What Is Distressed Debt?

Distressed debt refers to the debt (or bonds) of companies that are facing financial turmoil. These companies may be facing bankruptcy or may likely become bankrupt. When a company becomes bankrupt or enters a period of financial turmoil (often from overextending itself in debt), the company may sell its debt (and/or equities) to a new buyer or buyers. These new buyers are investing in the company’s distressed debt.

Who Is Interested in Distressed Debt Investing?

Mutual funds, private equity firms, brokerage firms, hedge funds, and specialized debt funds are entities that may be interested in purchasing distressed debt (and/or equities) from failing companies. These buyers usually have the resources to step in and offer to buy the debt at a deep discount.

Depending on the strategies that guide these investors, distressed debt investors may be on the lookout for a number of criteria when identifying companies to invest in:

• The company may have legal problems
• The company may be overextended in debt
• The company may have operational issues
• The company may be underperforming
• The company may be in financial trouble presently, but have a good chance of recovering.

Debt Gets First Priority in Liquidation

Buyers of distressed debt are generally more interested in the failing company’s debt (bonds) than its equities (stocks). The reason for this preference? If the company cannot be rescued and is eventually liquidated, debt owners have priority over equity holders – debts are liquidated first.

Distressed debt investing can provide a big return on investment for the investor with the resources, timing, and acumen to identify companies that are good candidates for restructuring or possible liquidation. In the event of liquidation, the buyers often make much more back on their original investment than they needed initially to put in.

Power Play – Forcing Restructuring

By purchasing distressed debt at low prices, a distressed debt investor ensures that they will have more power in facilitating debt restructuring for the company, or liquidating all assets if the company cannot be saved. In the event of liquidation, the total of the proceeds may exceed the market valuation for the company.

Distressed debt investors often take an interest in having the company restructure the debt or redesign its operations; the restructuring process may be monitored by a court. Investors in distressed debt usually assess whether the issuer will be able to improve its operations and restructure the debt in a more manageable fashion. Restructuring can take time and can serve to either shore up the debt, and/or to eventually convert it to equity. Mergers, takeovers, or a complete reorganization of company operations may be used in the restructuring process.

Distressed Debt Investing Offers Investment Diversification

Because distressed debt investing does not usually correlate with typical stock market risks, this type of investing provides diversification to other strategies. But distressed debt investing is usually high risk and requires the finely honed skill of being able to identify companies which may be overextended, undervalued, or on the verge of failure.

Vulture Funds for Public Distressed Debt

Vulture funds offer investors the chance to invest in the distressed debt (or equities) of public entities, such as governmental bodies. These funds feature high yield bonds that are in default or approaching default or equities that are in bankruptcy or approaching bankruptcy. These funds are managed with the goal of offering high yields at low prices.

Hedge Funds for Investing in Distressed Debt

Hedge funds also offer an investor the opportunity to invest in short term liquid debt securities. However, the large amounts of capital needed to invest in a hedge fund are not usually accessible to many smaller investors.

Distressed Debt Investing for the Small Investor

While distressed debt investing is usually difficult or impossible for small investors, mutual funds with holdings in distressed debt do exist. Legg Mason Opportunity Trust at http://www.leggmason.com/individualinvestors/products/mutual-funds/overview/LMOP.aspx is one example. Forbes magazine lists a few other mutual funds with distressed debt holdings at: http://www.forbes.com/forbes/2002/0930/400337_print.html

 Additional Resources

• New York University report on distressed debt in 2006 and 2007:http://pages.stern.nyu.edu/~ealtman/2006%20InvestPerf.pdf
• Citadel Investment Group, a distressed debt fund:http://www.citadelgroup.com/
• Business week article on hedge fund management with distressed debt:      http://www.businessweek.com/investor/content/jan2006/pi20060120_8038_pi025.htm      
  

• Distressed debt newsletter:      http://www.fridsonvision.com/?gclid=CP3V8ZXjgZQCFQhzHgodoEemXA