News

4 September 2007



CURRENT FINANCIAL UPHEAVALS AND THE CONSEQUENCES FOR HEDGE FUNDS AND PRIVATE EQUITY



Summary



Turmoil in the US mortgage market, a result of wider financial irrationality, has sparked a sharp contraction of credit markets, leading to meltdowns in a number of hedge funds. Some private equity funds that have made high-debt buyouts could crash too, and a number of pending buyout deals may not go through. The M&A boom is over. Mega-buyouts and the often related activist hedge fund strategies are out for the time being, while private equity involvement in longer-term restructuring strategies is in, as are distressed debt and secondary transactions. Regulatory problems, both private and public, have been revealed. The social fallout is considerable and could easily increase. This paper, pieced together from media reports, first looks at the origins and scope of the crisis. It then outlines the response of central banks and other public authorities, before going on to explain the consequences for hedge funds and private equity.



1. From Credit Glut to Credit Crunch



At the end of July, financing for the Alliance Boots (UK pharmacy chain) and Chrysler (US automobiles) buyouts, two of the biggest private equity-backed deals in the markets, ran into serious difficulties, intensifying fears about a looming credit crunch. Stock markets were hard hit over the following weeks on concerns that tighter credit conditions could derail the buyout boom that had boosted shares on the assumption that a bid for nearly any company could be imminent. The news also sparked a growing realisation that the world’s biggest banks were exposed to potential credit problems (FT, 17 Aug ’07).



Cheap credit had helped private equity firms mount ever-larger buyouts with ever-increasing amounts of debt. It also enticed pension funds and other institutional investors to pour cash into alternative investments, further boosting the private equity and hedge fund businesses, which displaced large companies as the banks’ most valued clients.



In recent months, all that has changed. Investors who previously snapped up private equity loans are now refusing low interest rates and easy credit conditions. That has left investment banks with an estimated $300 billion of debt on their balance sheets that they cannot distribute to pension funds and other big investors. “If market conditions do not improve, banks will be forced to mark down the value of that debt, triggering heavy losses,” noted the Financial Times (22 Aug ’07).



The tightening of credit conditions was triggered by the sub-prime mortgage crisis in the United States. Sub-prime mortgages are higher risk housing loans offered to people with poor credit ratings or on low incomes.



The sub-prime market had been booming. But things started to turn sour when a series of interest rate rises made monthly repayments too expensive. Unable to meet payments, borrowers have been defaulting on these loans. According to the Federal Deposit Insurance Corporation, defaults on loans at US banks rose 36% to $66.9 billion in the second quarter of 2007. That marked the largest quarterly rise in 17 years, and stemmed mainly from mortgage defaults (BBC NEWS, 23 Aug ’07).



As evidence of problems in the US sub-prime mortgage market had begun to emerge, world stock markets witnessed their first big wobble in February 2007. And by the end of August, there were no signs that the crisis had run its course. US homeowners' defaults were expected to rise further over the next months as thousands of mortgages move on to higher payback rates. There were also concerns that $1 trillion of prime-grade mortgages in the US could also be vulnerable to default (The Independent, 26 Aug ’07).



The consequences of the mortgage crisis have been worsened and spread round the world because much of the sub-prime debt has been resold as part of wider debt packages, with a lack of transparency of the overall scale of the problem and as to which financial operators are holding the worthless or devalued securities. This uncertainty has further sapped confidence in the financial system, raising fears of a full-fledged liquidity crisis, where investors prefer to hold cash or safe securities (short-term government bonds), while avoiding any riskier credit lines. Such a situation would prevent companies and banks raising the funds they need to keep operating smoothly.



Evidence of contagion started to pile up, as it became clear that European banks were among those holding a lot of US sub-prime debt. German regional banks, generally reputed for their prudence, were among those hit hard. On 24 August the government-controlled Bank of China disclosed the biggest exposure revealed so far by any bank in Asia to the US mortgage market.



The problems on the US mortgage market are the immediate but not the sole cause of the current financial crisis. US economist Paul Krugman: “The origins of the current crunch lie in the financial follies of the last few years, which in retrospect were as irrational as the dot.com mania. The housing bubble was only part of it; across the board, people began acting as if risk had disappeared” (IHT, 11-12 Aug ’07).



By the end of August, economists and bankers agreed that the tidal wave of cheap credit that fuelled the M&A boom had come to an end, but few were willing to predict how long the financial turmoil would last. Most economists were still predicting continued US economic growth for the rest of the year and into 2008, though many had trimmed their forecasts and were warning that even their somewhat downside views could be too optimistic.



