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Since financial matters tend toward the labyrinthine, it might be helpful to get a very straightforward refresher on distressed asset investing.  This link does a good job of presenting an understandable description.

The analogy that author Murray Priestley makes is that of a garage sale.  What might cost a dollar retail is obtainable for pennies used.   By definition, a distressed asset is one purchased from a company in dire financial straits, which is selling its assets for extremely low prices (”everything must go!” etc.).  It’s important to distinguish between the flailing company and the assets themselves, which might be capable of fetching a great price at a later date.

It’s possible to invest both directly and indirectly in distressed assets.  Direct investment is the act of buying and selling the assets yourself, and can be very very profitable.  Indirect investment is the practice of investing money into a distressed asset fund, which buys and manages the funds for you.  While more cautious, this method is often more prudent and ensures a more diversified portfolio of different accounts.

Priestly sums it up well:  “The growth opportunities are massive for companies as assets are available that, in a bullish market, would have been too expensive.”

Hot on the heels of Merril Lynch’s sale of $30.6 billion worth of collateralized debt obligations to Lone Star Funds for just $6.7 billion, Lehman Brothers is looking to sell $30 billion in distressed mortgage assets.

According to the August 1st Reuters article, Lehman brothers are hoping to find a domestic or foreign buyer, and will possibly provide funding for the sale.  Additionally, they might have hired Lazard Ltd financial advisory and asset management firm to assist them in locating buyers.

Lehman Brothers and Merrill Lynch are part of trend here, one of Wall Street banks looking to unload their risk-laden mortgage-backed securities to those investors with enough boldness, patience, acumen, and cash to hold onto these distressed assets until they become sellable again.

In the race to grab inexpensive distressed assets, wealthy private equity firms lead the comparatively cautious hedge funds. It pretty much comes down having lots of cash and cajones.

Still rich from the credit bonanza of years past, private equity firms are able to keep their distressed asset accounts during the current economic slump and sell them for big profits when the market has regained its footing.  Hedge funds are answerable to investors each month, and thus must be more conservative.

According to Chris Goekjian, chief investment officer at Altedge Capital, “Private equity players have locked-in money.  Distressed hedge funds can have quarterly or annual redemptions rights, so they definitely can get money pulled.  If they take on larger deals and get redemptions, it hurts.”

In an about turn, private equity firms are now financing the very banks that used to finance them.  Major banks like Citigroup and Merrill Lynch are unloading distressed assets for pennies on the dollar to private equity firms.  Within the last year, such firms have purchased $25-30 billion of distressed assets from these banks.

Mark Fennessy, restructuring partner with the London-based Orrick law firm, thinks these private equity firms have a clear edge: “They have the analytical and restructuring talent combined to ensure they can get deals.  Certain hedge funds lack real experience of having these deals.”

It’s inevitable that the economic marketplace will right itself again, and when it does, all these distressed assets could prove to be immensely profitable for these private equity firms.

To better deal with the increase of distressed assets in today’s financial marketplace, more and more law firms are starting to specialize in distressed asset management. According to a recent article on Law.com, Bryan Cave is the latest law firm to create a distressed asset group.

Many firms are receiving an increasing number of calls from lawyers needing advice on bank collapses, and according to Bryan Cave regulatory specialist Karen Garrett, “We decided to be proactive and not wait and be reactionary.” Among the goals are to better assist the failing banks, clients who have funds in such banks, and private equity groups who hold contracts with such banks.

In addition to Bryan Cave, Andrews Kurth and Thacher Proffitt & Wood have created distressed asset practice groups. These firms join the increasing number of hedge funds and investment firms also investing in distressed assets.

According to Garrett, there is already plenty of work to do: “We remember the 1980s and the early 1990s, so we know the depth of legal work that comes up when you start having a rash of bank failures and near failures.”

According to a recent article in The Wall Street Journal, banks and other financial institutions are acquiring foreclosed homes at a faster rate that they can sell them. Fannie Mae in particular purchased 44,071 homes during the first half of 2008, but has only sold 23,627. As of June 30, their balance of unsold homes was 54,173.

This bleak picture isn’t likely to change in the immediate future. Barclays Capital puts the tally of bank-owned American homes at 721,000, compared to just 112,000 two years ago! Furthermore, they expect an increase of 60% before the end of 2009.

As you can imagine, Fannie Mae and other financial institutions saddled with these foreclosed real-estate properties are very motivated, possibly even desperate, to sell them. Specifically, bulk purchases at very low prices, such as those we’ve chronicled elsewhere on this blog, are now being accepted, when in more robust economic times it’s unlikely they would even be considered.

As the saying goes, one man’s trash is another man’s treasure. The foreclosed accounts that U.S. banks are so eager to sell, even at less than 50% of the price such accounts were worth a few years ago, spell opportunity for saavy and motivated investment firms that specialize in management of distressed assets.

While this is bad news for many Americans, certain investors can eventually turn a profit by acquiring these foreclosed accounts in bottom-dollar bulk purchases, holding onto them until America’s real-estate crisis abates, and then selling them at top-dollar prices.

