By: John Gui & Ralph Sayegh
Are you an investor that seeks high risks and high returns? If your answer is yes, then distressed investing might be for you!
As the name suggests, distressed investing is an investing style, usually done through the debt of a company on the verge of default. The companies in question tend to have an unstable capital structure, represented by either a high leverage ratio or an inability to meet their short-term obligations. According to Oaktree Capital Management’s Matt Wilson, investors look for “a good company with a bad balance sheet”. Most importantly, investors aim to either replace the current management during restructuring or be paid out if the company declares bankruptcy. Therefore, the relationship between investors and current management can thus be categorized as hostile. Usually, the investors will purchase a company's debt piece by piece over an extended period to avoid turning heads. Moreover, once investors control over two-thirds of the companies’ debt they would then be able to control the outcome of the restructuring vote and thus gain an equity stake in the target firm in accordance with the U.S. bankruptcy laws.
Overall, investors purchase distressed debt at an extremely low price to par; furthermore, if the business recovers from bankruptcy, investors can sell the debt for a much higher price, hence indulging in an amplified return.
You might be wondering why distressed debt investors choose to take on a stake in the target’s debt as opposed to their equity. The key driver behind that decision comes down to the seniority of debt in the priority of claims offering greater protection for the investor in the probable case of default.
Ways to invest in distressed companies
Distressed debt investing is most common amongst hedge funds, as they seek to generate alpha through a portfolio of diversified investments. As institutional investors, hedge funds can purchase distressed debt through bond markets, mutual funds, and distressed firms. The former is the easiest way to purchase, it is just like purchasing any other bonds; furthermore, there is a large supply of debt during periods with rising default rates, such as in the onsets of the pandemic. Hedge funds can also acquire large amounts of debt from mutual funds in a single transaction avoiding any commission fees and need for secrecy. Finally, hedge funds can also work directly with distressed firms by extending credit in the form of credit lines or other fixed income instruments. Some funds might elect to take on a more activist role in the distressed firm’s management, exemplified through Pershing Square’s 2010 purchase of 39.7 million shares (16.8%) of J.C. Penny stock. An exhaustive list of other distressed investments can be found under Oaktree Capital’s Special Situations division’s list of portfolio companies that includes Boardriders, Buspatrol and Dayco to name a few.
Distressed investing for Individual Investors
A retail investor can also invest in distressed companies; however, the process by nature is more complex and risk prone than that of their institutional counterparts.
Through a simplified lens, a retail investor tends to find potential investment opportunities through the news. They then, after finding a suitable target, would have to evaluate their financial position with the help of financial databases of the likes of Capital IQ, Bloomberg Terminal, or directly from rating agencies websites. Finally, when it comes to taking on a position on the target, the retail investor will need to purchase the company’s debt through either a bond market or an exchange-traded fund, retail investors do not have the same level of optionality as more established institutional investors. The main risk to retail investors of this investment style is its capital-intensive nature that tends to favor actively managed funds.