Why buy distressed debt

One type of alternative investment is debt investing , which, as the term implies, is a capital investment in the debt of an organization, government, or entity. There are two types of debt investing: private and distressed. Distressed debt investing —also called distress debt investing, distressed investing, or distress investing—is the process of investing capital in the existing debt of a financially distressed company, government, or public entity.

A financially distressed company is one that has an unstable capital structure. When an otherwise successful company runs into problems with debt, a distressed debt investor can identify an opportunity and buy a portion of that debt with the goal of gaining a controlling position. In either situation, investors likely have a negative—or even hostile—relationship with owners or management. As such, distressed debt investing can be a tricky, unpredictable game.

Harvard Business School Professor Victoria Ivashina, one of the professors who teaches Alternative Investments , highlights the strategic nature of this investment type. Actively scan device characteristics for identification.

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Measure content performance. Develop and improve products. List of Partners vendors. Table of Contents Expand. Table of Contents. What Is Distressed Debt Investing? How Distressed Debt Investing Works. What It Means for Individual Investors. While there is no single standard definition for distressed debt, there are two widely referenced descriptions:.

If the market perceives the issuer as being at risk of default, the price will decline. But contrary to a common misconception, distressed debt does not necessarily mean that the underlying company is in financial distress or is post-petition. Based on the standardized credit rating system, distressed debt is categorized as being below investment grade. Uncertainty in the market can place downward pressure on prices, often excessively — which creates potential opportunities on which to capitalize.

Price is the most important consideration for short-term trading strategies. Upon news of distress, prices are volatile, and opportunistic traders can profit.

Securities that are distressed typically trade at a lower price, which reduces the risk of overpaying and the potential value at risk for the investor. However, while the relatively low price and the potential for a successful restructuring are reasons to consider an investment, they are not means to justify paying a premium. Martin J. Price-oriented strategy with a shorter-term expected holding period i.

Control investments require more capital. Since the firm has more to lose, the more its interests are prioritized over others that have comparatively less on the line. As demonstrated from the list below, most firms active in the distressed debt investing space operate multiple fund structures and strategies simultaneously. The participation of distressed firms during in-court bankruptcies has actually been suggested to have a positive impact on total recoveries.

One potential explanation for this is that distressed firms are focused on the equity upside because their returns depend on value creation , which is accomplished by a well-executed turnaround plan. Consistent performance in distressed investing requires not only being able to identify market mispricings, but also being able to recognize when the market price is valid. Strict diligence into the financial distress catalyst , credit metrics , and gauging the feasibility of a turnaround based on secular knowledge can each help mitigate some of the risks in distressed investing.

One of the most influential factors on creditor recoveries is the amount of senior credit and loan facilities e. Generally speaking, the more existing liens on the debtor and risk-averse senior secured lenders such as corporate lenders there are — the less likely there will be enough value to flow down to unsecured subordinated claims. In short-term distressed trading, there is no expectation of influencing the financial or operational decision-making of the company.

Distressed trading strategies have the objective of spotting temporary mispricing and capitalizing on these moments of irrational market behavior. Once the potential of default is announced in the market, mass-selling could ensue shortly, causing prices to decline. While steep reductions in pricing are sometimes justified, the odds of mispriced securities expand dramatically during these periods of uncertainty, especially if the sell-off is driven by herd-based mentalities and emotional reactions.

Distressed trading strategies ordinarily work best when involving well-known companies with large followings. This lack of correlation means the distressed debt is a fine way to diversify. The basic goal is to buy assets for a price well below their intrinsic or fair values. This is where a scavenger's keen senses come into play. The "vultures" must look carefully and meticulously at distressed companies to detect oversold securities or even specific kinds of accounting problems. They track industries and corporations that are on the brink of collapse or that have already gone under.

If the bonds of a company are trading well below what they seem to be worth, there may be an opportunity. Finally, intelligence and information from various sources are combined with top-level legal and financial skills to identify money-making potential.

What matters fundamentally is that the assets are undervalued and can be purchased at a large discount.

But everyone wants a bargain, so coming out ahead takes skill. It's not a life for the lazy or uneducated.

Self-described vulture Martin Whitman first got into distressed-debt investing in the s, because big bond houses such as Lehman Brothers considered it "beneath their dignity" to deal with bankrupt firms. He then gained control of the company, put it into bankruptcy and did a debt-for-equity deal with the other creditors. Less than a year later, the company resurfaced from bankruptcy free of debt and Whitman made a sizable gain.

In , a unit of Franklin Mutual Funds assisted in the saving of Canary Wharf, the London office complex built by the Reichmann family, the Canadian real estate developers. After the developer's holding company went bankrupt, lending banks gained control of the project. A group of investors, including Franklin's Mutual Series funds, bought back the development from the banks. Not long afterward, the London property market recovered, and in , Canary Wharf listed on the stock exchanges , which provided large returns on Franklin's investment.

It is not particularly easy for private investors to get into distressed debt. The quickest way is to buy into a hedge fund that contains a prudent allocation of distressed debt. However, for most investors, the minimum requirements of hedge funds make it impossible to invest in this manner.

There are a few mutual funds and hedge funds that are accessible to regular investors as well. If the idea appeals to your more predatory instincts and you can access this market, bear in mind that this is a high-risk field.