What is Distressed Debt?
Distressed Debt refers to securities which has made default, or under the process of bankruptcy, or facing situations which could lead to bankruptcy and are usually traded at large discounts in comparison to their par value. There is a great deal of risk involved in the purchase or sale of these securities as financial distress or bankruptcy may lead to these securities becoming worthless or zero.
- These securities have a below-investment-grade rating. Investment-grade ratings are provided by credit riskCredit RiskCredit risk is the probability of a loss owing to the borrower's failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt's principal and an interest component, resulting in interrupted cash flow and increased cost of collection. agencies, which signify the risk associated with particular securities or bonds. And since these securities are considered to be of lower investment-grade rating, thus a high level of risk is associated with its buying and selling.
- Investors buy or invest in these securities relying upon the strategy that if the company does not go into bankruptcy, they will realize a high return on their current purchase of securities at a significant discount. Mostly, large institutional investorsInstitutional InvestorsInstitutional investors are entities that pool money from a variety of investors and individuals to create a large sum that is then handed to investment managers who invest it in a variety of assets, shares, and securities. Banks, NBFCs, mutual funds, pension funds, and hedge funds are all examples. invest in these kinds of securities like hedge funds, private equity funds, etc.
Features of Distressed Debt
- They belong to companies that are facing financial difficulties or are on the verge of being bankrupt.
- They are issued at high discounts from their par value or face value.
- Credit rating agency allots below investment gradeInvestment GradeInvestment grade is the credit rating of fixed-income bonds, bills, and notes as assigned by the credit rating agencies like Standard and Poor’s (S&P), Fitch, and Moody’s to express the creditworthiness of and risk associated with these investments. rating to distressed debt securities.
- Large institutional investors invest in these debt instrumentsDebt InstrumentsDebt instruments provide finance for the company's growth, investments, and future planning and agree to repay the same within the stipulated time. Long-term instruments include debentures, bonds, GDRs from foreign investors. Short-term instruments include working capital loans, short-term loans. or bonds, either to reap a substantial profit if the company does not go into bankruptcy or else getting control of the business in case it does become bankrupt.
How Does it Work?
- These securities are issued at a substantial discount to its par value by companies that are facing financial difficulties. Large institutional investors identify these kinds of companies and deliberately purchase debt securities like bonds instead of stocks or shares.
- These investors, also known as “vulture fundsVulture FundsVulture fund is a hedge fund that invests in distressed companies by purchasing their bonds or securities at heavy discounts, and on maturity, they redeem them at par by filing a legal case for debt recovery, which gives them higher returns.,” are of the view that if the company comes out of its financial difficulties, they will earn high profits. And if it does go into bankruptcy, they will still get their due payments as they are debt securities holders, hence will get priority over shareholdersShareholdersA shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company's total shares..
- In the late 1980s, Martin Whitman, an American investor, purchased distressed debt securities of an oil service firm that was facing financial difficulty, gained control of the company, and went into debt to equity deals with other creditors. The company came out of bankruptcy, and Whitman made a substantial profit.
- In the mid-1990s, Franklin’s mutual funds purchased distressed debts from Canadian real estate Companies, who built Canary Wharf, London office complex. Franklin Investment reaped out a substantial profit when the holding companyHolding CompanyA holding company is a company that owns the majority voting shares of another company (subsidiary company). This company also generally controls the management of that company, as well as directs the subsidiary's directions and policies. became bankrupt.
- Distress debt investments where investors are buying debts at significant discounts and looking to earn substantial profit in case the table turns around.
- An investment where investors are looking to gain the control or ownership of the defaulted company through negotiation in courts if the company goes into bankruptcy.
- An active non-control strategy where these investors involve themselves in the restructuring process of the company so that they can negotiate and maximize and safeguard the interest of the class of securities held by them.
Who Invests in Distressed Debt?
- It is very difficult for individual investors to go into distressed debt investment due to the high risk involved and several other complexities. But they can choose to do so by investing in hedge fundsHedge FundsA hedge fund is an aggressively invested portfolio made through pooling of various investors and institutional investor’s fund. It supports various assets providing high returns in exchange for higher risk through multiple risk management and hedging techniques. or mutual fundsMutual FundsA mutual fund is an investment fund that investors professionally manage by pooling money from multiple investors to initiate investment in securities individually held to provide greater diversification, long term gains and lower level of risks. who are buying such debts.
- Therefore, investors with a large appetite for risk management can go into such debt securities investments. Private equity firmsPrivate Equity FirmsPrivate equity firms are investment managers who invest in many corporations' private equities using various strategies such as leveraged buyouts, growth capital, and venture capital. The top private equity firms include Apollo Global Management LLC, Blackstone Group LP, Carlyle Group, and KKR & Company LP., hedge funds, mutual funds, specialized debt funds are the main investors in the market who go for distressed debt investment because they have access to high- risk management strategies which an individual investor might not have to.
- Buying debts or bonds at a high discountBonds At A High DiscountA discount bond is one that is issued for less than its face value. It also refers to bonds whose coupon rates are lower than the market interest rate and thus trade for less than their face value in the secondary market. to its par value gives way for the high potential of reward.
- In case the company goes into bankruptcy, distressed debt investors can get ownership or control of the troubled company through negotiation.
- It is one of the high risks, thus high reward deal, as we all know, “higher the risks, higher the rewards.”
- The distressed debt fund market is very unpredictable in nature; it needs an experienced investor with access to diverse risk management techniques to enter into this market.
- High competition between firms leads to difficulties in negotiation at the time of the bankruptcy of the company.
- A lot of research and analysis is required before investing in these kinds of funds; therefore, it is not optimal for an individual investor.
- The risk associated with this type of investmentType Of InvestmentStocks, bonds, and cash equivalents are the three main forms of investments. Investment, in general, refers to the purchase of anything for future use with the goal of generating a regular cash flow or increasing the value of something over time so that it can be sold for a higher price than it was purchased for, i.e. capital gains. is enormously high.
- Investors should consider their risk appetite and access to risk management strategies.
- Research and analysis of the company whose distressed fund investors are going to buy to know if the company would be able to come out of a financial difficulty or not.
- Capability to realize benefit out of every investment opportunity which will come in the way while investing in distressed debt funds.
- Analysis of the riskAnalysis Of The RiskRisk analysis refers to the process of identifying, measuring, and mitigating the uncertainties involved in a project, investment, or business. There are two types of risk analysis - quantitative and qualitative risk analysis. involved with the investment in the troubled company.
This has been a guide to What is Distressed Debt & its Definition. Here we discuss the features of distressed debt, examples, and how it works along with types, advantages, and disadvantages. You can learn more about from the following articles –