Understanding Hedge Fund Strategies: Investing in Distressed Securities

By
Paul Milnes

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Investment in distressed securities has boomed in the last decade. With the market increasing in size and diversity, more and more investors have been getting on board with this type of hedge fund investment strategy. The market certainly isn’t a new one, with distressed securities having been around from the start, whether they be US railway bonds and shares, or other specific struggling companies over the decades.

The global economic crisis has certainly helped to boost this type of hedge fund investment, as the last few years have seen the number of company defaults soar, and hence the potential for distressed investments has soared too.

What are distressed securities?

Distressed securities are bonds, shares and other financial claims on companies that are in, or about to enter or exit, bankruptcy or other financial distress. These distressed securities tend to sell at discount prices, which means that there are often substantial profit-making opportunities for investors who can understand and analyse the potential rewards and risks.

Distressed securities most often come in the form of corporate bonds, bank debt, publicly-held debt or equity, or privately-held debt, including trade claims. However, they can also take the form of common and preferred stock, typically of a firm in distress that is heading toward or is in bankruptcy.

Understanding “distressed”

When a company’s securities become defined as ‘distressed’ it usually means that they have gone past the point of being just ‘reduced in value’. Whenever a company finds itself unable to meet its financial obligations its debt securities can be substantially reduced in value. When this debt’s yield to maturity (which is its anticipated rate of return if it is held to maturity) is more than 1000 basis points above the risk-free rate of return (which is the return of a “risk-free” asset such as U.S. Treasuries) it is considered officially ‘distressed’.

If one of the major debt-rating agencies rates a company’s debt at CCC or below, it is also often considered distressed.

Why invest?

For investors who are sophisticated enough to understand the ins, outs and risks of such investments, the bargain of distressed securities can be incredibly attractive. Let’s take a look at how it works, and why it holds such attraction for serious investors.

When a company becomes distressed, the investors already holding its securities tend to react to the impending threat of bankruptcy by getting rid of their securities at a reduced price, thereby presenting new investors with a potential bargain. These new investors tend to invest when they believe that the company is not in such dire straits as the market believes – it could be that the company in question doesn’t enter bankruptcy at all. A company may have to shut its doors but during the liquidation process it may have enough funds to repay its debt holders.

Alternatively, it may enter what is known as Chapter 11 bankruptcy, which allows a firm to continue trading while trying to figure out how to restructure the business successfully. Both of these potential eventualities can lead to the value of the company’s distressed securities increasing – and this is where investors can make a buck.

The risks

Anyone who invests in distressed securities has to be aware that not all outcomes will be this rosy, however. The majority of distressed securities are issued by companies that end up filing for bankruptcy, and in some cases this can mean the distressed securities becoming worthless. This is where an experienced investor’s skill comes into play. For example, a bankrupt company’s common stock will be rendered worthless, but more senior distressed securities, such as trade claims and corporate bonds, may not be. An investor has to have the knowledge required to figure out whether a distressed company really can improve its operations, reorganize with success, and increase the value of its securities – and which of these securities can offer a profit.

Passive investing vs. active investing

When an investor decides to go all-in on distressed securities, there are two significantly different approaches available to them:

Passive investing – this involves simply buying distressed securities and holding onto them until they appreciate, having in most cases already done a great deal of analytical work. This is a type of investment that can be taken over a longer term. An investor might alternatively have a shorter-term investment in mind, in cases where a restructuring process is moving along quite rapidly, but where (presupposing a successful outcome to the restructuring process) the securities do not yet reflect the true value of the asset.

Active investing – this type of distressed securities investment means getting highly involved in the restructuring and refinancing process. Often active investors will try to influence the process through active participation in a creditor committee. These investors may act on behalf of the creditors to ensure a fair outcome, and can often get involved in the legal aspects of the restructuring process. Any investor taking on this type of purchase of distressed debt is in for a far more time-demanding investment, and one that typically requires a lot of analytic work and legal nous.

Assessing the value of distressed securities

While there are two very different approaches to investing in distressed debt, the basic assessment that needs to be carried out by any investor at the outset can be more generally summarized. Whether investors are keen to remain passive, or want to get more involved, they need to possess the following in order to be able to fully assess whether the investment will be worth it for them in terms of both time and money:

  • Considerable understanding of the events that led to the fall in price of the firm’s securities.
  • Understanding the fundamental earnings power of the underlying assets of the distressed company, as well as being able to assess whether the company will be viable in future.
  • Knowledge of the willingness of the firm to restructure and repay its debt, as well as the quality of its existing management and owners.
  • A willingness to deploy specialist legal and economic resources, and an understanding of the costs involved.
  • The patience required to wait out what may be a long reorganisation/workout process, in some cases, several years.

To sum up, a company headed for bankruptcy might not seem like a fantastic investment opportunity. But with the right know-how and experience, sophisticated investors can swoop on a bargain and turn it into a major profit. For the kind of investor that likes to be ‘hands on’ it also presents an exciting and challenging project. Because of the risks and level of sophistication involved, it tends to be only large institutional investors—such as hedge funds, private equity firms and investment banks – that take on the challenge of distressed securities.

One thing’s for sure, this is a market that’s far from new, and so long as there are distressed companies out there, distressed investors will be able to make money and thrive as opportunities present themselves.

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