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Money Flowing into Distressed Investing

Date: Wednesday, January 16, 2008
Author: Chidem Kurdas, HedgeWorld

Large numbers of hedge funds and other managers are raising new distressed investment vehicles and moving portfolio allocations into this area, according to a survey by Debtwire. Almost all respondents said they expect company defaults to increase but are divided on how high the default rate will go.

More than $600 billion in capital is available for investing in distressed situations, according to Mick Solimene, managing director at Macquarie Securities (USA) Inc., an offshoot of the Australian bank.

U.S. private equity firms alone have raised more than $48 billion in 2007, up threefold from 2006. Mr. Solimene said capital is flowing out of merger and acquisition strategies and into distressed. He spoke at a press conference.

Some 72% of those polled by Debtwire said they will increase allocations to invest in troubled companies, and 74% of the hedge funds in the survey said they plan to raise new funds for this purpose.

Corporate defaults remain at an all-time low but the credit crisis set off by mortgage defaults has put a crimp in debt refinancing. There isn't enough refinancing for companies that recently went through leveraged buyouts so the crisis is spreading, said Michael Reilly, co-chair of financial restructuring at law firm Bingham McCutchen LLP.

"Most restructurings are designed to avoid defaults," he said. "Companies are anticipating ahead of time and calling lenders now before the debt comes due." Mr. Reilly represents creditors, including hedge funds, in corporate debt restructurings.

This is expected to be a pretty good year for distressed strategy hedge funds, said Ken Meehan, managing editor of Debtwire. In the survey, the majority of hedge funds said their target return for 2008 exceeds the 15% to 20% range. By comparison 2007 returns were lackluster. The Hennessee Hedge Fund Index's distressed component showed distressed managers tracked by the Hennessee Group earned about 8.9% last year.

Vulture investing opportunities are drawing so much money in part because there is a lot of shaky paper to go around, more so than in past credit cycles. Among U.S. corporate bond issues, 64% were speculative grade in 2007, up from 46% in 1997, said DeLain Gray, head of the corporate finance unit at FTI Consulting.

Distressed strategy practitioners vary in their focus, according to the survey. For instance, hedge funds are less attracted to distressed mortgages and various mortgage-related securities. While 64% of bank proprietary trading desks said they will invest in these instruments this year, 45% of hedge funds said they will and cited the lack of liquidity as the main reason for not participating in the mortgage market.

Restructurings have become more complicated than in previous credit downturns because companies now have many layers of debt and there are more constituents, said Mr. Reilly. In addition, growing participation by hedge funds in what used to be the preserve of traditional creditors is changing markets such as bank loans Previous HedgeWorld Story.

He pointed out also that companies and creditors are now global and the location of insolvency cases is an issue. Countries' bankruptcy laws differ, so the outcome of an insolvency case may depend on where it is filed. Law firms have built global teams to deal with such situations.