The large number of business restructurings, falling profit margins and stock prices indicate "now may be the right time for investing in distressed [assets]," according to an October 2008 report by PricewaterhouseCoopers. "Seizing the opportunities are private equity firms that have raised new funds focused on distressed investing," says Curt Cornwell, a partner at PricewaterhouseCoopers Transaction Services in New York.
The report suggests several ways for financial advisors to get in on the action by investing in private equity, in hedge funds or in mutual funds that invest in distressed bonds and stocks.
Private equity and hedge funds, for example, can buy debt of distressed companies and provide financing to companies that can't get it from banks. For example, they might use a "loan to own" strategy, in which they invest in private equity turnarounds and buy into Section 363 bankruptcies, which are packaged asset sales.
The report said that in a distressed environment, private equity buyers have an advantage over corporate buyers. It is more difficult for public companies to purchase distressed assets or companies because of their investment constraints. By contrast, the private equity buyer can fix the operation and any reporting issues easily.
Although private equity deals have declined in the past year, those making acquisitions now are putting more equity into their deals, leaving the option of levering up until later when economic conditions improve, according to the report. Such investors are searching for mismanaged companies with sound business strategies. They attempt to identify hidden value through market analysis and operational improvement opportunities.
"In many instances, investors look for noncore assets that can provide liquidity and/or be managed more efficiently outside of current ownership," Cornwell says.
Turner Smith, a principal with Tuckerbrook Alternative Investments, a Stamford, Conn.-based money manager, is investing in private equity and hedge funds that invest in distressed securities. Those managers, he says, all have excellent long-term track records.
Smith says that Uncle Sam's $700 billion bailout of financial institutions has to some degree stabilized the distressed asset market. The danger is that investors will take positions in distressed assets but then the U.S. government will require the contracts to be rewritten.
There are also a lot of legal minefields to avoid when investing in insolvent companies.
Smith is also concerned that highly leveraged hedge funds that invest in illiquid securities could experience future losses. "In this sector, high quality tranches with a fair bit of credit protection is important," he says.
Smith, for example, is investing in private equity players that specialize in turnarounds. Such funds use debt to take control of a company, then wipe out its equity and try to revive it.