CAPITAL MARKETS - In the Eye of the Storm

Highly secretive, fast-growing Highland Capital spent the past decade becoming the world’s biggest buyer of risky corporate loans -- and preparing for a collapse in that very market. Now the crisis is here. Is Highland ready?

When the 260 employees of highland capital management gathered at the Lake Las Vegas resort in southern Nevada on August 9 for their annual company retreat, few felt like celebrating. The markets for high-risk loans and bonds, the Dallas-based firm’s investment specialties, were in turmoil, and deep losses were spreading throughout the financial world.

Even the posh venue -- a 3,600-acre complex featuring three championship golf courses, two world-class spas and a giant, man-made lake carved into the desert -- offered an eerie reminder of market troubles: Highland had gotten a sweet deal on the place after buying a big piece of a $540 million loan that the developers, Texas investors Lee and Sid Bass, had taken out in June to keep the resort afloat.

But if many of their staffers were jittery, the senior managers of the firm, founded in 1993 by James Dondero and Mark Okada, were determined, even optimistic, having learned the hard way how to survive, and prosper, in tough times. They persevered through the crunches that followed the 1998 collapse of hedge fund Long-Term Capital Management and the 2000 implosion of the technology bubble by intensely scrutinizing credits and taking a hard line with companies and their lenders in bankruptcy proceedings. Along the way they earned a reputation for caution and thrift: pinching pennies by flying coach and doubling up in hotel rooms on the road.

“Highland’s like a Hummer -- built to handle any terrain,” Okada told the assembled troops. “We’re ready for the rough road and any obstacles out there.”

Tough-minded and sharp-elbowed, the secretive founders of Highland have fashioned the most powerful nonbank investor in the $1.25 trillion market for high-yielding corporate loans. As the biggest single buyers of the risky loans that have financed the leveraged-buyout boom of recent years, they have acquired the power to make or break big deals. Success has followed. Since 2003 Highland’s assets under management have increased sixfold, to $40 billion, on the strength of 20-plus percent average annual returns that have attracted money from such savvy investors as the California Public Employees’ Retirement System, the Ontario Teachers’ Pension Plan and real estate billionaire Samuel Zell.

“No one can write a bigger ticket than Highland,” says Donald Pollard, co-head of leveraged finance at Credit Suisse. “They can take a deal stuck in the mud and give it momentum.”

Highland also knows when to pull back. The firm takes a notoriously tough approach to credit and, despite its big appetite, stopped buying the riskiest LBO loans earlier this year. It shunned the $10 billion in debt backing Cerberus Capital Management’s buyout of troubled automaker Chrysler, as well as the $14 billion loan for Kohlberg Kravis Roberts & Co.'s takeover of First Data Corp.

In June a Highland-led group of investors met with Standard & Poor’s and pushed the debt-rating agency to crack down on so-called “covenant-lite” loans, which lack traditional protections that let lenders force flagging companies into bankruptcy and had become all-too-routine in LBO financing. S&P subsequently warned that such loans would return less than conventional ones in bankruptcy reorganizations.

Highland’s lobbying of S&P and its summer buying strike, along with growing worries about credit quality, helped to grind the leveraged-loan market to a standstill last month. That left Wall Street banks with some $300 billion in LBO loan commitments they couldn’t syndicate to investors and likely will have to sell on the cheap to trim their credit exposure. That’s an outcome that has Highland’s opportunistic partners salivating.

“The market is finally coming to grips with what we have been very vocally talking with our counterparties about for at least a year,” says Okada, who along with Dondero and several other Highland partners agreed to a rare series of interviews with Institutional Investor throughout the spring and summer. “The banks will either have to ride it out or sell the debt at huge discounts. From our viewpoint, this is an enormous opportunity. The Street needs to clear these loans, but it will cost them.”

Adds Dondero, “The repricing of fear and greed among the buy side, the sell side and the ratings agencies is healthy and overdue.”

