Third Avenue's Focused Move in the Credit Markets

Stipp: Distressed, obviously, an area of expertise for Third Avenue, but also an area where you really need to be careful going in. Do you think that you're going to have a rather large allocation to the distressed debt, and could you explain what your investment process is going to be in that very treacherous area?

Gary: Sure. There are five key categories that we're going to invest in this fund across the bank loan, high-yield convertible space. We have performing bonds and loans, stressed performing credits, distressed, meaning we think that the prices are at a deep discount to fair value, but low probability of actually filing for bankruptcy, and then debt-for-equity restructuring, so companies in bankruptcy.

Then the fifth is capital infusions. These are rescue financing, exit financings, and DIP loans (debtor in possession) that are tied to the default cycle.

We see where the debt for equity restructurings, which are less liquid, will probably be a maximum of 20% of the fund, but we expect a lot of opportunities in the capital infusion area in particular. We as a firm are trying to invest and have invested for over 20 years in this area.

With a shortage of capital, with GE, and CIT, and others being out of this business, where capital providers like ourselves with deep-dive bankruptcy expertise can invest very profitably with 10% to 20%-types rate of return on senior secured debt. We see that is a very attractive opportunity.

Stipp: Now in this area of distressed debt, obviously it requires some patience. It requires probably a little bit of steel will, and sometimes that's something that mutual fund investors don't have.

Do you think there would be any challenges with the mutual fund structure and also trying to run a longer-term philosophy where you might have torun through some rough patches? How do you think you would manage that in an open-end fund environment?

Gary: Sure. First, we have a decent-sized amount of our fund is going to be in performing and stressed credits, which are very liquid. That takes care of the liquidity, but where we're buying is what we call safe and cheap.

So we think we're buying in good companies where we don't have a permanent loss of capital, and we're buying at a discount to what we feel fair value is. Therefore, we can then play offense in that distressed category, where we believe...

It may sound far more risky, but if I'm buying a senior secured bank loan, which is top of the capital structure, first to get recovery in a bankruptcy, and I'm buying that at 50, 60 cents on the dollar, in essence, my risk at the end of the day is a lot less than buying an unsecured, high-yield bond which ranks second in priority behind that bank loan, buying that at par where I have limited upside and a lot of downside.

So there may be a little bit more mark-to-market volatility, intraday, day-to-day, but at the end of the day, you find that distressed investing, especially done properly, can provide far superior risk-adjusted returns.