Distressed securities firm Schultze Asset Management is looking to crack into the CDO market, either in partnership with existing high-yield CDO managers, or as collateral manager itself, said seniors at Schultze.

The firm is currently in talks with a number of parties, including large banking institutions and insurance companies that want to offload bad assets from their balance sheets, in the same manner that Patriarch Partners has teamed with both FleetBoston and CIBC World Markets, to work out their distressed portfolios utilizing a CDO structure.

According to Edward Petit, a managing director at Schultze, the current environment in the distressed market is ripe for arbitrage. "The opportunities are virtually boundless right now, on both the long and short side," Petit said, adding that investing both long and short in distressed securities is a unique aspect of Schultze's investment mandate.

Because of the current opportunities, Schultze is banking on the idea that established high-yield CDO managers will be seeking distressed specialists to partner with, the rationale being that the two firms could leverage off each other's expertise, and/or market presence.

"A significant portion of the product in the existing high-yield CDOs is either distressed or approaching distressed," Petit said. "[Because of that] there would be a compelling rationale right now for a high-yield manager to form a relationship with a distressed specialist."

Schultze was founded in January 1998, and currently runs a domestic limited partnership, an offshore fund and a robust managed account business, devoted 100% to distressed securities investment management, the firm said. Schultze is presently staffed at five, which includes founder and managing member George Schultze, Petit and three researchers.

Boundless opportunities

According to Moody's Investors Service, on a principal basis, the trailing 12-month default rate is currently at 10.97%. Schultze believes that the bank debt market is above or near that range.

"There are really plenty of original holders out there looking to do these types of deals," said George Schultze.

The other current dynamic is the evolving accounting rules, which are becoming more stringent and requiring more mark-to-market accounting. Because of this, many banks, insurance companies and other large investors will become "forced sellers" of distressed and defaulted assets.

"The market must sort of deleverage, and this debt has to get into the secondary buyers' hands," Schultze said. "So we view this as an opportunity for us, as a new firm in this sector with a built-up track record, to grow our business and expand, and also provide a solution for the seller."

Evidenced by industry interest, the distressed debt CDO structure could be a viable resolution for the accounting debacle, as it can remove the asset from the balance sheet while offering a similar return profile for the seller, which is presumably participating in the equity upside of the CDO.

In addition to accounting pressures and the higher number of default securities in the current market, there are fundamental differences between this and the last bankruptcy cycle which are contributing to the current opportunities. Essentially, the quality of the debt issued in this cycle is lower than in the last cycle, Schultze argued. "We would hear the term good company/bad balance sheet' quite a bit in the last bankruptcy cycle," Shultze said. "In today's bankruptcy cycle, we're seeing bad companies with bad balance sheets."

"The implication is that there's very little to be had in the recoveries in this market in a lot of the deals, so it makes great sense if you short them," Petit added. Unlike the high-yield market ten years ago in which high yield bonds were a leveraged buyout tool much of today's outstanding bonds were issued by speculative companies that may never have been profitable.

Further, these factors have worked to depress distressed debt prices across the board, which means that resale value on debt with promising recovery is often in line with legitimately worthless debt. This spells opportunity for those who can tell the difference, Schultze said.

Distressed securities

Schultze Asset Management's expertise in the distressed realm stretches beyond debt, as the firm often owns long and short equity positions in a company, identifying unique opportunities, such as a stock recovering value post bankruptcy.

"The equity side has more relevance in our established vehicles, and we don't know if we'd be incorporating equity in CDOs," Petit said.

Still, experience in distressed equity is important, Petit said, because distressed debt holders are likely to receive a package of securities, including equity, in a recovery: "Does that mean that the CDO has to dispose of the post recovery equity? Maybe the bid is unreasonably low, and we think it's a better bet to hold the security than to sell it. That's really a question of the deal provisions, though."

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