2. The Authorities Respond



The European Central Bank and later the US Federal Reserve, the Bank of Japan, the Russian Central Bank and the Bank of Canada injected billions of dollars of short-term loans into the global banking system, so as to keep it functioning.



On 17 August, the US Federal Reserve also reduced its discount rate, the rate at which it lends to banks. Soon after, it was reported that a group of US and European banks had borrowed $2 billion from the Federal Reserve. “By taking the unusual step, Bank of America, Citigroup and Germany's Deutsche Bank among others, aim to improve access to available credit. But the move also highlights the highly fragile state of credit markets” (BBC NEWS, 23 Aug ’07).



An editorial in the International Herald Tribune (18-19 Aug ’07) had warned: “But the main effect of a rate cut to calm the financial markets would be to protect big investors from the consequences of their bad decisions. That’s not the Fed’s job, and would violate the precept that a healthy market requires investors to accept responsibility for the risks they incur.”



Central banks would undoubtedly reply that the sole purpose of their action is to keep the real economy moving, thereby protecting incomes and jobs. None the less, it is astonishing how in a financial crisis billions can immediately be found to prop up the financial system, whose analysts never tire of criticising the slightest subsidy to any other part of the population. And how ordinary citizens are suddenly upgraded to being the system’s hostages.



Contrasting with the speedy support for the financial system, “Help has been way too slow in coming for the estimated 1.7 million people in America who will lose their homes to foreclosures this year and next,” complained another editorial in the International Herald Tribune (11-12 Aug ’07).



The number of home repossessions in the US rose dramatically in July. There was a 93% jump in filings for repossessions on the same month a year ago, and a 9% rise on June's figure, according to property firm RealtyTrac (BBC NEWS, 21 Aug ’07). And the problem is not confined to the United States. More Britons had their homes repossessed in the first half of the year than anytime since 1999 as interest-rate increases hurt sub-prime borrowers (IHT, 4-5 Aug ’07).



US President George W. Bush, in a late response to the mortgage crisis, announced several steps on 31 August to help borrowers meeting the rising cost of their housing loans. The federal government’s mortgage insurance programme would be changed to enable an additional 80,000 homeowners to benefit, in addition to the 160,000 likely to use it in 2007 and the following year. Lenders would be pressured not to foreclose on certain borrowers. Democrats and some Republicans had been accusing President Bush of indifference to the plight of the many people who were losing their homes, comparing his response to his administration’s delays in providing relief after hurricane Katrina hit two years before (IHT, 1-2 Sep ’07).



Meanwhile, heavy job losses are being reported in the housing and financial services industries. And more are expected.



Another constant feature of financial crises is that regulatory issues, a taboo when things are booming, become a legitimate issue.



Starting with private regulation, where the performance of rating agencies is being criticised. Paul Krugman again (IHT, 18-19 Aug ’07): “For it is becoming increasingly clear that the real-estate bubble of recent years, like the stock bubble of the late 1990s, was both caused and fed by widespread malfeasance. Rating agencies like Moody’s Investors Services, which get paid a lot of money for rating mortgage-backed securities, seem to have played a similar role to that played by complaisant accountants in the corporate scandals of a few years ago. In the ‘90s, accountants certified dubious earning statements; in this decade, rating agencies declared dubious mortgage-backed securities to be highest-quality, AAA assets.”



The obvious failure of the rating agencies has been the focus of criticism from the European Commission and especially the German government, perhaps partly in order to divert attention from the deficiencies of government regulation.



As regards transparency, one expert said: “I don’t think any of the regulators have a handle on where the net exposure of sub-prime is,” noting that in Europe even less public data are available than in the United States. It was also reported that accounting rules in Europe offer few assurances to investors trying to avoid companies indirectly or directly exposed to sub-prime loans. International Financial Accounting Standards, which are similar to those in the United States, started to apply in 2006. But, given the lack of a European financial regulator [like the SEC in the US], not all European countries have implemented them similarly and their enforcement varies (IHT, 11-12 Aug ’07).



In the United States, the Securities and Exchange Commission was reportedly examining financial statements at Wall Street firms, including Goldman Sachs and Merrill Lynch, to make sure they were not hiding sub-prime-related losses (IHT, 11-12 Aug ’07). However, unlike the supervision resulting from the obligation of investors to immediately report to the SEC any acquisition of a large stake in publicly traded companies, no central government agency can closely track who may be holding sub-prime or other mortgage-related securities.



