Distressed Debt Primer

How Does Distressed Debt Investing Work

The term “vulture funds” is affiliated with distressed investors, which can be attributed to the opportunistic strategy utilized by the majority of distressed funds.

Despite the negative connotation associated with the term, distressed funds provide capital to borrowers in situations that require immediate funding to remain in operation in the near term. The pre-existing lenders are often banks or institutional investors not interested in or comfortable with holding distressed debt and often look to offload the debt.

Distressed debt investors also increase market efficiency by providing the expertise and comfort level with distressed debt which has the impact of reducing the likelihood of a bad outcome (liquidation) in favor of a restructuring with the business emerging as a going concern. But note that the potential for a turnaround and value creation is the reason to consider investing, rather than means to justify paying a premium.

Therefore, one piece of the puzzle is investing in debt trading below par, but a sizeable portion of the potential upside is predicated on the post-reorganization recoveries received exceeding the initial investment amount.

What is Distressed Debt?

So, when is debt considered distressed? While there is no single standard definition for distressed debt, there are two widely referenced descriptions:

• Martin Fridson: Fridson, known for his contributions to high-yield debt research, defined distressed debt as having a yield to maturity (“YTM”) in excess of 1,000 basis points, or 10%, above that of comparable Treasuries
• Stephen Moyer: Moyer, in his book Distressed Debt Analysis, defined distressed debt as when the market value of the company trades under $1 per share and some (or all) of its unsecured debt trades at a discount of more than 40% below par

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.

The perception of the company by the market is what determines whether a certain debt instrument becomes “distressed”. Based on the standardized credit rating system, distressed debt is categorized as being below investment grade.

^{S&P Credit Ratings (Source: S&P Global)}

Distressed Debt Analysis: Speculative Investment Strategies

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.

For distressed investing with longer hold periods, the strategy is a blend of value and event-driven investing:

• Value Investing: Investing in securities that are underpriced relative to what an investor believes to be their intrinsic value (with the expectation the price will eventually correct itself)
• Event-Driven Investing: Timing investments to correspond with when potentially value-creating strategic and operational changes are being implemented into the company

Distressed investing resembles “deep” value investing where a security could be justifiably underpriced, but an impending restructuring serves as an event-driven catalyst that could create value.

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. Whitman Letter to Shareholders (Source: Third Avenue)}

Learn More → Hedge Fund Strategies Primer

Passive vs. Active Distressed Debt Investing Strategy

There are two distinct classifications of distressed investing strategies:

1. Passive Investing
2. Active Investing

Who are the Top Distressed Debt Investing Firms?

A distressed fund’s amount of capital allocation determines what strategies are used and what level of control is pursued. 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.

• Alternative Asset Managers: Eg., Oaktree Capital, Apollo Global, Blackstone GSO, Angelo Gordon, Avenue Capital, Elliott Management, Sculptor Capital
• Private Equity Firms: Eg., Cerberus Capital, Centerbridge, Sun Capital, Crestview Advisors, KPS Capital, MatlinPatterson, Corsair Capital
• Hedge Funds / Special Situations Funds: Eg., Third Avenue Management, Baupost Group, Silver Point Capital, Anchorage Capital, Aurelius Capital, Tennenbaum Capital (BlackRock Subsidiary), Bayside Capital (H.I.G. Special Situations & Distressed Debt)

The participation of distressed firms during in-court bankruptcies, contrary to a common misconception, 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.

What is the Investment Criteria of a Distressed Fund?

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.

Distressed investing may have high returns, but they also carry high risk, as most intuitively understand.

Strict diligence into the financial distress catalyst, credit metrics, and gauging the feasibility of a turnaround based on secular knowledge can help mitigate some of the risks in distressed investing.

Common examples of distressed investing diligence questions are listed below:

One of the most influential factors on creditor recoveries is the amount of senior credit and loan facilities (e.g., DIP loan), as it provides insights into how recovery proceeds are likely to be distributed based on the absolute priority rule (APR).

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.

How Do Distressed Debt Trading Strategies Work?

