Distressed Debt Investing

Distressed debt investors seek equity-like returns with the downside protection that investing in debt provides.

In doing so, distressed debt investors employ his investment strategy to seek the best of both worlds.

Below is a visualization of the way a company is capitalized:

Now shown below is the same company if it were to become distressed:

Notice that all three slices of the company are smaller. But the debt has retained the most value, while the equity piece has lost the most value. This can be called “crushing the equity value” and refers to the weight of the debt causing problems for the owners, or equity holders, of a given company.

While the features that make distressed debt investing the best of both worlds (in terms of seeking equity-like returns with downside protection) are enticing, these situations often come with a lot of hair on them.

For starters, the equity holders who financed the company with debt likely thought that the underlying businesses or assets would be able to handle the costs of servicing the debt. Indeed, it is unlikely they would have structured the debt in a way for it to become distressed in the future.

In a distressed debt situation, the original debt holders become concerned that the underlying asset or business may not support both the operating costs and financing expenses required. They may also be concerned that their original investment is unlikely to be repaid in full and instead is driving the price of the debt below its face value.

But this is often where the difficulty begins! In addition to underlying businesses that already struggle to meet their current obligations, bankruptcy, a frequent feature of distressed debt investing, imposes additional costs onto firms that ran into trouble.

An army of lawyers, accountants, and consultants line up to advise and negotiate over the assets of the company and all of these players get paid before any distressed debt investors do. Otherwise, why would they take the time to work on the situation?

The axiom, “no risk, no reward”, is fitting here for many distressed debt investors. In exchange for taking the risks involved with investing in distressed assets, the rewards can be immense.

A lot of this has to do with time preference. The investors who originally held the loan are already looking at losses. If they bought a piece of debt for 100 cents and it currently trades at 60 cents, they already lost 40 cents of their principal investment.

These investors also do not have the legal expertise to navigate bankruptcy courts should a distressed situation progress to that stage. For this reason, it’s best to cut losses and move on.

Beyond providing liquidity to exiting investors and stepping into a messy situation, distressed debt investors have skills that add value to their legal claims.

Like we mentioned earlier, lawyers, accountants, and consultants are all involved in the process so distressed debt investors have a lot of professionals to contend with who all represent various stakeholders.

Navigating this process can get messy. The best way for distressed debt investors to mitigate their risk is to pay the lowest amount possible. Besides paying a low price, distressed debt investors can mitigate risk by being up to date on various rulings in bankruptcy courts globally and by following changes in the law in any jurisdictions in which they may transact.

After a company has already become distressed, a lot of the risks may have already presented themselves. While these situations can be difficult to navigate a lot of the downside is priced into debt securities being purchased at discounted prices. These types of price declines can occur before a company formally files for bankruptcy as investors anticipate the financial decline of the business.

Management of the companies can avoid bankruptcy in creative ways by offering new securities to investors that offer protections above existing securities. These protections are meant to entice new investors into the situation and keep equity holders from losing their investment. But if management cannot convince this new class of investors to come in and keep the business afloat, then a bankruptcy will likely be filed for the company. When companies enter bankruptcy, they typically get relief from paying their creditors instantly, though as we mentioned earlier there are other costs incurred.

Once the bankruptcy proceeding is underway, distressed debt investors will work towards an agreement with the distressed company to sell off a company’s assets in order to receive their investment back. However, these investors often become the new equity holders by converting the company’s debt they are holding and taking the assets for themselves.

In this scenario, distressed debt investors become business operators. If the business improves under their stewardship and management, outsized returns may begin to be recognized because these companies were purchased at prices where they were likely valued at their lowest.

By converting distressed debt into the company’s new equity, the company’s cash can be reinvested in improving their business, because the cash is no longer needed to pay interest expense or settle debt maturities.

By eliminating these prior uses of cash, the company now has the ability to look towards a future of creating value.

Charter Communications is a great example of the upside being captured.

Reuters reported in 2009, “Charter cut its debt load by 40 percent, or $8 billion, under the plan. It is also poised to generate positive cash flow by reducing annual interest expense by more than $830 million. Existing Charter common shares have been canceled.”

Since emerging from bankruptcy, the company’s shares have soared.

When many think of distressed debt investing, they think of companies emerging from bankruptcy without their prior debt burdens, or of companies being stripped of their assets in order to satiate their new owners.

But countries and states can default on debt as well. Some of the most famous examples are Argentina and Puerto Rico. While politicians in such countries often lash out at hedge fund managers for taking advantage of their distressed debt situations, it often does little to deter these types of investors from seeking these opportunities when they arise.

Argentina was a particularly interesting case because they borrowed in US dollars. This subjected the sovereign nation to another sovereign nation’s creditor and bankruptcy laws. When the government of Argentina tried negotiating with its distressed debt investors so that they could exit bankruptcy, the country offered other investors 30 cents for every dollar they owed.

The Wall Street Journal wrote, “In the Argentina dispute, the holdout hedge funds won an important victory in 2012. A U.S. court issued an injunction that prevented Argentina from paying other bondholders until it settled its debts with the hedge funds.”

This locked Argentina out of the debt markets for 15 years and distressed debt investors eventually negotiated for 75 cents on the dollar.

Meanwhile, Argentina’s previous leader who refused to settle with these hedge funds was later indicted for corruption.

Distressed debt investing is a complex legal endeavor.

Investors are attracted to this investment style because debt securities are protected in bankruptcy court. However, the main basis of this protection is the fact that the security holders have a better chance of recovery than any equity holders.

This protection in court above equity does not protect distressed debt investors from the army of professionals that are looking to carve up the assets in question.

These costs of distressed debt investing are often more expensive than the interest expense that the businesses in question have already failed to pay.

When distressed debt investors successfully navigate the bankruptcy process, they can be handsomely rewarded by either disposing of a company’s assets or by taking control of them as the new equity holders of the company.