Distressed asset investing refers to purchasing debt or equity securities of companies that are experiencing financial distress and are either in bankruptcy or are on the verge of bankruptcy. Distressed assets often trade at substantial discounts to their intrinsic or potential value, providing opportunities for skilled investors. Here are some key strategies for investing in distressed assets:
Conduct deep fundamental analysis – Carefully analyze the company’s assets, liabilities, cash flows, industry outlook, and restructuring alternatives to identify mispriced opportunities. Often require legal and bankruptcy expertise.
Obtain seniority in capital structure – Target debt instruments that are high up in the company’s capital structure and therefore have priority over other claimants. This reduces potential loss in a bankruptcy.
Participate in restructuring process – An activist approach involves participating directly in the restructuring process by serving on creditor committees or providing debtor-in-possession financing. More control over outcome.
Diversify exposures – Build a diversified portfolio across industries, investment types, and stages of distress. Avoid concentration in a few situations. Manage liquidity risk.
Hedge risks – Use derivatives, short positions, and portfolio construction to hedge industry, credit, and interest rate risks embedded in distressed exposures.
Be patient – Many distressed situations take time to play out. Requires patience to see the investment thesis materialize. Holding power affects returns.
In summary, distressed investing requires specialized skills in security analysis, bankruptcy law, and restructuring processes. Careful security selection and risk management are essential to generate returns from this complex asset class.
Conduct in-depth fundamental analysis of distressed companies
The key to success in distressed investing is deep fundamental analysis. Investors need to carefully analyze the company’s assets, liabilities, cash flows, and industry outlook to identify securities that are mispriced relative to their potential recovery value. Legal expertise is often needed to analyze the priority of claims in the capital structure. Companies in distress often have opaque financials, off-balance-sheet liabilities, and hidden obligations that require diligent research to uncover. Conservative projections of cash flows, liquidation values, and recovery rates are essential.
Target senior, secured debt instruments
Within a distressed company’s capital structure, the most senior and secured debt instruments generally have the highest recovery rates in bankruptcy. By investing in senior secured bank loans, bonds, and notes, distressed investors can reduce their downside risk relative to junior claims. However, the most senior debt often trades at smaller discounts to face value. The ‘fulcrum’ securities that combine reasonable downside protection with upside potential require careful analysis.
Participate actively in the restructuring process
Beyond just buying claims, distressed investors can participate directly in the restructuring process to gain more control over the workout outcome. They can provide debtor-in-possession financing, serve on creditor committees, propose reorganization plans, and influence management changes. This activist approach requires legal and bankruptcy expertise but can lead to superior investment results.
Diversify exposures across situations
Given the binary nature of many distressed outcomes, prudent portfolio construction is critical. Investors should build a diversified portfolio across industries, investment types (debt/equity), and stages of distress. Too much concentration in a few situations creates unmanaged risk. Liquidity risk management is also key as distressed assets are inherently illiquid.
Use hedging strategies to manage risks
The uncertain nature of distressed outcomes makes risk management essential. Investors can use derivatives, short positions, put options, and diversification to hedge unwanted industry, credit, and interest rate risks embedded in distressed exposures. Hedging reduces downside without limiting upside potential.
In summary, distressed investing requires honed skills in security analysis, legal expertise, and active participation in the restructuring process. Careful selection of claims in the capital structure along with prudent risk management can lead to attractive returns from this specialized asset class.