According to the New York Post, foreign investors have begun purchasing billions of dollars worth of foreclosed American real estate.  It’s not hard to see why. REO (real-estate owned) homes have fallen so drastically in value that they are worth anywhere from 31-80 cents on the dollar.

A foreign sovereign (state-owned) fund from Adu Dhabi is one such investor, and has begun investing in distressed U.S. real-estate assets.  With a reported $875 billion in assets, this fund has the resources to invest in and make a considerable profit from North America’s foreclosed homes.

Mark Hanson, a consultant for Field Check Group Mortgage, has been hired by an unnamed foreign sovereign fund to search for particularly good foreclosed home accounts.  He is narrowing his search to REO homes.  So far, he has secured an outstanding deal:  a $2 billion package of foreclosed American homes, at 31 cents on the dollar.

While these types of deals might still be unusual, they will become increasingly common as America’s financial market undergoes more bank failures and real-estate woes.

Enoch Lawrence, senior VP of CB Ricard Ellis, sums it up: “This type of bulk buy would make an impact on the market.  They (foreign sovereign funds) are in a unique position because they have a long time horizon to invest and a cheap cost of capital.  It’s actually a perfect time for them to acquire these REO assets.”

It’s not just foreign sovereign funds that stand to profit in this market.  If you read more of this blog, you will see notable examples of shrewd U.S. investors scoring audacious deals.  If you want to maximize your profits during this economic downturn, you’d be wise to consider working with like-minded investors.

A recent Reuters report states that an increasing number of hedge funds are investing part of their portfolios in distressed assets.  A survey of 100 hedge fund managers by the Schwartz Cooper law firm found that more than 60 funds have invested in distressed companies, and almost 40 funds plan to buy assets from such companies within the year.

Richard Bendix, director of the survey, explains it this way: “Hedge funds are under increasing pressure from their investors to perform, but the risks associated with that performance have increased dramatically.”

For investors and fund groups planning to invest in distressed assets, it is paramount that they fully understand insolvency situations, namely, their legal obligations should they be unable to sell their stakes in distressed companies.

These responsibilities aren’t dissuading an increasing number of investment firms.  The fund managers surveyed are especially interested in the housing, automotive, construction, and energy sectors as upcoming distressed asset opportunities.

Whatever their inherent risks, it’s becoming clear that distressed assets are a growth opportunity too lucrative for aggressive investors to pass up.

With the economy in the toilet, savvy and boldness can land investors incredible deals. As we’ve mentioned, one potentially lucrative buy, which takes full advantage of the general skittishness now plaguing banks and investment firms, is the purchase of distressed assets for bottom-dollar prices.

Case in point: investor John P. Grayken’s Dallas-based private equity firm, which earlier this week inked a fantastic deal with investment titan Merrill Lynch. Lone Star paid a paltry $6.2 billion for Merrill Lynch’s distressed-asset mortgage investment accounts. Grayken must be grinning. His firm paid 22 cents on the dollar, netting a package with a face value of $31 billion. Furthermore, Merrill Lynch also agreed to finance 75% of the price, therefore taking responsibility for the majority of any potential losses from accounts that don’t succeed.

Stated in more mundane terms, this is roughly the equivalent of paying $6,200 for a $31,000 car, and then having the seller promise to pay for 75% of all potential future repair costs.

Smarts and aggressiveness serve distressed-asset management companies like Lone Star Funds and Team Nation Holdings well.  Still, as the truism states, timing is everything. By knowing when to exploit the anxieties of the marketplace, these companies can secure deals that would be unheard of during calmer, healthier economic times. Furthermore, many of these distressed accounts can be immensely profitable once the economy regains its footing and the marketplace follows suit.

Lone Star and Team Nation aren’t the only ones engaging in this practice. According to The New York Times, “the business of trading distressed debt is undergoing a renaissance on Wall Street, as money managers and traders search for ways to profit from fears that defaults will keep rising on a wide range of consumer and duplicate loans.”

One caveat: if this practice were easy, more investors would do it. If you decide to allocate part of your investments into this increasingly popular niche area, find a company that specializes in this practice. With their help, your returns could be substantial.

At a time when many people are concerned about what the downturn in the market has done to their investments, smart investors start looking for places to grow their money that doesn’t follow the general downward trend.

Well, they say that crisis breeds opportunity, and so it does. Many of the smartest investors are turning for ways to leverage the changing market by focusing on distressed assets.

The International Finance Corporation (part of the World Bank Group) is one such institution that supports purchasing distressed assets.

“IFC offers a comprehensive package of services in distressed asset investing, including long-term loan financing, equity and mezzanine financing, technical assistance, and advisory services. Our involvement provides comfort to international investors, local partners, and governments, and is often a catalyst for other investors.”

Basically the idea is that large companies will often sell their distressed assets at a rate much below going market price, offering an area that can show substantial gains for people with the experience and know-how to turn such situations around.

With the market facing a downturn in many areas, investing in distressed assets has never looked more promising.