When a company is in bankruptcy or close to filing for bankruptcy, any bonds bought from are considered distressed debt. While companies go through periods of adverse financial status, they typically recover and resume business. When they cannot recover from a severe economic crisis, they become distressed debt investments.
What Is Distressed Debt?
Typically, distressed debt can be procured for pennies on the dollar of its actual market value due to the urgency of the imminent defaulting risk on debt payments. The business needs to either find the funds quickly or dump bonds at a severe discount to make its payments. What happens now is that the company will owe money back to anyone who purchased its distressed debt.
If the business cannot pay within the allotted time, it may need to cede control of the company to the debt owners. As a result, most investors who partake in distressed debt investing are reasonably sure the company will not recover, giving them control over a debt-free company.
Example of a Distressed Debt
Many firms will specialize in procuring distressed debt with the sole purpose of funding these companies through bankruptcy. Often referred to as debtor-in-possession loans as when the company is in bankruptcy, those who purchased the distressed debt can provide input in the restructuring process. For example, when the buyer is confident in the business’s ability to succeed once the debt is gone, they will purchase the distressed debt, take control during bankruptcy, and guide the business to financial profitability.
Hedge funds will often invest in distressed debt as well, hoping the company will become profitable after bankruptcy and they can sell their bonds at a much higher margin. The increased risk, high reward nature of distressed debt is ideally suited for hedge funds.
How Do Hedge Funds Invest in Distressed Debt?
Some hedge funds have a small portion of their portfolio as distressed debt. Others, called vulture funds, are hedge funds that specialize exclusively in procuring distressed debt, primarily in government debt from distressed countries. Hedge funds use a few methods that can procure distressed debt. The first of these is the bond markets. This way is the easiest, and a large amount of distressed debt is available directly after a firm defaults.
Hedge funds can also purchase directly from mutual funds. Buying directly benefits both sides, as a more significant quantity can be transacted without worrying about market prices. Also, both sides avoid exchange commissions.
The last method is probably the most intriguing, and that’s buying directly from the distressed firm itself. In this case, the hedge fund directly offers credit to the distressed company in bonds or a revolving credit line. Since the distressed company typically needs cash in short order to turn things around, this can be a good option for the distressed entity as well. If multiple hedge funds extend credit, then they all avoid overexposure of risk.
Hedge funds occasionally will also take on an active role in the firm’s post-bankruptcy restructuring, offering advice and guidance to rebuild effectively. Alternatively, they can also restructure the repayment terms for the extended credit, giving the distressed firm more freedom and flexibility to work on its issues.
Risks of Distressed Debt Investing for Hedge Funds
While ownership of the debt is less risky than owning the equity due to debt taking precedence over equity in the liquidation process during bankruptcy, risks still exist. The main risk is that having priority does not guarantee payback; it only increases the likelihood. The risk is also mitigated by making minimal investments compared to their size. Due to high return potential, these small investments can pay off big time while carrying little overall risk.
For example, a hedge fund takes 1% of its total capital and invests it in a company’s distressed debt. If the debt is purchased at 20 cents on the dollar relative to market value, it emerges from bankruptcy at 80 cents on the dollar, which constitutes a 300% return on investment and a 3% return on total capital.
Distressed Debt Investing for Individual Investors
While perfectly tailored to a hedge fund, the attractiveness of distressed debt investing is also appealing to individual investors for the same reasons. Although it’s unlikely that an individual investor would ever take an active role in the restructuring, several opportunities exist for an individual investor to invest in distressed debt.
The first step is to identify and find distressed debt. If the distressed company is already in bankruptcy, this will be easy to see through company announcements, news, and other information. If they have not begun bankruptcy proceedings, you may determine which companies are close to a filing by using bond ratings offered by Moodys, Standard & Poor, and the like.
Once a good distressed debt candidate is found, the next step is to determine how to procure the distressed debt. One option is to use the bond market, as some hedge funds do. Another way is to utilize exchange-traded debt, which allows smaller buy-ins such as $25 to $50 instead of the $1,000 that bonds require. The much smaller amounts make distressed debt a more viable option for individuals.
Risks of Distressed Debt Investing for Individuals
Hedge funds can “hedge” their investments by making smaller investments across a wide array of financial instruments. In this way, they mitigate risk and loss if their investment in distressed debt goes bad. However, the individual investor is typically unable to do that, and any investment in distressed debt will constitute a higher portion of their overall portfolio. Individual investors, therefore, need to exercise more discretion and be more diligent when selecting distressed debt investments. Choosing a distressed debt with lower risk but still a high rate of returns is advisable here.
Distressed debt is a classic example of high-risk, high-reward investment, and much is to be gained by those willing to assume the risk. Managing these risks either by hedging or doing significant research to make sure you’re picking the right distressed debt investment can provide great returns by enduring a distressed company’s trying financial times. If you’d like more information about debt investing as well as other opportunities for investments, reach out to our knowledgeable team at Titan Funding in Boca Raton. You can reach us at 855-929-1134 or contact us online 24 hours a day, seven days a week.