Some argue that the global financial system faces an ever-growing risk of volatility. In a recently published book, “A Demon of Our Own Design”, Richard Bookstaber, a former manager of a computer-driven hedge fund, argues that the proliferation of complex financial products like derivatives, combined with the use of leverage (debt) to increase returns, inevitably means that there will be a regular stream of market contagions, where a crisis in one corner of a financial market reverberates through the global financial system – one of which, someday, could be calamitous (Joe Nocera in IHT, 18-19 Aug ’07).



3. Impact on Hedge Funds



In theory, hedge funds should benefit from financial volatility, as their strategies are designed to profit from declining as well as rising asset prices.



This has indeed been the case for some hedge funds. But those with over-exposure to sub-prime mortgage debt have been among the chief victims of the liquidity crisis. And their collapse heightened the panic, especially as some leading, reputed banks were hit with embarrassing ease.



In comparison with private equity firms, hedge funds face the disadvantages of more frequent reporting obligations, and the greater ease with which investors can withdraw their money. “Nervous investors are awaiting monthly numbers, which most hedge funds provide. If the investors want out, and they have fulfilled any requirement to keep the money in the fund for a certain amount of time, they can pull their capital. Too many redemptions can force funds to sell [assets] into a bad market, resulting in worse losses” (Jenny Anderson in IHT, 4-5 Aug ’07).



Among the bigger names to be caught out:



UBS, Switzerland’s leading bank, announced on 4 May that its adventure with an in-house hedge fund was over. It was forced to fold Dillon Read Capital Management back into its investment banking arm less than two years after it was set up. The decision was triggered by a $123 million first-quarter loss on US sub-prime mortgage investments. The move led to a $300 million restructuring charge. By early July, Peter Wuffli, UBS’s chief executive, had been ousted in part over concerns about his handling of the DRCM debacle. In the middle of August, the bank warned that market turbulence could lead to “very weak” second-half profits (FT, 17 Aug ’07).



On June 19, it emerged that investment banks that had lent money to two hedge funds run by Bear Stearns Asset Management were on the verge of seizing assets to try to recover their cash. The highly indebted funds had invested in supposedly very safe, highly rated complex debt products that in turn had exposure to bonds backed by sub-prime mortgage debt. A month later, investors were told they had lost all their money in one fund and would get back just nine cents for each dollar invested in the second fund. Bear, a leading New York-based investment bank, had granted $1.6 billion in emergency financing in June, the biggest attempted bailout since the collapse of Long-Term Capital Management LP in 1998. Bear’s former co-president Warren Spector resigned in August (FT, 17 Aug ’07; Bloomberg, 13 Aug ’07; BBC NEWS, 31 Aug ’07).



In August, New York-based Goldman Sachs Group Inc., the world’s second-largest hedge-fund manager, announced it would invest about $2 billion to shore up its Global Equity Opportunities Fund. Outside investors including Maurice ``Hank'' Greenberg, the former chairman of American International Group Inc., and billionaire Eli Broad would put an additional $1 billion into the hedge fund. Assets had dropped by $1.4 billion to $3.6 billion in the previous week, as the fund's computer-driven investment strategies were upended by the sudden decline in stock prices worldwide (Bloomberg, 13 Aug. ‘07).



At the end of August, one analyst observed: “It is inconceivable that the many hedge funds that were under pressure to sell were able to square their books in last week’s sell-off [of assets]” (IHT, 25-26 Aug ’07).



So the news of hedge fund collapses continues to come in. On 30 August, it was reported that an Australian hedge fund had filed for bankruptcy protection in New York. The $100 million Basis Yield Alpha Fund had ties to high-risk US mortgages. As the crisis in the US sub-prime market spread, the value of its underlying investments fell. Unable to meet calls from its creditors to pay back loans, the fund was served with default notices. The notices would have allowed its creditors - which include JP Morgan Chase, Goldman Sachs and Citigroup Global Markets - to seize assets or close out trades. The Cayman Islands-registered fund is a division of Australia's Basis Capital (BBC NEWS, 30 Aug ’07).



What will happen to activist hedge funds?



An activist hedge fund buys a stake in a company, in order to pressure its management to increase shareholder value. To that end, it runs well publicised campaigns that attract other hedge funds and often private equity funds too – the notorious swarm of locusts. A fairly recent example is the purchase by London-based hedge fund TCI of a small, but influential stake in ABN AMRO, the largest Dutch bank. TCI then agitated for the board of directors to pursue the bank’s break-up, sale or merger.