Highland’s souring view of credit extended beyond leveraged loans. In February the firm began selling short a host of mortgage-related securities, including an index of subprime mortgage bonds known as the ABX. It has made more than $500 million on the trade. Convinced that housing market woes will bleed into the economy and the equity markets, the firm also sold short the S&P 500 and Russell 2000 stock indexes. By late August those benchmarks had dropped about 6 percent and 8 percent, respectively. Those dour bets have kept the firm’s six hedge funds, worth about $5.5 billion, up some 7 to 8 percent on the year despite losses of about 3 percent in three of the funds in July.

“Everything we have done since the last market crunch,” 46-year-old partner Jack Yang told employees at Lake Las Vegas, “has been in preparation for the next one.”

And Highland has certainly been preparing. This month it is set to close on a new $1 billion fund, raised from its traditional investors, that will be poured into beaten-down loans. This distressed private equity fund has been operating internally with a nominal amount of the partners’ capital. The objective is to eventually convert the debt into equity during bankruptcy reorganizations and profit from subsequent IPOs or takeovers. Such a “loan to own” strategy could prove profitable as the credit cycle turns and corporate defaults inevitably rise from today’s record-low levels.

“They have an instinct about when to raise money,” says Daniel Toscano, head of U.S. syndicated lending at Deutsche Bank. “Dondero knows when to step on the gas and when to hit the brakes.”

And Highland’s investors, many of whom have put new money into the latest fund, are pleased with the results. “They’re weathering this well and have a lot of dry powder to invest in wider spreads,” says Curtis Ishii, senior investment officer for global fixed income at CalPERS, for which Highland runs $350 million in three separate accounts that each have returned more than 20 percent in the 12 months through August.

Still, Highland must contend with serious risks. In the midst of this summer’s credit crunch, some of the $10.6 billion in bank-loan mutual funds Highland manages were down by as much as 15 percent. And when issuance of structured-debt vehicles called collateralized loan obligations had all but ceased amid worries over increasing loan defaults, Highland’s ability to expand its $20 billion of CLO assets was crimped, putting on hold its planned IPO of a closed-end fund that would invest in its current and future CLOs.

Highland executives have a handful of defaulted assets among the firm’s 1,700 or so debt holdings, and they are banking on a certain level of defaults to feed their appetite for distressed investment opportunities. They are also counting on some companies to have trouble repaying debt so Highland can profit by providing rescue financing. But it’s a fine balance they must strike. Should problems in the credit markets spill over into the overall economy and trigger a recession, the firm could be hurt by too high a spike in defaults of overly indebted companies. And if too many companies cannot pay interest on debt, Highland’s CDO equity positions and bank-loan funds will suffer. Its holdings could also be hit by a renewed bout of forced selling by hedge funds or a decision by lending banks to sell down their loans and bonds.

Yet the firm’s biggest investors remain confident that Highland will not only survive the storm but emerge stronger and with enough capital to pounce on beaten-down securities in the secondary markets and acquire smaller, less diversified rivals that run into trouble as market woes deepen.

That’s good news for Dondero and Okada, who harbor grand ambitions for their firm, aiming to transfer its deep-value investment philosophy to a host of other asset classes, including equities and real estate. Late last year they expressed interest in acquiring mutual fund manager Putnam Investments before its $3.9 billion sale in February to Power Financial Corp., and in December they made a $4.7 billion bid for bankrupt auto-parts maker Delphi Corp., which the company rejected in favor of a rival reorganization plan led by hedge fund Appaloosa Management.

“If you are in a storm, it’s better to be on the QE2 than on a rowboat, and Highland is like the QE2,” says Michael Rosen, CIO of Angeles Investment Advisors, a $230 billion asset manager based in Santa Monica, California, that is a big investor in Highland’s funds. “We remain highly confident that they will generate excellent returns for us in the coming months.”

AGGRESSIVENESS, HARD WORK AND SIZE ARE THE KEYS to Highland’s success. The firm employs 120 portfolio managers, analysts and other investment professionals, more than five times the industry average for bank-loan managers with more than $5 billion in assets, according to Orion Consultants. Analysts are expected to pull 60-hour weeks; those whose ideas make the most money for the firm earn up to three times more than their colleagues.

“They understand credit better than anyone else in the industry,” says Karl Dasher, CIO of $100 billion money manager SEI Investments, which has money in several Highland funds.

