Distressed asset investing has become an increasingly popular alternative investment strategy in recent years. This approach involves purchasing assets that are underpriced or distressed due to economic downturns, industry changes, overleveraging, or other external factors. As a higher risk, higher reward tactic, distressed asset investing requires extensive research and rigorous analysis to identify ideal opportunities. When executed successfully, it can lead to substantial returns for patient investors.
This strategy allows investors to acquire assets at deep discounts, with the goal of selling them for significant gains once conditions improve. Distressed assets can include real estate, mortgages, debt securities, equities, and entire companies. The distressed asset investor aims to purchase when current owners are under duress and forced to sell at fire sale prices. However, thorough due diligence is necessary to avoid potential pitfalls and accurately evaluate the intrinsic value.
Key skills for distressed asset investors include financial modeling, legal expertise, operational restructuring knowledge, and patience for an extended holding period. While higher transaction costs and lower liquidity characterize this approach, the potential payoff from purchasing solid assets at bargain prices can be considerable. This strategy is best implemented by specialist firms rather than individual investors. With proper execution, distressed asset investing offers a compelling way to find hidden value opportunities.
Distressed asset investors utilize various tactics to acquire and enhance undervalued assets
Distressed asset investors employ diverse approaches to target and acquire discounted assets:
– Purchase equity stakes in troubled companies – This allows investors to gain control and direct restructuring activities. Acquiring majority ownership positions enables shareholders to appoint turnaround specialist management teams and implement operational fixes.
– Purchase distressed debt securities – Rather than acquiring equity, investors can buy deeply discounted bonds, bank debt, and other obligations of distressed firms. This debt can potentially be converted into equity during restructuring.
– Pursue liquidations – Investors purchase distressed inventories, facilities, and other assets directly from bankrupt companies and position them for sale under more favorable conditions.
– Buy unfinished projects – Uncompleted properties, mines, and infrastructure can be acquired cheaply and completed more economically. This was common during housing busts.
Once acquired, improving operating performance is critical. Investors pursue financial restructuring including debt/equity swaps and divesting of non-core assets. Operational restructuring enhances competitiveness via cost-cutting, product/service refinement, modernized technology, scaled operations, and management overhaul. Legal restructuring utilizes Chapter 11 and other laws to eliminate debts and revamp businesses. Adding value relies on aligning management incentives with shareholder interests. Ultimately the end goal is to sell refurbished assets to strategic industry buyers or via public markets.
With the right framework, distressed asset investing allows investors to profit from assets that have become mispriced due to external macroeconomic factors rather than poor fundamentals. It generates outsized returns for those with the necessary expertise and patience to accurately identify and rehabilitate battered gems.
Risks and costs of distressed asset investing necessitate careful evaluation
While the potential upside of distressed asset investing is substantial, prudent investors are aware of the elevated risks and costs involved with this strategy:
– High due diligence burdens – Extensive research is mandatory to identify assets with true turnaround potential and avoid value traps. This diligence requires financial, operational, tax, legal, industry, macroeconomic, and other expertise.
– Liquidity risk – Distressed assets trade infrequently and can be difficult to sell when desired, especially for minority owners.
– Restructuring risks – Corporate turnarounds may fail despite the best efforts and capital investments of new owners.
– Valuation uncertainty – Accurately determining fair value for distressed assets can be more art than science despite rigorous modeling.
– Legal risks – Outcomes of restructuring plans, creditor negotiations, and bankruptcy proceedings are hard to predict.
– Time risk – Restructuring and turnarounds take time, tying up capital that could be deployed elsewhere.
– High transaction costs – Specialized advisory, diligence, legal, and restructuring expenses add up.
– Concentration risk – Distressed deals are often lumpy, increasing volatility versus more diversified investments.
Given these hazards, distressed asset investors typically target annualized returns of 25% or higher. Many distressed funds also charge hefty performance fees. Individual investors should generally avoid overexposure to this inherently risky asset class.
Experienced specialist firms are best positioned to capitalize on distressed asset opportunities
While the potential returns of distressed investing appear highly appealing, executing this strategy successfully requires world class expertise, resources, and access. Several factors make this a difficult area for individual investors to navigate:
– Niche focus – The most lucrative distressed assets are identified through extensive relationship networks cultivated over years. Casual investors lack such connections.
– Competitive auctions – The most desirable distressed deals are fiercely contested by experienced industry players, pushing prices toward fair value.
– High minimums – Institutional distressed funds often have minimums of $5-10 million, shutting out individual investors.
– Active management needs – Restructuring and overhauling distressed assets is an involved, hands-on process requiring relevant skills.
– Opaque markets – The distressed asset space lacks transparency and rarely utilizes public listing markets where individual can participate.
As a result, distressed investing is best left to alternative asset managers who specialize in this area. Well-known distressed asset firms include Oaktree Capital, Apollo Global Management, Ares Management, Fortress Investment Group, and Avenue Capital. Such niche specialists possess the expertise and industry connections to source deals, conduct due diligence, acquire assets, drive turnarounds, and profitably exit investments. They also have the scale to diversify holdings across multiple distressed assets. While generating sparkling historical returns, even top-tier distressed funds carry enhanced risk due to their focus on bargain but broken businesses.
When approached prudently, distressed asset investing offers skilled investors an opportunity to achieve outsized returns by acquiring fundamentally sound businesses trading at steep discounts. Success relies on rigorous security selection, thorough due diligence, structured buyouts, patient turnarounds, and well-planned exits. While individual investors face hurdles, specialized alternative asset managers have the expertise and resources to capitalize on this strategy. Distressed asset investing should be viewed as a high-risk, high-reward complement to traditional portfolios for qualified investors.