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Distressed ABS face legal risk

While some continue to debate whether the knife is still falling, others have decided that the distressed credit markets already offer an attractive investment opportunity.

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 Block’s 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.

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