One observer, Andrew Ross Sorkin (The New York Times, 26 Aug ’07) notes that there is an often “symbiotic relationship” between private equity buyout firms and activist hedge funds: “Thomas H. Lee, the private equity fund manager, acknowledged that relationship during a speech this year. ‘I’d like to thank my friends Carl Icahn, Nelson Peltz, Jana Partners, Third Point,’ he said. ‘I’d like to thank these funds for teeing up deals because they’re coming in there and shaking up the management and many times these companies are being driven into some form of auction.’”



But Mr Sorkin argues that activist hedge fund strategies depend on cheap credit “That may mean the activist bravado of yore … may disappear along with easy credit. … Activism, for the most part, is a one-trick pony. For all of activists’ hemming and hawing about strategic change, their real mission boils down to four things: have the company sold, break the company up or push it to take on debt so it can buy back stock or issue a big dividend. All of those strategies rely on cheap capital, but because of the current credit squeeze, that financing is vanishing.”



Like private equity firms, some hedge funds are branching out into the distressed debt market, as explained in the next section.



4. Impact on Private Equity



If only because “buyout funds live and breathe debt” (The Independent, 26 Aug ’07), one would expect them to be badly hit by the current financial turmoil and in particular the squeeze on credit. It will be more difficult and more expensive for PE funds to borrow money to buy companies. If the economy slows down, acquired companies’ cash flow will too, making it harder for PE funds to pay back borrowed money. Volatile share markets will also make it more difficult for PE funds to re-sell companies, especially as the potential buyers may themselves face tighter credit conditions. Not only PE fund buyouts but mergers and acquisitions in general will be hindered by tighter credit, financial volatility and economic uncertainty.



On the other hand, PE funds don’t have to report as frequently as hedge funds do, and their investors have committed their money for longer periods. Also, the larger private equity firms have been successful in their recent fundraising. Though they must now put this money to work, they can restructure future buyouts, so as to rely more on investors’ funds and less on borrowed money. This may reduce returns, but deals can be refinanced with more debt at a later stage, should markets ease. And ultimately PE funds’ performance will be compared not with their own past performance but with that of traditional forms of investment under current conditions. Besides, more volatile share markets may make re-selling more difficult, but, during declines, it will also offer buying opportunities.



Also remember that company buyouts are not the sole line of business of private equity firms, although it has been their largest and most buoyant activity in recent years. Venture capital can take up some of the buyout slack, as can, especially in sectoral or general economic downturns, the so-called distressed debt business. Even in the M&A business, smaller and medium transactions may be hit less than mega-deals (valued at $1 billion or more). And there may be a shift in strategy away from acquiring and fairly rapidly re-selling individual companies towards keeping companies longer and restructuring and combining them.



And there are signs that the business has not been taken by surprise – that it was expecting the credit cycle to turn, so that already in the first half of 2007, private equity firms and the institutions that invest in them were adjusting their strategies.



In sum, M&As in general and PE buyouts in particular are likely to slow down. But leading private equity firms may continue to outperform traditional investment managers, and may even strengthen their position as less competitive PE players are squeezed out.



The current position of Blackstone Group illustrates the contrasting fate of private equity firms. By 27 August, the value of its shares had fallen 23% to $23.80 from its initial public offering in June, but fund investors had not lost faith in the firm. Blackstone said in August it had raised $21.7 billion to establish the world’s biggest buyout fund yet (Bloomberg in IHT, 29 Aug ’07). But it was warning that huge buyouts were out for the time being. "You're not going to see a lot of mega deals or mega public to privates -- it's just too hard to get the financing," said Tony James, Blackstone’ COO (Dow Jones in CNNMoney.com, 26 Aug ’07). That view is shared by Kohlberg Kravis Roberts. And Permira, one of Britain's biggest buyout firms, said it was unlikely to pursue any large deals for several months (Telegraph.co.uk, 22 Aug ’07).



That must be set against a background in which the value of announced total US PE buyout deals plummeted to $18 billion in August (1 to 26), from $87.4 billion in July and $131.1 billion in June (Bloomberg in IHT, 29 Aug ’07). The tighter credit market was also jeopardising several pending deals. The $45 billion buyout of TXU Corp. was one of them. While management at the Texas utility was busy cajoling shareholders to vote yes on the deal, acquirers led by Kohlberg Kravis Roberts and Texas Pacific Group needed to line up the loans. They were trying to finance the deal with $37.2 billion in bank loans. The Texas energy utility warned that if the deal fell through, "the current state of debt and equity markets make alternative transactions unlikely” (Dow Jones in CNNMoney.com, 26 Aug ’07).