“Highland is notorious for its work ethic,” says Thomas Maheras, co-CEO of Citigroup’s investment bank, a big trading partner and supplier of new issues. “There is a pride in beating the competition.”

The firm also trades frenetically -- at least by the standards of the typically buy-and-hold loan market. This allows it to juice performance without piling on too much leverage. Highland’s ten-person trading team buys and sells $24 billion worth of loans a year, easily making it the most lucrative brokerage client in that market, according to several Wall Street loan-trading executives. The trading is one reason eight of Highland’s ten retail bank-loan funds have five-star ratings from Morningstar (the other two merit four stars), and all of them beat the average performance of peers without increased leverage, according to data from research firm Lipper.

Highland’s trading desk also pounces on others’ bad fortune in the secondary markets. In September 2006, when $6 billion hedge fund Amaranth Advisors imploded after a wrong-way bet on natural-gas futures, Highland bought the majority of its $2 billion leveraged-loan portfolio at substantial discounts to market prices. It also bought discounted securities from Sowood Capital Management, a hedge fund that suffered big losses in the subprime meltdown.

At the top of the operation are Dondero and Okada, both 45, an unlikely pair who define Highland’s culture and set the tone for its army of credit analysts. Dondero, an intimidating 6-foot-4, can often be blunt and temperamental and spends his free time hunting big game. His office walls are covered with the heads of wild boar, water buffalo and other beasts; a giraffe-skin rug covers the floor. Dondero, the son of a purchasing manager for a pharmaceuticals company, was raised in upscale Montvale, New Jersey, about 30 miles north of New York City. He studied finance and accounting at the University of Virginia. Okada is eight inches shorter than his co-founder, his wiry frame building to a closely shaved head. The soft-spoken son of a Presbyterian minister, Okada came of age in Huntington Beach, California, and studied economics and psychology at the University of California at Los Angeles. At leisure, he surfs and plays guitar.

The pair have in common more than two decades in the credit markets spanning several boom-bust cycles. Dondero cut his teeth as a bond analyst in the mid-1980s for American Express Co. in Los Angeles. He pushed the credit card company to take bigger risks, urging, for example, that it invest $25 million in the junk bonds financing Kohlberg Kravis’s epic $25 billion LBO of RJR Nabisco in 1988.

The following year an ambitious Dondero joined Birmingham, Alabamabased Protective Life Insurance Corp., after concluding that it would take too long to climb the corporate ladder at American Express. At 27, he was soon running a $2 billion portfolio of guaranteed investment contracts for Protective out of Los Angeles.

Okada, meanwhile, had joined Mitsui Manufacturers Bank in Los Angeles after graduating from UCLA in 1984. One year later he moved to Louisiana, when his wife, Pamela, now a pediatrician, began her medical residency at Tulane Medical Center. Okada took a job managing a commercial loan portfolio for New Orleansbased Hibernia National Bank. In 1989, Hibernia asked him to sell about $1 billion in loans to help offset real estate losses, and Dondero, still running Protective’s GIC book out of Los Angeles, bought some.

In 1991, when Pamela Okada finished her residency, Dondero hired Okada as a portfolio manager at Protective. Dondero taught him about preferred stock, high-yield bonds and derivatives, while Okada educated Dondero about the intricacies of syndicated loans. The pair minted money for Protective by buying junk bonds that plummeted in value during a spike in defaults following the era’s LBO boom and the collapse of Drexel Burnham Lambert.

“It was a great time to put assets to work,” recalls Dondero.

When Protective decided to move the GIC operation to its Birmingham headquarters in 1993, neither man wanted to go. Dondero asked if they could stay in Los Angeles and still manage some of the insurer’s money. Protective agreed and launched a joint venture, Protective Asset Management Co., with the two young portfolio managers, seeding them with $750 million. Dondero and Okada sought a niche where they could outperform other fixed-income managers and chose corporate loans. The market was then dominated by big banks, which would arrange loans for companies and distribute them to syndicates of rivals and smaller, regional banks. Pamco and a few other pioneers, such as Eaton Vance Corp., were among the first nonbanks to take part in big loan syndications. Pamco also was the first to design software to electronically track loan portfolios. Today’s version of that program, called Wall Street Office, is used by more than 80 percent of loan managers; Highland sold it to JPMorgan Chase & Co. four years ago.

