Private equity firms have been actively investing in distressed companies as an alternative investment strategy. This involves buying the debt or equity of mature companies facing financial difficulties. While risky, distressed private equity investments offer the potential for very high returns. In this article, we will explore the opportunities and risks of private equity distressed investing.
High potential returns from turnarounds of distressed companies
The main appeal of distressed private equity investing is the potential for very high returns if the target company can be successfully turned around. Distressed companies are often undervalued due to temporary problems or market overreaction. If the PE firm can resolve issues like excessive debt burdens or leadership problems, the value of the company may increase dramatically. This allows the PE firm to eventually sell the restructured business for a significant profit. Of course, successful turnarounds require operational expertise and access to additional capital.
Specialized expertise in distressed investments
Leading private equity firms build up specialized teams focusing solely on distressed opportunities. These experts devote their efforts to identifying distressed companies that can be acquired at low valuations but still have viable underlying businesses. The team works to turn around companies by resolving debt problems, improving operations, or replacing ineffective management. Many generalist PE firms lack the specialized expertise required to consistently profit from distressed situations.
Risk of underlying business failure remains high
While the potential returns are high, the risks of distressed investing are also elevated. There is always the chance the underlying business is too far gone and cannot be saved even with restructuring efforts. Failed turnarounds can lead to a total loss of the private equity firm’s investment if the company is liquidated. Extensive due diligence is required to filter out companies that have fundamental problems that cannot be fixed.
Difficulties exiting distressed investments
Exiting distressed private equity investments can also be challenging compared to traditional private equity. IPOs or sales to strategic buyers may not be feasible if the company still carries negative perceptions. As a result, PE firms often have to get creative with exit strategies. For example, they may capitalize the company with additional debt while paying themselves dividends. Or they may sell to another distressed PE firm specializing in turnarounds rather than strategic or financial buyers.
In summary, private equity distressed investing provides the opportunity for outsized returns but also elevates risks. Success depends on specialized expertise in identifying viable distressed companies and executing operational turnarounds. While the potential payoff is high, investors should carefully evaluate risks such as underlying business failures and difficulties exiting restructured investments.