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 is because the liquidity of the security is one of the main considerations when it comes to trading.

Otherwise, the illiquidity of a relatively unknown investment makes a short-term exit less likely, regardless of whether the initial investment thesis was correct or not.

Trading around distressed securities sees the highest volume in:

• Companies with Large Public Followings
• Senior Tranches of Debt with Lower Risk

What is the Illiquidity Discount in Distressed Securities?

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.

The more liquid an investment, the more likely it is priced near its fair value – as liquidity is the highest at the top of the capital structure.

The purchase price of a security should reflect the illiquidity risk of the investment, especially if taking a short-term trading approach. Investors require extra compensation for the risk that market conditions may be illiquid when they hope to sell their holdings. Typically, the more illiquid an investment, the lower the trading price.

What is the Distressed-for-Control Buyout Strategy?

The longer the anticipated investment holding horizon, the more the fund’s returns are contingent upon the actual turnaround of the debtor.

Distressed-for-control refers to the long-term, “buy-and-hold” investment approach.

While long-term distressed investments can produce outsized returns, these investments require substantial time commitments and an acceptance of downside risk.

A control-oriented investment is often a calculated bet that the debtor successfully emerges from a restructuring process.

One piece of the puzzle is investing in debt trading below par, but a sizeable portion of the potential upside is predicated on being able to receive additional post-reorganization recoveries from a successful restructuring process.

Typically investments are made in the debt tranches near the top of the priority waterfall, as these securities hold a reasonable chance of recovery in Chapter 11, especially since these firms seek to actively participate in the reorganization.

^{Oaktree Distressed Investment Strategy (Source: Oaktree Capital)}

Given the magnitude of their controlling stake, active-control investors often receive a seat on the board of directors and are prioritized during negotiations regarding the plan of reorganization (POR).

It is often difficult, however, to acquire enough debt securities to hold a majority stake. That said, this particular long-term investing approach has been predominately utilized by distressed private equity firms in recent years.

For an investment to be considered active control, a single investor must hold:

• 1/3 Minimum to Block a Proposed POR
• 50%+ to Hold a Controlling Stake

Fulcrum Security in Restructuring: “Value-Break” Analysis

For active investors, a common investment strategy is to target fulcrum securities if they believe that the post-reorganization equity is currently undervalued.

The fulcrum security is the most senior security that, after undergoing restructuring, has the greatest likelihood of conversion into equity ownership (e.g., debt-equity swap).

Martin J. Whitman Quote: Profiles in Investing

“ER: Do you typically buy the most secured debt?

MW: We will usually try to buy the most senior level of debt which will participate in the reorganization.”

^{Source: Graham And Doddsville}

One of the best ways to reduce investment risk is to purchase senior secured debt, but the potential for high returns is greatly reduced.

The senior secured debt is unlikely to be underpriced and has less leverage in negotiating the POR because they are most likely going to be repaid in full in either cash, new debt, or a mixture of both.

Even if the price paid was at a significant discount, the return will be far below equity returns in a successful turnaround because the upside of equity, in theory, is unlimited.

Conversely, riskier forms of debt can easily end up worthless or receive lower recoveries – yet, from a returns perspective, the purchase of debt with lower priority can also be an attractive entry point if those securities could be converted into equity.

Loan-to-Own vs. Distressed-for-Control: What is the Difference?

Loan-to-own and distressed-to-control are frequently used interchangeably. But one minor distinction to be aware of is that loan-to-own can be used to refer to providing new debt to a company near distress and not purchasing the existing debt of a distressed company.

In a loan-to-own situation, the distressed fund offers to structure a new loan for the company before it actually defaults on its existing obligations, usually at very expensive terms.

The lender is aware of the default risk, but even if the borrower defaults, a part of the lending strategy was to be converted into equity ultimately. In either case, the lender receives a high yield, but the potential upside is greater under equity conversion.

How Does Specialty Lending Work in Restructuring?

Specialty financing alleviates short-term liquidity shortages, preventing fundamentally sound companies from having to file for bankruptcy protection.

