November 19, 2008
Opportunities in Distressed Debt
Posted by Michelle Harner

One investment opportunity that is plentiful in the current environment is distressed debt.  (For a basic explanation of distressed debt, see here.)  Toxic loans and discounted bonds are easy to come by.  But are they a good buy?  Some say it depends on whether you think the markets have hit bottom.  You do not want to overpay for these assets or end up taking a loss.


It also may depend, however, on your strategy for realizing a gain from these assets.  An investor who desires to buy the debt at a low price and then sell it quickly at a higher price likely wants the market to bottom out before buying.  These types of distressed debt investors commonly are referred to as “vultures” and typically are very active in a company’s debt right before and during that company’s bankruptcy.  Nevertheless, an investor who desires to invest in distressed debt for purposes of influencing decisions at, or buying, the company may not wait so long to buy.  These investors are concerned not only with price but also with percentage ownership and priority of the debt.


This latter type of investor often is said to be investing for “control.”  (For a succinct explanation of investing in distressed debt for control, see here.)  Control investors generally seek to acquire a majority or, at least, a blocking position (typically 33%) in the debt.  Those positions allow the investor to control any vote by the holders of that debt issuance either by supporting the measure (typically when in the majority) or rallying against it (either as the majority or blocking minority holder).  Control investors also seek to purchase a tranche of debt that would be subject to compromise in any financial restructuring.  Purchasing at a level too senior may mean that your issuance simply is paid off without any input from the debtholders (although 100% repayment is never a bad thing) and purchasing at a level too junior may mean that your investment simply is wiped out, again without any input from the debtholders.  The investor is looking for that tranche of debt that is just right—not too high and not too low and, preferably with some pro-debtholder covenants that provide the investor with additional leverage in restructuring negotiations with the company.


The activities of distressed debt investors are difficult to track.  Hedge funds and private equity firms are the primary players in this space, and most do not publicly disclose their holdings or investment strategies.  Nevertheless, the limited empirical and anecdotal evidence available suggests that investing in distressed debt for control purposes is a growing strategy among private funds.  According to an empirical survey that I conducted in 2007, over 65% of the respondents indicated that they use their distressed debt investments for control purposes.  Moreover, over 67% of the respondents indicated that they invested in distressed debt in 2007, and 36.6% indicated that they would increase their distressed debt holdings in 2008, with 53.7% investing at the same level.


I suspect that the current financial crisis and the growing numbers of bankrupt companies will increase the level of trading activity in distressed debt.  In fact, according to recent reports, BlackRock, Third Avenue Value Management, Trust Company of the West, Pimco, Metropolitan West Asset Management, Apollo and others are raising or have raised significant money for distressed debt funds (see here and here).  Reports also suggest that distressed debt funds are very well financed, having reportedly raised over $30 billion in the second quarter of 2008 alone (see here and here).


Distressed debt investors generally outperform the markets, and economic downturns obviously help them achieve their performance targets.  For example, according to one article, “[a]fter the dot-com bust and the massive bankruptcies of Enron, WorldCom and Adelphia, distressed-debt managers returned 32% in 2003 and 18% in 2004 on average, according, which tracks fund performance.” So, these funds appear to be a good investment for investors.


But are distressed debt investors and their funds good for the debtor company?  As I suggested above, many observers view these investors as vultures that destroy, rather than create value.  Some distressed debt investors certainly fit this description.  Nevertheless, distressed debt investors can provide a company with much-needed liquidity and may help identify underutilized or untapped value or ineffective management at a company.  In those instances, I think the potential exists for distressed debt investors to add value.  I explore some examples of control investors arguably adding value in a recent article.  As the article suggests, however, the control asserted by these investors also poses significant potential problems.  I think additional research is needed before any final verdict can be rendered on distressed debt investors.  And this current cycle should provide plenty of data to study.

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