Within a year of setting up the joint venture, the thrifty Dondero -- who despite his ample wealth still flies coach -- moved the five-person shop to Texas, attracted by the state’s lower costs and lack of an income tax. Dallas was close enough to Okada’s family in California, yet just an hour’s time difference from the money-center banks in New York. By May 1995, Dondero and Okada had bought Protective’s interest in the joint venture and renamed the firm Highland Capital Management. To transfer the loan investments from Protective’s balance sheet, Highland issued a newfangled product being pitched by Merrill Lynch & Co., called a collateralized debt obligation. The vehicle was one of the first CDOs ever created. Highland hired Todd Travers, a former finance executive at American Airlines with no credit training, as its first credit analyst in February 1995. The small team grew assets to $4 billion by 1998, chiefly by issuing a string of new CLOs.

Then disaster struck. In August 1998, Russia defaulted on its debt; one month later Long-Term Capital Management imploded. Spreads widened across the credit markets, and risky loans quickly fell into distress. The value of the loans in Highland’s CLOs began to decline, and in 1999 several went into default. Things got worse the following year when the dot-com stock bubble burst and the economy fell into recession, spurring a wave of defaults, some fraud-fueled, by investment-grade companies. In early 2001, 50 of the more than 600 loans Highland held were in default, and the equity tranches of the firm’s CLOs, which suffer the first losses when loans in the pool go bad, were in danger of losing much of their value.

To stave off such losses, Dondero and Okada began taking more-aggressive positions in bankruptcy reorganizations. Such workouts had long been controlled by banks, which typically took a firm but diplomatic approach with debtors in an effort to recover assets without damaging long-term-client relationships. Highland shook up this clubby realm, relentlessly seeking to maximize its returns.

In January 2001 the firm forced financial news provider Bridge Information Systems into bankruptcy after it violated a cash flow covenant on an $800 million bank loan. Bridge’s banks and its owner, buyout firm Welsh, Carson, Anderson & Stowe, wanted to restructure the debt and inject $100 million into the company, giving loan holders just 15 to 20 cents on the dollar. Lenders had to vote unanimously to keep the company out of bankruptcy; Highland, which owned less than 8 percent of the loan, argued that creditors would recover far more if Bridge were sold. Highland filed for an involuntary Chapter 7 bankruptcy in February 2001, effectively putting the company on the auction block. In September, Reuters bought Bridge for $373 million. Highland and other lenders recovered every dime of their principal.

The Bridge deal put Highland on the map as a force in leveraged lending, and the banks and LBO firms that had ruled the market were none too happy. In response to Highland’s Chapter 7 filing, Welsh Carson said in a statement that it was “truly unfortunate that the unilateral act of a single creditor representing less than 8 percent of the senior debt has disrupted the process of reorganization.” The big East Coast banks looked down their noses at the Texas upstart that was upending the long-established order of things.

“The other lenders accused us of being reckless -- the Dallas Cowboys,” recalls Patrick Daugherty, who joined Highland in 1998 from Bank of America Capital Markets and is now a partner running distressed investing. “But we recovered our loans.”

Highland took on other buyout shops, including Thomas H. Lee Partners and the Carlyle Group. Highland sued T.H. Lee in 2002 after the bankruptcy of Big V Supermarkets, which the LBO firm had owned since 1990. Highland had bought a chunk of Big V’s bank debt before the chain’s November 2000 bankruptcy filing and alleged in its complaint that T.H. Lee failed to fully inform it about the company’s mounting cash flow problems. By May 2003, after a bankruptcy court judge threw the case into mediation and T.H. Lee agreed to make Highland whole for its losses, plus interest, relations between the two firms had become so strained that T.H. Lee instructed Wall Street banks to blackball Highland from financings for its portfolio companies, including Michael Foods and mattress maker Simmons Co.