By the end of August, there were growing doubts over whether the money could be found to finance pending deals, given the current financial climate. Counting just the biggest US private equity deals, $220 billion in borrowing was needed, according to Thomson Financial (Dow Jones in CNNMoney.com, 26 Aug ’07). And planned deals like the sale of the UK’s Virgin Media and Cadbury Schweppes’ US drinks business were being indefinitely postponed.



The drop in PE buyouts reflects the broader decline in M&A activity. According to Thomson Financial, US M&A in the first week of August was sharply down on the year before. The last time deal activity was so slow in this period was in 2003 – “most bankers date the start of the mergers-and-acquisitions boom that now may be in its death throes to some time in 2003” (Dana Cimilluca on Wall Street Journal deals blog, 7 Aug ’07).



There were two additional worries for private equity buyout funds, besides the general slowdown in M&A activity.



First, there were signs that private equity’s share of M&As was declining, while that of industry buyers, sometimes called strategic investors, was rising. According to Thomson Financial, private-equity firms were the buyers in just 13.5% of total M&A deals struck in the US from July 23 to August 8, nearly two-thirds down from 36.1% in the year up to that period. Corporate acquirers increased their participation to 70.4% of the total from 44.5%. (Foreign acquirers account for the balance.) “So-called strategic buyers are taking center stage mainly because the high-yield debt markets private-equity firms use to fund their deals are, for all intents, no longer functioning. Corporations, meanwhile, have stock to use as currency, not to mention plenty of cash on their balance sheets. (Microsoft, for example, has 34 billion saved up.)”. Many of them also have investment-grade ratings, meaning easier access to risk-shy lenders (Dana Cimilluca on Wall Street Journal deals blog, 14 Aug ’07).



There is a similar trend in the UK, where by August the proportion of total acquisitions by buyout firms had fallen slightly from last year's historic high of 26%, reported Thomson Financial. In July, Imperial Tobacco scored a victory for industry buyers by winning the battle to purchase the Franco-Spanish cigarette-maker Altadis, seeing off a group led by CVC Capital Partners (Telegraph.co.uk, 22 Aug ’07).



Second, and perhaps partly explaining the growing popularity of industry buyers among company sellers, US companies recently resold on stock markets by private equity firms, have seen disproportionate declines in their share prices. Of all the companies floating shares in 2007, it was reported in August, three of the five worst performers were backed by private equity firms, according to Dealogic. Of the best performing companies, just one was backed by private equity. Not surprising therefore that private-equity-backed IPOs were losing their appeal. The high prices and debt levels of the companies being offered, two hallmarks of PE-backed offerings, were making investors more and more nervous in the current situation (Reuters News, 24 Aug ’07).



A desire to improve their standing among sellers and as well as the strength of companies offered for resale may partly explain moves by certain private equity firms towards longer-term, more industry-wide strategies. Two private equity funds, Citigroup Private Equity and Morgan Stanley Principal Investments, said in March 2007 they had entered into a strategic partnership with Bertelsmann AG, Europe's largest media company.



Also, instead of simply purchasing and reselling individual companies, private equity firms may combine acquired companies to create multinational groups. An example of this in media is ProSiebenSat.1's June 2007 buyout of SBS Broadcasting, orchestrated by their joint owners KKR and Permira to create a European broadcaster to rival market leader RTL. Individual companies can also be affiliated to PE-controlled sector-wide groups. Blackstone’s holdings in tourist attractions in Europe, the United States and Asia are now combined in the PE firm’s UK-based Merlin Entertainments Group, which plans to become "the world leader in location based, branded family entertainment".



As already noted, buying up companies is not the only line of private equity business. Other business of relevance here are:



Venture funds make investments in start-up and early-stage enterprises.

Distressed debt (or vulture) funds purchase assets released by distressed (forced) sales, including the corporate bonds of companies that have either filed for bankruptcy or appear likely to do so.

Secondary funds specialise in buying stakes in PE funds from the original investors; i.e. second-hand PE assets.



Fallout from the credit crunch has made the US’s Nasdaq stock exchange, which includes many start-up companies, more volatile. But some analysts do no expect a major effect on the flow of venture capital.



