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.