Highland wasn’t winning friends on Wall Street, but it protected its investors’ money, as well as its own, while other loan investors were getting hurt. The firm’s success in squeezing value out of distressed loans convinced Dondero and Okada to launch a fund specifically targeting these investments. With $10 million from the firm’s partners and $10 million from outside investors, they started Highland Crusader, a hedge fund that today is worth $3 billion. The fund targeted beaten-down health care and telecommunications loans and took the same aggressive approach to restructuring situations. In 2002 it bought the debt of San Diegobased Leap Wireless International for as little as 17 cents on the dollar. When Leap emerged from bankruptcy in August 2004, the debt converted to equity at more than 120 cents on the dollar. Highland has sold most of the stock for a profit but still owns about 5 percent of Leap. The investment has returned approximately 800 percent so far, says Daugherty. Last year Crusader returned 40 percent; in late August it was up 7 percent for the year despite losing 4 percent of its value in June and July.

HIGHLAND EMERGED FROM THE TURN-OF-the-centrury credit crunch determined to be better prepared for the next downturn. That meant extending its reach beyond bank loans, as well as raising capital that couldn’t be withdrawn by investors in the event of future market distress. But to accomplish those objectives -- and to ensure continued access to newly issued loans -- Highland had to soften its image and interact more diplomatically with outsiders.

“Highland was viewed very negatively by the investor and underwriting community,” says Anthony DiNovi, co-president of T.H. Lee. “They had an attitude of sue first and ask questions later.”

Dondero and Okada don’t completely agree with that assessment, arguing that they fought only when necessary to recover capital. But they realized they had to change the perception of the firm. They wanted to manage retail funds and invest in other asset classes, but needed help communicating with investors, LBO firms, rating agencies and banks. The pair turned to Yang, a former Chemical Bank loan syndication pro who had built Merrill Lynch’s leveraged-finance business in the 1990s and headed it until 2002, when CEO E. Stanley O’Neal decided to get out of it. Yang had sold loans to Okada when he was at Hibernia and helped Highland launch its first CDO.

“Jack Yang is smart, strategic and honest as the day is long,” says Okada. “He keeps you out of trouble.”

Recalls Yang: “Jim and Mark had built a fantastic platform. But they needed more strategic resources.”

He joined Highland in July 2003 as a partner and quickly went to work to help Highland expand into the bank-loan mutual fund business. He spearheaded its acquisition of Columbia Management Advisors’ $1.8 billion closed-end loan fund business in April 2004. The deal gave Highland a track record to present to fund wholesalers, who previously said they were unable to market the firm to retail investors. Since then it has raised $8 billion more in retail funds, giving it about $10.5 billion split between closed-end and quarterly redemption mutual funds. These are overseen by Joe Dougherty, a partner who joined Highland as an analyst in 1998. These moves made Highland more stable. The capital for closed-end funds is raised in a single offering, and investors get out by selling their shares on the open market, not redeeming them to Highland. Its quarterly redemption funds -- most mutual funds can be redeemed daily -- give it a cushion in rough markets.

In May 2005, Highland made its first move overseas, buying ING’s European bank-loan mutual fund business, which had E600 million ($756 million) in assets. The deal gave Highland a beachhead in the region just as European LBO activity began to heat up and financing markets began to shift toward investors holding loans instead of banks. Europe now accounts for nearly $4 billion in assets.

Yang also pushed Highland to mend fences with T.H. Lee and other private equity firms, no small matter as investors rushed into recovering credit markets and new-issue allocations grew scarcer. In 2004, Okada phoned DiNovi to make peace, and Highland regained access to T.H. Lee’s deals. Last year Okada initiated several meetings to improve relations with LBO shops, including sit-downs with officials at Apollo, T.H. Lee and Welsh Carson. He stressed Highland’s size, long-term ambitions and restructuring expertise, contrasting his firm with newer entrants into the loan market that lacked its scale and experience with workouts.

“Okada and his team realized the best way to get good returns for investors was not a scorched-earth strategy,” says DiNovi. “That change in attitude has been critical to their success.”

But Highland has taken a hard line on what it views as excesses in leveraged lending of late. As LBOs soared in recent years -- accounting for 22 percent of mergers and acquisitions volume during the first half of 2007, up from 12 percent in 2005 -- so did issuance of the lowest-rated debt, including covenant-lite loans. Investors with little credit expertise -- from brand-new hedge funds to upstart CLO managers and foreign banks -- flooded into the leveraged-finance markets. Highland began positioning itself for the boom to end badly.