Specialty lending is a category of highly customized capital financing meant to aid companies facing temporary liquidity problems (i.e. where the current cash balance is insufficient to fund their working capital needs).

Over time, more specialty lenders have emerged, such as subsidiaries of investment banks, business development companies (“BDCs”), and direct lenders.

Specialty financing is not necessarily distressed credit; it more broadly entails lending to companies facing unanticipated circumstances (e.g., an unforeseeable event, cyclicality, seasonality).

Furthermore, these financing arrangements are typically made out-of-court and before the issue has developed into a serious concern. Despite the risks, the underwriter usually views the catalyst as short-term and has a positive outlook on the long-term viability of the business.

There are numerous types, but two of the most common lending models are:

1. Rescue Financing: Companies right on the verge of distress receive debt capital or a much-needed equity injection from a lender to prevent the company from filing for bankruptcy protection
2. Bridge Financing: Short-term lending solutions to provide liquidity to companies with limited access to the capital markets, but before the point where they are right on the verge of distress

And this “emergency” capital is often used for:

• Equity Injections: Used to fund working capital needs, pay suppliers/vendors or employees, meet interest expense payments or principal amortization repayments
• Repurchases of Debt: Stabilizes the balance sheet by reducing near term obligations; the funds are used to repurchase debt to normalize the D/E ratio (i.e., “take out the tranche”)

Historical Distressed Fund Performance: Counter-Cyclical Returns

Collectively, distressed debt funds have fared better in times of market turmoil and challenging macroeconomic conditions.

Companies in financial distress have restricted access to the capital markets – this means that distressed funds can often be the only source of capital available as most traditional lenders cannot tolerate the risk. For investment firms, distressed debt investment strategies can be appealing by adding elements of counter-cyclicality to their portfolio.

Common indicators preceding a wave of corporate defaults are:

1. Low-Interest Rate Environment and Lenient Lending Standards (i.e., Masking “Red Flags”)
2. Corporate Leverage Multiples Near Record-High Levels
3. Recent Financing Predominately High-Yield Bond Issuances (i.e., Shifting from Senior Debt)
4. Gradual Increase in Recession Concerns with Signs of GDP Slowdown
5. Declining Corporate Credit Ratings (e.g., S&P Global, Moody’s, and Fitch Ratings)

The unexpected tightening of the credit markets, which worsens the corporate liquidity crisis, is often the “event” that sets an economic downturn in motion.

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).

Uncertainties surrounding the financial markets can also cause a “liquidity crunch”, which is when the cash in circulation is in short supply while demand is disproportionately higher.

What Causes Underperformance at Distressed Funds?

Periods of robust economic growth consist of fewer corporate defaults, causing competition among distressed investors to increase and resulting in lower fund returns (and indirectly benefiting debtors).

Another external factor that can constrain fund performance is the intervention by the Fed, as seen by their efforts to limit the damage caused by the COVID-19 pandemic. In order to stop the free-fall observed at the start of 2020, the Fed responded by:

• Implementing fiscal and monetary policies that made capital easy to access (e.g., cutting interest rates, vocal announcements that rates will remain unchanged until the economy had stabilized)
• Injecting the economy with an unprecedented amount of capital to stabilize the equity markets
• Providing relief packages for industries that took disproportionate financial losses caused by the lockdowns (e.g., airlines)

The number of bankruptcies filed in 2020 was the highest number of filings since 2009, but as shown below, the number of distressed issuers fell substantially as the year progressed.

^{Distressed Debt Downtrend Since March 2020 Peak (Source: Bloomberg)}

The Fed effectively curbed the free-fall in corporate bankruptcies. While the equity markets spiraled downward in the early aughts of the COVID-19 pandemic, bullish sentiment returned within a matter of months.

Lenders were also more receptive to out-of-court renegotiations because most understood the COVID-19 pandemic to be a short-term, external disruption. There was a notable increase in the extension of debt maturities (i.e., “amend and extend”) that reduced near-term repayments.

^{Refinancing and Maturity Extensions (Source: S&P Global Ratings)}