BlackRock announced in May that it would purchase $15 billion in mortgage assets from UBS, which it will manage in a new distressed assets fund. At the beginning of May, New York-based fund WL Ross & Co closed on its purchase of H&R Blocks Option One mortgage servicing unit for $1.3 billion to aid its investments in distressed mortgages. But the risks go beyond just analysing underlying loans, say lawyers.
Structuring investment vehicles that can suitably take advantage of the cheap assets is a challenge, say lawyers, and one that is bringing the hedge fund and private equity structure yet closer together.
Given the illiquidity of the assets, and the inherent difficulties in valuations, the typical hedge fund structure is no longer suitable. Stephanie Breslow, a partner with New York law firm Schulte Roth & Zabel, suggests that a hybrid vehicle more akin to a private equity fund than a classic hedge fund might be an effective structure for investing in distressed asset-backed securities.
The "private equity light" fund would have a relatively short fixed term similar to a hedge fund of three to five years. Redemption rights, however, would have to be eliminated. Fees in the new structure could still be taken on a net asset value basis, however, says Breslow. If the traditional hedge fund structure remains attractive for marketing or other purposes, "liquidity can be managed to some degree in the hedge fund structure through a combination of long (and perhaps staggered) lock-ups, gates, side pockets and, if necessary, use of in-kind distributions or suspension of redemptions," says Breslow. "However, lock-ups do not offer a permanent solution, because the redemption date eventually comes around. At the same time, use of more extreme tools such as gates, suspensions and in-kind distributions are best reserved for extraordinary circumstances rather than as a routine method of managing liquidity. Funds that resort to use of these techniques often face an escalation of investor redemption requests and an inability to raise new capital, which forces them into dissolution."
In addition to considering structure, one lawyer points out that having exposure to mortgage servicing rights or whole loans is opening up risk of lawsuits. "A prospective buyer will need to thoroughly evaluate the creditworthiness of the seller. If loans are repurchased that were originally improperly underwritten, then the fund may face liability as the deep pocket defendant," he says.
To boot, with analysts boosting their forecasts of sub-prime foreclosures over the next two years, funds jumping in to buy distressed asset-backed securities might well find the going harder than they imagined in terms of credit selection. Credit Suisse has forecast 1.39 million sub-prime foreclosures over the next two years, and Friedman Billings suggests that sub-prime loan defaults might top 30% by December.