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.

On the event-driven, short-term side, he is investing in hedge funds that purchase bank bridge loans and mortgage-backed securities. The yield spreads on these securities are higher than they were in 2000 and 2001.

He is also investing in hedge funds that own residential AAA-rated mortgage-backed paper and corporate real estate loans. These credits are selling at just 45 cents on the dollar today. Smith furthermore has a stake in hedge funds that do direct lending to companies.  

"We haven't seen this kind of opportunity in distressed securities in many years," he says. "It's going to be a longer period of distress than prior cycles, and timing is important. There are some bright spots that could be very profitable."

Richard Wilson, analyst with the Hedge Fund Group in New York, said some hedge funds with large cash positions are buying distressed assets. And a number of hedge funds have consulted turnaround or workout specialists to help evaluate potential investments.

But he cautions that these funds are high risk. Plus, he adds, it may be difficult for investors to get information on hedge funds buying distressed assets because many billion-dollar-plus-size hedge funds prefer to keep their investing strategies confidential.

"There are many hedge funds investing in distressed assets," Wilson says. "There are hedge fund startups investing in pools of residential mortgages, medium-sized hedge funds investing in distressed commercial real estate financing projects and many large funds positioning themselves within the financial sector to hold a large swatch of undervalued assets once the bear market ends. The trick is knowing where the real bottom is so you are not caught under a falling knife in the market."  

A couple of large, well-known hedge funds engaged in distressed asset investing are Avenue Capital Group, New York, and the Spinnaker Capital Group, located in London and Boston. Avenue Capital uses a combination of distressed/stress acquisitions and highly structured debt investments to generate returns. The Spinnaker Capital Group buys assets that are severely distressed to the issuer, but not because of general market conditions. The fund aims to buy low-cost assets that have a reason to rise based on their clear future value in the longer term.

On the private equity side, Bain Capital, Boston, a leveraged buyout firm, wants to buy troubled financial companies and distressed mortgage-backed securities that otherwise would have been paid for by taxpayers. Bain plans to overhaul the companies, then resell or take the firms public.

On the investment company side, there are several open-end mutual funds snapping up distressed company stocks as well as debt.  
Martin Whitman, portfolio manager of the Third Avenue Value Fund, has about $315 million invested in distressed bonds. These include GMAC senior unsecured notes maturing in three years, MBIA surplus notes and Forest City unsecured notes. These yield over 20%.

They are distressed, but paying interest. He expects the workout value on the notes to be about 70 to 90 cents on the dollar. 
"The odds strongly favor that each security will remain performing until maturity call," he says.

Municipal bond insurance companies such as AMBAC and MBIA, despite being downgraded by the rating agencies, should generate large amounts of cash, he adds.

On the stock side, the Third Avenue fund is investing in beaten-down, well-capitalized stocks in North America and Asia, and these make up about 70% of the portfolio. 

At midyear, for example, the fund bought Sycamore Networks, a leading telecommunications equipment manufacturer. Whitman snapped up shares at close to the amount of cash on the company's balance sheet, less its liabilities. Other large stocks selling below his net asset value calculations are Cheung Kong, Henderson Land Development and Toyota Industries.  

"Distressed securities seem to be trading at ultra-attractive prices," Whitman says. "Discounts have widened for common stocks of very well capitalized companies where the common stocks are trading at meaningful discounts."

On the fixed-income side, Dean Di Bias, high-yield portfolio manager with Advantus Capital Management, St. Paul, Minn., said higher quality mortgage bonds and asset-backed securities are a good buy. He's snapping up the best tranches in poorly performing pools.
"We believe value is waiting to be discovered in the non-agency mortgage and asset-backed securities markets," he says. "A growing number of sellers have pushed prices down and substantially increased yields on what were recently considered very high quality and safe investment-grade debt securities."

Di Bias, for example, said that a seasoned BBB-rated subordinated security issued by a well-known issuer has "excellent fundamentals and credit metrics, yet trades at a higher yield than B-rated corporate bonds."

Although there are tons of distressed securities in the market, Franklin Templeton's Shawn Tumulty, head of the Mutual Series' distressed securities team, says there is still substantial downside risk. As a result, the Mutual Series funds are investing in collateralized senior bank loans.

"We see more opportunities in stressed as opposed to distressed assets," he says. "Most value has been placed on senior secured loans. The default rate remains low, but that could change in tight economic conditions."

Tumulty says that the unsecured debt can't be priced accurately and the downside is uncertain. By contrast, secured debt with asset coverage can be priced based on replacement value.

For example, the portfolio manager recently purchased Calpine at just 70 cents on the dollar. The paper is secured by state-of-the-art gas turbines used in generating electric power.

On the stock side, he's invested in companies going through restructuring, like Virgin Media. The company provides television, broadband, fixed-line and mobile telephone services in the United Kingdom. The company plans to cut 2,200 jobs, or 15% of its workforce, over the next three years.   

Other mutual fund managers, like David Winters, portfolio manager of Wintergreen Fund, are buying and holding stocks that are selling at distressed prices. But the companies have solid business that generates cash flow, and they also benefit from pricing power and from management that creates shareholder value. 

He recently increased his positions in Wynn Resorts after the stock dropped nearly 30%. The company owns Macau, the only gambling casino in China, as well as upscale properties in Las Vegas.

He also bought Chesapeake Energy, an oil and natural gas exploration and production company with properties in 25 states. The stock is selling at just over one times book value.

"Although no one knows precisely when, it is inevitable that these wild bargain prices will at some point in time come to a close," Winters says. "When that happens, many investors will wish they had accumulated a bigger stake in these bargain companies."