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With many companies in bankruptcy or facing the risk of it, hedge funds that trade in distressed debt have been busy of late. A quick look at the auto sector shows a handful of funds investing in bankrupt companies such as

Dana Corp.



Delphi Corp.


, or betting on the future of struggling

General Motors

(GM) - Get General Motors Company Report


The idea is to buy securities of distressed companies at deep discounts in the hope that the investment will be worth much more after a turnaround. Katalin Kutasi heads up the distressed investing portfolio of Kellner DiLeo Cohen & Co., a $345 million hedge fund that specializes in event-driven and arbitrage strategies. She has 26 years of restructuring and distressed experience, primarily with Alliance Capital Management. In a conversation with

, she explains some of the basics of this poorly understood strategy. Can you give us a quick primer on distressed investing?

Katalin Kutasi

: Distressed investing can actually encompass many different styles and approaches. Typically, distressed investing involves investing in the debt or equity (or derivatives) of companies experiencing financial, legal or operational difficulties. The level of stress or distress can range from companies underperforming relative to expectations all the way through the default and bankruptcy spectrum to post-reorganization equities. Positions can be debt or equity; long or short; pairs trades and capital structure arbitrage; or simply oversold securities during periods of material market selloff or due to other inefficiencies. Investors may be looking for control or may be more opportunistic or trading-oriented.

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How is your distressed style different than what other hedge funds do? What sets you apart?

Unlike many, we focus our long positions exclusively on the smaller, middle market issuers -- typically with debt issue sizes of $300 million or below. With over 50% of the high-yield universe in these middle-market issues, we see plenty of opportunity in that market. We also take a fundamental, bottom-up, credit-intensive approach with a staff that is highly experienced with extensive backgrounds in global distressed debt, restructurings and bankruptcy law. Our focus is primarily North America with a mix of bank debt, unsecured debt (including trade claims) or bankruptcy claims and equity. We short opportunistically, although tend to short larger issue sizes due to technical concerns.

Why the preference for smaller companies?

We have found better value in the smaller names and smaller issue sizes. Those issues are less widely followed and less widely traded. Many of the big, widely traded names move on momentum and rumor -- sometimes divorced from reality or fundamental value. We find that happens less in the smaller names and there is better value in that segment of the distressed universe. Regardless of issue size, you always look for companies that are well positioned relative to their competitors with a defensible market position or opportunities that can be harvested.

Is today a good time to manage a distressed portfolio and why?

Conventional wisdom is that this is a tough time to manage a distressed portfolio due to the low default rate, limited distressed opportunities and the amount of capital looking to be invested. However, I maintain that it is actually a very interesting time in the distressed market. We have been able to identify opportunities leading to strong portfolio performance and believe the dynamics are in place for a significant upturn in default rates and distressed product. I believe that this default cycle will be very different from previous cycles for numerous reasons, among which is the unprecedented levels of leverage through senior debt and the emerging dynamics and issues inherent in the tremendous increase in second lien debt. Opportunities will abound for those with the experience to navigate the minefields.

What are the sectors where you see the greatest potential?

We expect the active sectors during 2006 to continue to be airlines -- which continue to be plagued by industry issues including over-capacity, high fuel costs, high legacy costs and the increasing commoditization of air travel -- and auto parts, with highly publicized defaults and issues surrounding the auto manufacturers. While we generally don't like the equity of the airlines due to all of the issues outlined above, we see some compelling opportunities, although very much case by case, in the secured paper, through Enhanced Equipment Trust Certificates.

We also see opportunities in the packaging sector, which has been plagued by high energy costs and high resin prices and faced a significant selloff during the third quarter of 2005. While many prices have recovered we still see opportunities in that space. We also expect consumer products to have some interesting opportunities as consumers begin to feel the impact of higher interest rates, high energy costs and a softening real estate market. In all of these sectors, there are opportunities to both go long and short.

Give us examples of stocks that are coming under pressure as a result of distressed players.

Distressed investors are playing GM, GMAC and


(F) - Get Ford Motor Company Report

in many different ways, many of which involve plays on the stock. There is tremendous pressure on those stocks as well on the stock of many of the auto parts manufacturers. The stock of

United Airlines


also came under pressure as the company emerged from bankruptcy as many distressed investors sold off the positions they received out of the bankruptcy proceeding.