An Introduction to Distressed Debt Investing Strategies

Upgrading to a paid membership gives you access to our extensive collection of plug-and-play Templates designed to power your performance—as well as CFI’s full course catalog and accredited Certification Programs. The federal financial safety net is supposed to protect large financial institutions and their creditors from failure to reduce systemic risk to the financial system. However, these guarantees also encouraged imprudent risk-taking that caused instability in the very system the safety net was supposed to protect. The external debt of IDA-eligible countries more than doubled over the past decade to a record US$1.1 trillion.

1. Those involved in distressed debt are often some of the first to be paid back, ahead of shareholders and even ahead of employees.
2. This allows investors to turn a profit if the company recovers or goes bankrupt.
3. A court will order the priority of creditors to receive payment when a company declares Chapter 11 bankruptcy.
4. This document and the information contained herein may only be distributed and published in jurisdictions in which such distribution and publication is permitted.
5. Lend-to-own situationsMany companies fail simply because they are overburdened with debt.
6. 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.

They can see the value of the debt go up a great deal if they believe there can be a turnaround and if it turns out that they’re right. A distressed borrower is a borrower who is unable to fully repay their debt on time, due to financial difficulties. A distressed borrower can be either a person or a business whose income falls due to unforeseen circumstances. Working with an adviser may come with potential downsides such as payment of fees (which will reduce returns). There are no guarantees that working with an adviser will yield positive returns.

Access Exclusive Templates

Compared to Example C, the fulcrum security is located higher in Example D as a byproduct of the lower comps-derived valuation. In our 2nd scenario for WidgetCo, the only adjustment we will make is that the industry comparables are more impaired and thereby leads to WidgetCo being valued at a multiple of 2.0x EV / EBITDA (a $400mm implied valuation). Similar to the case of LightingCo, WidgetCo was also negatively impacted by COVID-19 and the debt on its balance sheet soon became a concern, as the face value what is distressed debt of its debt surpassed its enterprise value. Until 2020, the implied valuation of WidgetCo was always greater than the debt it has held (unchanged for the past four years), based on the industry-derived multiple. However, this took a turn for the worse in 2020 as the valuation multiple had a drastic reduction to 3.5x. LightingCo’s outstanding debt balance was $300mm whereas its implied enterprise value based on current projections (and the industry multiple from peer group benchmarking) comes out to $150mm.

How Hedge Funds Invest in Distressed Debt

Most debt relief programs will help you clear your debt within three or four years — and do so with lower payments that are easier to make each month. Sure, your credit score may take a hit in the beginning, but in the long run, you can end the program with a clean financial slate — making it possible for you to build a positive credit score in the foreseeable future. Only after a significant deterioration in the debtor’s financials and/or a contraction in the industry valuation multiple would it become necessary to locate the value break and then price the fulcrum security. Thus, despite the moderate (or above-average) leverage multiple, WidgetCo is still considered distressed under our definition for these exercises. But some examples of mitigating factors that could help a struggling company in the short term would be Divestitures of non-core business segments (and using the proceeds to remain afloat) and a pre-existing Revolving Credit Facility (“Revolver”).

Distressed Debt Investment Strategy

If you’re able to secure two-thirds of the company’s bonds, you can control the restructuring vote and gain equity, but you may not be paid out first. There are multiple warning signs that could indicate a company is experiencing financial distress, or is about to in the near-term. Struggling to break even suggests a business that cannot sustain itself by generating internal funds and must instead raise capital externally. This increases the company’s business risk and lowers its creditworthiness with lenders, suppliers, investors, and banks. Limiting access to funds typically results in a company (or individual) failing.

The most common strategies for distressed homeowners are forbearance, reinstatement, loan modifications, or a short sale. It’s then up to the company to make the most of these funds to become solvent once again. If the company is unable to do that, then the buyer has an opportunity to take control of it or be first in line for payment in a bankruptcy filing.

Balancing out distressed debt investments with stocks, bonds and other securities can help you to keep risk in check. Distressed debt strategies introduce many of the same risks common to other alternative investments, such as liquidity risk and loss of investment principal. In addition, depending on the strategy employed, distressed debt investors should be mindful of a potential lack of information about a company’s underlying finances and the potential for future market-level or company-level distress. The world of distressed debt has its ups and downs, but hedge funds and sophisticated individual investors have much to gain by assuming the risk potential.

