Distressed debt represents outstanding debt securities or loans of corporate or government entities experiencing financial distress. Distressed debt investing is an investment approach that seeks to acquire such securities at substantial discounts and take steps to increase their value.
Distressed debt securities belong to entities whose creditworthiness is compromised and are either in default on their debt or heading in that direction. A distressed company, or other entity with outstanding debt securities, may be experiencing problems such as cash flow shortfalls, debt overload, covenant violations, potential bankruptcy or an unstable capital structure. Its debt is considered distressed if it is unable to service or refinance it using conventional approaches.
While these parameters are not without exception, distressed debt securities are defined by the Corporate Finance Institute as those with a credit rating of CCC or less and which are priced at current yields that are at least 1000 basis points greater than the risk-free interest rate. Note that “junk bonds” are those with credit ratings of BBB or lower, so distressed debt securities are deemed to have even greater credit risk.
Investing in distressed debt is high-risk and is predicated on more than simply buying high-yielding securities. Selection and proper due diligence are key, as is the strategy for ensuring that bondholders will be paid. In most cases, the investor is looking for one of several things to happen:
These scenarios are expected to lead to substantial gains in the value of the relevant debt securities. Because of its high-risk/high-return characteristics, distressed debt investing is typically a domain of institutional investors such as hedge funds, mutual funds, brokerage firms, specialised debt funds and private equity firms.
Because distressed debt investing often involves taking control of the company or forcing it into bankruptcy, it is a strategy that is not generally welcomed by company management and is generally implemented without their cooperation. There can also be competition among distressed debt investors to take control of specific distressed entities.
Legal issues can also be important in distressed debt investing, as investors attempt to navigate through bankruptcy or liquidation proceedings to access their capital.
Distressed debt funds seek to provide their investors with an attractive risk-return opportunity through acquiring a portfolio of distressed debt securities selected and managed by the fund’s general partner (GP). The GP must identify the opportunity and manage the strategy by which they will seek to maximise the investors’ returns.
The GP must then acquire the securities – a process that differs from private equity funds in that the latter are implemented under cooperative efforts with company management, whereas distressed debt acquisitions typically take place in a more hostile environment in which management will likely oppose the GP’s attempts to take control.
Whereas a private equity GP will seek an acquisition or IPO as an optimal exit for their fund, a distressed debt GP generally seeks to either restructure the target entity or position themselves as a senior debt holder in the target’s bankruptcy. In bankruptcy, debt holders will have a clear priority over equity holders and term loans can have a higher priority than debt securities.
Distressed debt will be more opportunistic during a recession or when a particular company or industry has been weakened economically, perhaps by competition, new technology or obsolescence. In such situations, the markets may punish the debt securities of distressed securities more severely and be more likely to price them at lower valuations.
Another scenario that is likely to produce distressed debt opportunities is when interest rates are rising fast. This makes it more expensive for companies to borrow money or issue debt, putting more strain on their financial positions.
Distressed debt strategies may include either passive or active strategies for maximising investor returns.
Passive strategies focus on the strategic acquisition of undervalued debt securities issued by companies perceived to be in acute financial distress. Securities are acquired by investors who have reason to believe that the current price discount overstates the actual risk of default or that the financial stress of the issuing company is a market overreaction that will ultimately be favourable to them. In essence, this approach seeks to buy and hold the debt until the situation remedies itself and the price climbs or a reorganisation or bankruptcy occurs.
Active strategies seek to acquire discounted debt securities in situations where investors intend to actively pursue a path to more favourable valuations or a restructuring event. This path might be to acquire control or pressure management into a reorganisation or bankruptcy that will enhance investor value. An active strategy may also include a plan to convert the debt into equity, thereby generating investor value through equity enhancement instead. In such cases, the strategy to gain control or effect an equity conversion is typically part of the investment strategy.
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