As for distressed debt, PE funds and the institutions that invest in them were already preparing for that line of business in the first half of 2007, a sign that sophisticated players had anticipated a downturn in the credit market for some time.



As its name suggests, distressed debt thrives on financial upheaval. Among the junk released by forced selling there are also gems. During the US’s 1980s savings-and-loan crisis, vultures could pick up perfectly good mortgages for 15 cents on the dollar, thereby earning mouth-watering returns. That sort of deal will be attractive to hedge funds in particular. The Economist reports (23 Aug ’07): “While some hedge funds suffer, others are poised to snaffle up bargains. Citadel, Ellington and Marathon Asset Management, among others, have both the ready cash and the inclination. Citadel traditionally keeps more than a third of its assets in cash or liquid securities, allowing it to pounce when opportunities arise. It recently took over a chunk of Sowood Capital, a rival that buckled under bad bets.”



Private equity funds may focus on corporate debt: the bonds of companies that have either filed for bankruptcy or appear likely to do so in the near future. “The strategy of distressed debt firms involves first becoming a major creditor of the target company by snapping up the company's bonds at pennies on the dollar. This gives them the leverage they need to call most of the shots during either the reorganization, or the liquidation, of the company. In the event of a liquidation, distressed debt firms, by standing ahead of the equity holders in the line to be repaid, often recover all of their money, if not a healthy return on their investment. Usually, however, the more desirable outcome is a reorganization, which allows the company to emerge from bankruptcy protection. As part of these reorganizations, distressed debt firms often forgive the debt obligations of the company, in return for enough equity in the company to compensate them” (vcexperts.com).



And that is what many investors and PE firms have been preparing for. In its analysis of US PE fund-raising in the first half of 2007, Private Equity Analyst (July ’07), a Dow Jones newsletter, observed: “For the first time in a long time, mega buyouts aren’t the only fundraising game in town.” The newsletter reported that funds for distressed companies had raised $23.7 billion through the first six months of the year, already more than the $19 billion raised in the whole of 2006. The numbers included funds that buy equity or debt in distressed companies with an eye to gaining control.



The newsletter quoted one analyst as saying: “The increasing demand for distressed funds is based on where people believe we are in the credit market and economic cycles. With the significant and easy credit that has been available for buyouts, the increasing multiples being paid for deals and the leverage ratios these deals are closing with or have after being recapitalised, the risk of increasing defaults certainly is high.” The newsletter said that in Europe too there was “anecdotal evidence” of an upswing in interest in distressed opportunities.



The first half of 2007 also saw an increased in the amounts raised by secondary funds, which specialise in buying stakes in PE funds from the original investors. Such US and European funds combined raised $12.8 billion in the first half of 2007, much more than the roughly $4 billion raised in the first half of 2006. The Dow Jones newsletter said: “While the strength in secondary fund-raising is primarily a result of growth in the primary market, such firms, like distressed shops, have traditionally done well when limited partners are anticipating an uptick in distressed opportunities. That’s because they can pick up on the cheap private equity portfolios from limited partners looking to flee the asset class.”



The newsletter added: “The fact that both these sectors [distressed debt and secondary acquisitions] were so strong in the first half [of 2007] can be taken as evidence that general and limited partners [i.e., investors, like pension funds] alike have been anticipating that a turn in the credit cycle is nigh.” How right they were!



“Ironically, the very firms that helped to inflate the credit bubble are now among the keenest to profit from its bursting. Blackstone and TPG, two of the biggest sponsors of leveraged buyouts, both have distressed-debt funds, and Blackstone has expanded its already big restructuring unit,” reports The Economist (23 Aug ’07).



If vulture fund operators have made the right bet, it would suggest that the global economy is in for a rough ride. The Independent (16 Aug ’07) quotes the head of a £300 million distressed debt fund as saying: "We are just at the tipping point in the market that we have been waiting for for a year and half. … We are very bearish on the US economy. We think the housing market will drag the US economy into recession by the first quarter of next year, and that will lead to a significant increase in default rates, especially in highly levered private equity deals. Fundamentally that's what we are waiting for. This will create forced sellers. We are very encouraged by what we are seeing."



But distressed debt, like any other financial bet, is not without its risks. The Economist (23 Aug ’07) warns: “Two skills will be particularly useful: spotting the gems in the rubble, and timing. … After WorldCom's collapse, many would-be vultures swooped too early, tearing into the discounted bonds of cable and telecoms firms, only to see them tumble further.”