Those looking to acquire distressed debt have a host of other factors to evaluate. Not only must they consider the cause of the devaluation of the companies' debt, but also they must carefully analyze the purchase price of the security in the context.

The increasingly bleak economic news portends a massive financial storm on the horizon, assuming it is not directly overhead.

The signs of this tempest are everywhere on Wall Street; from massive bank losses, projections of corporate defaults 10 times that of a year ago, to increasing difficulties within the recently prospering buyout funds. The storm has already engulfed much of Main Street with a precipitous drop in jobs, home values and stock portfolios. This tide has claimed as its victims a growing number of companies in the financial, real estate and retail sectors, and it threatens companies in a widening array of industries. Yet, with economic downturn turning to crisis, there is one group in the financial sector finding new opportunities: the distressed investor.

Distressed investors scour the markets for companies or industries evincing a decline. There were relatively few distressed investors during the last downturn, but today the number of firms committed to distressed investing brings nearly $1 trillion to distressed acquisitions. The growing number of participants in this market means there will be fierce competition for these new opportunities, many of which are highly complex and obviously risky. Nonetheless, despite the flood of distressed opportunities and the appetite of those to acquire them, caution and diligence should be the watchwords for those investing in distressed corporate opportunities or debt.

Distressed investors generally have two alternatives: acquiring the assets of a distressed company or purchasing (often at substantial discount) its debt. Those choosing the former path are generally left with two options: acquiring the assets outside of a formal bankruptcy proceeding or purchasing the assets "free and clear" through a bankruptcy sale.

Both options have benefits and drawbacks. An asset can usually be acquired more quickly outside of bankruptcy, and the competition for the asset is generally lessened. The bankruptcy sale does, however, provide greater certainty to the ultimate buyer, as the buyer takes the asset "free and clear" and has substantial flexibility in assuming only the most favorable of the company's assets. Moreover, the most aggressive early participant can likely obtain the benefits of "stalking horse" protections, including a breakup fee should they be outbid.

Regardless of which path is chosen, the potential buyer of distressed assets must remember two maxims: first, that the asset ended up in distress likely due to a confluence of operational and balance sheet missteps and, second, that the investor's ultimate goal is to maximize the value of its distressed investment, likely for a future capital event. Thus, it is essential that the investor evaluate the ability of the company to provide an appropriate return on the distressed investment. This involves, among other factors, understanding the company's historical performance in its existing market and developing a realistic business plan that demonstrates the company's ability to shed its past problems and compete. The investor must also recognize what must happen when the hangover of the auction has passed: It must assume meaningful control of the company. The lessons of the past cycle have taught us that merely throwing money at a distressed company will not create long-term value.

Those looking to acquire distressed debt have a host of other factors to evaluate. Not only must they consider the cause of the devaluation of the companies' debt, but also they must carefully analyze the purchase price of the security in the context of the company's enterprise and liquidation values. And the investor must scrutinize the capital structure and loan documentation to determine the relative rights of the various tranches of debtholders and identify and invest in the "fulcrum" security. It is at this point in the capital structure that the investor can exert the greatest leverage and, in many circumstances, extract the greatest return. Finally, the distressed investor must be wary of impending bankruptcy proceedings, which can cause delay and risk on the one hand, yet tremendous fluidity and upside rewards on the other.

The coming year promises a boom in distressed investing, but much like the economic boom, which has now apparently ended, the rewards will flow to those who bring skill, discipline and patience to this process.

By Richard Chesley, partner in the finance & restructuring practice of Paul, Hastings, Janofsky & Walker LLP. This article was featured in The Deal www.thedeal.com.