“The irrational exuberance was being driven by equity, convertible and multistrategy hedge funds entering the credit space,” says Dondero.

In January 2006, Highland sold most of its high-yield bonds and put the proceeds into bank loans, which typically pay lower interest but are senior to bonds in bankruptcy restructurings and thus less risky. In August 2006 the firm’s partners started to get nervous about the residential mortgage market overheating and cancelled two planned collateralized debt obligations designed to invest in asset-backed bonds, returning $2.7 billion to investors. With Dondero expecting corporate defaults to begin rising from record lows, Highland bought a restructuring firm, Barrier Advisors. In February, after months of research, the firm put on its ABX index short position -- the trade that has thus far saved its skin amid the summer’s carnage.

Highland also became more selective about which new loans it would buy. Executives worried about the overly borrower-friendly terms and pricing of covenant-lite loans, which, according to S&P, have accounted for nearly one in four new issues so far this year. Even loans with covenants were being too aggressively sized and priced for Highland’s liking. The average debt-to-equity ratio on LBOs so far this year is 5.9, up from 4.85 in 2004. Highland began focusing its buying -- something it must do continuously for its CLOs as loans in these portfolios mature -- on a smaller group of what it believed were the highest-quality deals coming to market.

The firm can be choosy because of its stature in the market, derived primarily from the piles of capital it can put to work. In late April, for example, Highland revived the syndication for real estate magnate Zell’s $13.4 billion buyout of newspaper publisher Tribune Co. Banks led by JPMorgan had guaranteed to arrange a $10 billion loan for Zell but had trouble syndicating it amid investor worries about the newspaper industry’s future. The banks had a choice: hold big pieces of the loan or ratchet up the interest rate to make it more attractive to buyers. Zell’s investment company, Equity Group Investments, turned to Highland, which had already declined to buy the paper because it judged the risk premium inadequate, to see what could be done to salvage the deal. Okada suggested that if Tribune repaid $1.5 billion of the loan within 18 months and increased the interest rate by 75 basis points, to 3 percentage points over LIBOR, Highland would buy $600 million of the debt from the banks, more than enough to kick-start the stalled syndication. JPMorgan made the changes, and within days the financing was completed.

“It’s pivotal to get Highland in the book on a large transaction,” says Jeffrey Klein, the Equity Group managing director who oversaw the deal. “They are able to write very substantial checks.”

THE TURMOIL IN GLOBAL CREDIT MARKETS IS UNQUEStionably causing Highland some pain. But the firm’s investors are confident that it can ride out the storm and emerge stronger. CalPERS, the biggest U.S. pension fund, already has $350 million with Highland and is planning to commit more capital in coming months, says senior investment officer Ishii. SEI Investments may do the same. “This is the most severe bank-loan market we’ve seen in years,” says investment chief Dasher. “But not only does it not change our view of Highland as a manager, it increases our conviction that we want to work with managers like them. As the market settles over the next 12 months, they will be one of the funds we look to add capital to.”

Such confidence should allow Highland to pursue its grander ambitions, which include raising more-permanent capital in public markets and pushing into equities and real estate. Acquisitions of money managers -- whether reeling CDO shops or big, name-brand houses like Putnam -- are among its goals.

“Everything Highland has done since 2002 has been in anticipation of a change in the credit cycle,” says Yang. “We now have the ability to grow when the CDO markets shut down.”

But the firm is wary of expansion for its own sake and aims to stay true to its investment philosophy while moving into new markets. “Every area we expand into is a direct extension of the credit and relative-value skills we have,” says Dondero. “It’s not style drift when you apply the same exact processes to other asset classes.”

Once Dondero, Okada and other Highland partners made this message clear to worried employees at the Lake Las Vegas resort last month, everyone calmed down and managed to have a good time, taking part in a bowling tournament and a talent show -- where Okada and other Highland employees played in a rock band that called itself “Subprime” -- among other diversions.

Back in Dallas a few days later, Dondero couldn’t help but light up when considering the turmoil in the markets. “We are a great manager when markets are good,” he says, “and the best manager when markets are bad.”