Just as leveraged buyout funds were the outstanding asset class of the early 1990s and venture capital funds led the pack in the latter half of the 1990s, the first five years of the millennium will belong to distressed funds, according to Wilbur Ross, chairman and ceo of WL Ross and Co. And the distressed funds that will really succeed are those funds equipped to deal with the defaults of smaller companies, Ross said. That is because the majority of defaults in the current crop involve less than $250 million in liabilities, and these smaller companies are under-researched by Wall Street, which does not have the analytical resources to deal with one new bankruptcy every two or three days, he explained. As a result, the vast bulk of sell-side research is focused on a handful of big names, like Kmart and Enron.
"The search is for a dollar bill that you can buy for 50 cents," Ross said. "But withMerrill Lynch,Lehman Brothers and the other banks all trading and researching the big names, there is no reason to think it is an imperfect market."
Compounding this problem, too much capital is coming in from the $5 billion or so of dedicated funds raised in the last year and from the migration of merger arbitrage, convertible arbitrage and multi-strategy hedge funds over to the distressed space, Ross said. Pequot Capital Management, which recently launched a $2 billion distressed hedge fund, is an example of a fund that is too big to be concentrating on the large defaulting companies, he noted. Officials at Pequot declined comment, but one person familiar with the firm said the hedge fund's real size is closer to $250 million and that it invests in distressed companies throughout the capital structure.