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How hedge funds are changing distressed debt

US hedge funds are being drawn to a growing European distressed debt market and, in the process, changing the way it functions, say Igino Beverini of Lazards and Bruno Cova of Paul Hastings

The European distressed securities market is on the rise. A tide of M&A and private equity deals threatens to undermine credit quality. Credit rating downgrades are expected to increase among industrial companies from the low levels seen in the last two years, and are likely to outstrip upgrades. Yet with economic conditions remaining relatively benign, rating agencies believe defaults will stay low in 2006, before picking up in 2007.

(This article appears courtesy of International Financial Law Review,  to take a free trial click here)

The bigger risk is the abundance of liquidity from private equity firms and hedge funds, which is expected to persist well into 2006, given recent heavy fundraising by buyout investors. Debt leverage in buyouts has reached record levels, surpassing the peaks of the 1990s and suggesting a potential bubble. At the same time covenant structures, which should provide creditors with increased security, have weakened.

Heading to Europe

US hedge funds are moving into this growing distressed market in Europe. In the last two years, hedge funds poured into distressed debt in the US, according to a report published by Greenwich Associates. It says that hedge funds accounted for 82% of trade volume in US distressed debt and nearly 30% of US sub-investment-grade bonds and credit derivatives as of February 2005.

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