Distressed debt is about to have its day, according to some prominent investment managers.
"A lot of money has been raised in anticipation" of a bull market in distressed debt, said Martin Fridson, chief executive of Fridson Investment Advisors LLC and former head of high-yield strategy at Merrill Lynch & Co. Inc. Both firms are based in New York.
That money is sitting on the sidelines, but it won't be sitting there much longer, Mr. Fridson said.
"The time is not yet; we're just waiting," said Bruce Berkowitz, founder of Fairholme Capital Management LLC of Miami, adviser to the $8.4 billion Fairholme Fund.
But it is almost here, said Mr. Berkowitz, whose investing acumen is so well respected that he is mentioned by some industry experts as a possible successor to Warren E. Buffett at Berkshire Hathaway Inc. of Omaha, Neb.
According to James Keenan, co-manager of the $1.7 billion
BlackRock High Yield Fund, offered by
BlackRock Inc. of New York, opportunities in distressed debt are already starting to pop up.
Not everyone, however, thinks that rushing headlong into distressed debt makes sense.
Distressed debt by its very nature is risky, said Stephen Gorman, president at Gorman Financial Management of Hingham, Mass., which has $150 million in assets.
It promises equitylike returns, but investors may not realize they come with equitylike risk, he said.
"On the fixed-income side, I would rather have my clients take the equity-type risk in traditional equities," Mr. Gorman said.
In preparing his firm for the anticipated distressed-debt opportunities, Mr. Berkowitz said, he hired a new chief executive and chief operating officer with experience dealing with distressed companies.
And in May, shareholders of the fund approved a change that will allow it to own more than 10% of a company, giving Fairholme the ability to influence companies that are in distress.
The strategy of distressed-debt firms involves first becoming a major creditor of the target company by grabbing its bonds at pennies on the dollar. This gives the creditor the leverage it needs to call most of the shots during the reorganization, or the liquidation, of the company.
"Normally, if a company gets into distress, we want to have a say who the new management [will be]," Mr. Berkowitz said.
It's a trend that will likely gain steam, according to Mr. Keenan.
"There are opportunities right now," he said. "That grows over the course of the next 18 months."
It's a belief rooted in a pessimistic market view.
"The expectations for growth over the next 12 to 15 months are still way too high," Mr. Keenan said. "Businesses that were leveraged up will ultimately run into issues."
The key to making money in distressed debt is knowing which companies can overcome those issues, said Ernest Monrad, a senior vice president with Boston-based Northeast Investment Management Inc., adviser to the $1.15 billion Northeast Investors Trust, a mutual fund that holds distressed debt.
"You have to try to pick something you think will be viable going down the pike," he said. "It's easier said than done."
For example, debt issued by financial companies hit by the credit crisis will likely be trading at distressed levels if they aren't already, Mr. Monrad said.
It's hard to see the government allowing banks to fail, since "they stand at the crossroads of our economy," he said.
Thanks to derivatives and other creative financial instruments, however, evaluating financial companies such as banks can be a nightmare, Mr. Berkowitz said.
An easier call is to invest in health care and pharmaceutical companies, he said.
There are drug companies and HMOs that currently are being priced "as if they are on the way towards death" because of concerns over the outcome of the fall election and the skyrocketing cost of health insurance, Mr. Berkowitz said.
"But the bottom line is that the baby boomers are just starting to retire," he said. "We all want to live to 100 and tap dance until the last day."
In such an environment, health care companies are poised to be big winners, Mr. Berkowitz said.
The bonds of such companies aren't yet trading at distressed levels, but they are stressed, he said.
With default levels expected to rise, chances are, investors will have plenty of distressed debt from which to choose.
New York-based Standard and Poor's expects the trailing-12-month speculative-grade default rate to increase to 4.7% by the end of the first quarter of 2009. That compares with a default rate of 1.4% for the 12-month period ended March 31.
That may represent increased opportunity for distressed-debt investors, but they may have a hard time taking advantage of it, Mr. Fridson said.
With so much money sitting on the sidelines, finding value may be more difficult than it has been past markets, he said.
Of course, that's assuming that all the distressed-debt players with cash stashed away are equal, which they are not, Mr. Fridson said.
Investing in distressed debt requires extensive knowledge of the market, he said, especially since an "information gap" opens when a security becomes distressed and many analysts stop covering it.
That's not likely to dissuade investors who feel that there is money to be made investing in distressed debt, Mr. Fridson said.
Right now, they are just waiting for "the other shoe to drop" before they rush in, he said.
"There's not a lot of activity right now," Mr. Fridson said. "The [Federal Reserve] can't lower rates for fear of inflation, and it can't raise rates. It's kind of put everyone in a holding pattern."
It's a situation, however, that's not likely to last long, Mr. Fridson said.
E-mail David Hoffman at [email protected].