To explain the concept of the fulcrum security in more simplistic terms, imagine distributing the enterprise value of a distressed company to all claim holders based on their seniority within the capital structure. This strategy focuses on acquiring a company’s debt at a fraction of its value and working with the company to restructure the overall debt. The debt may be regarded as distressed due to perhaps idiosyncratic reasons, a company may be overleveraged, suffer from a blow to its cash-flow, or an event affecting many companies like a global recession. Securities are labeled as distressed when the company issuing them is unable to meet many of its financial obligations. In most cases, these securities carry a «CCC» or below credit rating from debt-rating agencies, such as Standard and Poor’s or Moody’s Investor Services. Distressed securities can be contrasted with junk bonds, which traditionally have a credit rating of BBB or lower.

The Motley Fool reaches millions of people every month through our premium investing solutions, free guidance and market analysis on Fool.com, top-rated podcasts, and non-profit The Motley Fool Foundation. The anticipation of defaults by lenders causes the downturn, as the capital markets become stringent on lending standards, which causes a deceleration in the money supply (and higher interest rates). A control-oriented investment is often a calculated bet that the debtor successfully emerges from a restructuring process. The longer the anticipated investment holding horizon, the more the fund’s returns are contingent upon the actual turnaround of the debtor. The further down the capital structure one goes, the fewer investors there are with the risk appetite to invest and the higher the likelihood of finding mispricing.

Restructuring during bankruptcy can even result in distressed-debt investors becoming part owners of the troubled company. Distressed borrowers can also become distressed if they simply don’t understand the terms of the loan. In the late 2000s, subprime mortgage borrowers often became distressed borrowers because they were issued loans they didn’t understand and couldn’t afford. Typically, lenders https://personal-accounting.org/ have the incentive to only issue loans that can be repaid, but the structure of the late 2000s mortgage market encouraged reckless lending, because mortgage originators usually didn’t assume any repayment risk. For professionals in investment banking or other areas of corporate finance, it’s important to factor in the impact of financial distress on the entire capital structure of a firm.

Distressed securities often appeal to investors who are looking for a bargain and are willing to accept risk. In some cases, these investors believe the company’s situation is not as bad as it looks, and as a result, they anticipate their investments will increase in value over time. However, they feel confident that there might be enough money upon liquidation to cover the securities they have purchased. As demonstrated from the list below, most firms active in the distressed debt investing space operate multiple fund structures and strategies simultaneously. In a single transaction, hedge funds can acquire larger quantities—and mutual funds can sell larger quantities—without either having to worry about how such large transactions will affect market prices. A distressed borrower can request that a lender grant them forbearance, or the suspension of payment obligations for a specific period of time.

In most cases, a minor haircut in the total value of their proceeds is worth not having to deal with an extended process with further complications stemming from appeals, complaints, etc. As a result of getting only partial recovery, the fulcrum’s security claims will be converted to equity (usually instead of a debt claim), and often positions the holders of the fulcrum security to lead the plan of reorganization (POR) going forward. TurnaroundsDistressed debt can be a great way to invest in a turnaround situation because debt is given preference to equity in the event of bankruptcy. That is to say that while a stock’s value in bankruptcy is usually zero, debt often retains some of its value in a worst-case scenario, limiting downside risk if a turnaround fails. Founded in 1993, The Motley Fool is a financial services company dedicated to making the world smarter, happier, and richer.

Our Company

In many cases, it may be better to tap into the debt relief you need now and work to rebuild your credit once you have a clean financial foundation to build upon. If you continue down the same path with your credit card debt, there’s a minimal likelihood that you’ll see improvement in your credit utilization or debt-to-income ratio any time soon — and the occasional missed payment may continue. That means you may end up dealing with poor credit for significantly longer if you do nothing than you would if you sign up for debt relief. Resolution plans or corporate «living wills» may be an important method of establishing credibility against bailouts. The government safety net may then be a less attractive option in times of financial distress.

The term often means that the debt is trading at a large discount to its par value. Another strategy for distressed borrowers are loan modifications, which lenders will offer to either lower the total repayment amount required by the borrower or extend the length of time given to repay the full loan amount. Lenders will sometimes offer a loan modification if they are afraid that absent the modification, the borrower will default entirely on his obligations. Distressed borrowers sometimes have different options to get current on their loans, as lenders have the incentive to find a way for borrowers to repay their debt, even if it means being repaid late or in less than the full amount owed.