In the wake of some hedge funds pulling back risk, participants at a recent Investing Summit in Asia feel that private equity, boutique firms, institutions, and sovereign wealth funds will begin buying distressed debt (see FinanceAsia.com article). Many of these firms are expected to enter the secondary market for distressed assets given the opportunity to buy them at large discounts. Nonetheless, participants at the conference worried that all the "distress" was not currently in these assets, and that there was no reason to rush into buying them. Ed Altman, Professor of Finance with the NYU Stern School of Business, agrees, and predicts that the assets and the bargains will be available for another 6-12 months.

Hedge Funds Review is reporting that hedge fund managers are investing less in distressed debt than one year ago, down 12 percent (48 percent to 36 percent) from last year (see article). This is somewhat counter to other reports that have discussed how other notable managers, such as John Paulson, are seeing distressed debt as an area with excellent opportunities. Many of the managers that are investing in distressed debt appear to be investing primarily in secured loans, utilizing a "loan-to-own" strategy. The feeling is that secured loans are less risky and provide more opportunity since if the company files for bankruptcy, the debt investors may have the ability to acquire control of the company if the borrower seeks to deleverage by exchanging debt for equity. Of course, this strategy seems viable only if there is an expectation that the levered company will eventually recover, and could explain why both the banking and energy industries are two of the more popular industries for employing the loan-to-own strategy. There is an expectation in the market that energy companies will continue to generate interest and capital, while the banking industry is likely to receive federal support to prevent total collapse.

Pimco's is working to raise money for a $5 billion fund to purchase tranches of depressed mortgage-backed debt (see London Telegraph Telegraph article and Bloomberg Bloomberg article). Pimco managers are meeting investors to gain commitments for the new fund, called the Distressed Senior Credit Opportunities Fund (already dubbed Disco). The fund will invest in senior and super-senior securities backed by commercial and residential mortgages. Of interest is that while the fund will look for securities backed by traditional home equity, credit cards, and auto loans, the focus of the fund will be more international. Given the senior nature of the debt, the fund will be less risky than some other debt funds. Subordinated debt, selling at even more distressed levels, is still raising concerns. The current move appears more opportunistic than an indication that the credit issues are behind us. As seen recently with other similar investments by John Paulson and Goldman Sachs, those with the capital can often name their price and define their terms. Just a new spin on the golden rule: "Those with the gold make the rules."

As reported at Reuters, hedge funds have been raising capital and are looking for ways to deploy it in the current market. Possible outlets include distressed debt and higher quality mortgage debt. Funds also hope to take advantage of lower stock prices as forced selling of equities is expected to intensify as the summer progresses. Famed hedge fund manager John Paulson, who made a correct (and profitable) bet on sub-prime last year, predicts more gains from distressed debt as he expects to see an additional $10 trillion opportunity develop over the next 6-24 months.

Changes in focus are already showing benefits. The Credit Suisse / Tremont index rose 2% in May, as long/short equity, event-driven, and emerging market funds outperformed. High volatility and widening credit spreads are also creating opportunities for convertible arbitrage funds. Of interest is that quants funds are also optimistic, with the optimism not necessarily due to the current market opportunities, but due more to less competition from other quant funds. Last year forced credit selling created unpredictable moves (both directional and magnitude) that ended up shaking out a number of less-capitalized funds that were unable to adapt quickly enough to changing market conditions. Whether the rest of 2008 is any more predictable is yet to be seen.