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Stressing About Distressed

By: Marc Raybin, Editor in Chief - Date: 01/29/2008

The U.S. stock market has been on a rollercoaster in the last week and with it the rest of the world economy. Recession is looking more like a reality with each passing day. The Federal Reserve Bank took the emergency action of cutting interest rates by .75% of a point in an effort to stave off impending doom. With individuals appearing to be in distress, what about companies and private equity firms that invest in these kinds of situations? The odds are pretty good we will continue to discuss this sector as the year progresses, but responses from people in the asset class may surprise a few readers. Not everyone is in agreement investors in the sector should be licking its chops and that a distressed investing bonanza is eminent.

There might be more opportunities this year in distressed investing than there have been in the last few years, but that does not mean it is a surefire road to buying low and selling high. There are, after all, a number of factors that go into the strategy than just that. There may be more available, but it is the same economic conditions that created the opportunities that may make it more difficult to exit.

“Both tightening credit standards and economic slowdown have the effect of increasing the number of distressed situations,” says Paul Halpern, a partner at Versa Capital Management. “However, the economic slowdowns make turnarounds harder to execute.”

Greg Gale, a partner with the law firm of Squire, Sanders & Dempsey, warns if the economy does fall into a recession and there are more opportunities for investors to snap up portfolio companies on the cheap that could be counterbalanced by an increased cost for financed leverage and a decrease in availability of lending sources. Gale also points out other private equity firms will be more likely to hold onto their investments and ride out the storm. As a result, the inventory for targets will shrink from recent years.

To be sure, it is not all that bad for the sector. Smart money suggests there will undoubtedly be opportunities and private equity firms that specialize in distressed investing will be able to take advantage of the situation.

Rick Chance, a managing director at KPMG Corporate Finance, is more than just a little gloomy about the prospects for the U.S. economy.

“The 75-basis point reduction is not going to save the economy - the recession train has already left the station,” laments Chance. “Consumer and business confidence is deteriorating big time.”

If that continues, the odds are pretty good companies will be for sale. The key for potential acquirers in this atmosphere is to use less borrowed money than has been used in similar deals in the last few years.

“There will be significant opportunities for funds that can purchase with decreased leverage,” says Gale. “During the last downturn, some funds were quite successful in buying at good valuations with less debt and refinancing when the economy recovered.”

That begs the question of where those opportunities will be. 
Steve Zuckerman, head of the special situations group at investment bank Farlie Turner & Co., says the confluence of subprime meltdown and the resulting credit crunch, rising fuel prices and a declining housing market will obviously negatively impact the real estate and real estate-related companies, such as building product businesses.

“In addition, the $6 billion erosion to home equity will have a considerable impact on consumer spending and will likely cause financial challenges in a variety of industries, including retail, casual dining, manufacturers and distributors of durable goods,” Zuckerman says.

Something else to consider is the effect of the weakening dollar on the U.S. buyout scene. We’re already seeing foreign investment taking advantage of the declining value of the greenback. Zuckerman says foreign investment in U.S. companies accounted for more than 25% of all 2007 deals.

“With the foreign investors’ appetite for U.S. deals showing no signs of a slowdown, I think we will see increased competition among private equity and foreign investors to find U.S. deals,” says Zuckerman.

Gale thinks there is a chance for foreign investors to invest in U.S. private equity funds. This could become even more prevalent if the dollar shows signs of recovering in time for when the funds would look to exit their investments.

Still, not everyone is in agreement. Halpern sees little effect of the battered dollar on the U.S. distressed market when it comes to foreign investments.

“Generally, foreign sourced investment in distressed situations is very rare,” says Halpern. “Other than recent infusions of capital into money-center banks, I don’t see this factor having much of a direct impact in our space.”

If the theory of the economy being a zero-sum situation holds true, then that means when companies are losing money and in distress, there are other businesses out there making money and thriving. How they will work when the economy recedes, is something all investors will know about soon enough.

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