit in place, which it used briefly before deciding to liquidate the fund. (The balance has since been paid down.) Despite the use of those tools, rapid outflows clearly swamped the fund's ability to meet redemptions.

Are There Signs That Investors Should Look For in Evaluating Other High-Yield Funds for Liquidity Risk? There are several telltale signs to look out for, such as large stakes in lower-quality bonds, especially if such positions are concentrated in individual names or sectors. Positions like these could be difficult to unwind in a stressed credit market. Another sign is yields that well exceed market norms, as they can denote outsized credit or liquidity risk. Finally, shareholder concentration or volatile flows can leave a fund vulnerable to a large redemption request at a highly inopportune time, raising the risk that the manager will have to sell quickly, driving down prices in the process.

What Are the Lessons for Shareholders? Probably the biggest lesson is that certain strategies, like concentrated distressed debt investing, are not suited to an open-end format that demands daily liquidity. That mismatch is what ultimately cost the fund and its shareholders.