What seems hard to achieve is basically very simple effect. The secret lies in additional render pass which overlays our new texture on top of source one (it's nothing that can't be done in UED, but this way reduces BSP complexity). Of course we're limited by UEngine 1 editor GUI but with few tricks effect can be quite impressive. What I've done is declared structure which holds all info about 'overlay' then in DrawComplexSurface I'm iterating through all of those overlays and render 'em.
With few neat tricks adding DXT5 support (and importing dds) to UEngine can be quite easy thing (although it took me some time to figure things out). Easiest way to take is make UTexture subclass and import raw data directly into some variable, then just save it.