By: Lucas Martin & Matthew Urbanky
In the financial industry, firms may contribute to several different investments that do not include stocks, bonds, or cash. As a starting point, this is what is known as Alternative Investing, and it can include private equity, hedge funds, and commodities, just to name a few. However, for the purposes of this article, we will be taking a closer look at the concept of Distressed Debt Investing, a form of alternative investments.
What is Distressed Debt Investing?
As defined by Harvard Business School, distressed debt investing “is the process of investing capital in the existing debt of a financially distressed company, government, or public entity”. Investors will often keep a close eye on companies that have a successful business model or in-demand products or services, who are still experiencing financial distress. One financial entity that particularly enjoys this form of alternative investments are Hedge Funds.
Why Hedge Funds Love Distressed Debt?
In the case that you, the reader, are not yet familiar with the idea of hedge funds, they are essentially pooled investment funds that trade in relatively liquid assets. They often utilize more complex trading and risk-management techniques and can generate large amounts of returns in short periods of time, all while being capable of losing that money just as quickly. While hedge funds themselves are considered alternative investments, they also engage in distressed debt investing. So, why do they love distressed debt? The answer is simple: The potential for profit. This follows the general financial principle that, the greater the risk you assume, the higher the potential return. There are two main ways in which hedge funds pursue, and achieve, this goal: 1) Restructuring and 2) Bankruptcy.
When hedge funds invest in a distressed company (usually in the form of bonds), they often do so with the goal or intent of owning a controlling share of the company’s debt. Because of this, they will be able to greatly influence the restructuring process of the struggling company. Further, if a hedge fund is successful in bringing a company out of its debt and gaining control through the restructuring process, they may emerge as equity owners. If the distressed company emerges from bankruptcy, hedge funds will also be able to sell the company’s bonds for a much higher price.
Another important aspect of a hedge fund’s investment indistressed debt is bankruptcy. If the distressed company is not able to effectively restructure and repay its debt, it will be forced to liquidate its assets and pay out the company shareholder. In this case, hedge funds can still benefit as distressed debt investors, since debt holders are paid out before equity holders.
Risks
While the high returns may sound appealing to the average investor, there are many risks that hedge funds must first consider before investing in distressed debt. To summarize, these risks often include:
Future financial distress: The company could fail financially and fall back into bankruptcy.
Competition: Other debt investors may prevent the hedge fund from obtaining a majority share.
Poor access to financial information: A lack of complete financial information could lead a hedge fund into poor investment decisions and ultimately failure.
Key Takeaway
The strategy of investing distressed debt certainly has its many benefits and drawbacks. However, if executed correctly with a proper risk management strategy, hedge funds love distressed debt, and may see large returns by investing in it.