The ABCs Of Distressed Credit

Distressed credit, special situations, credit opportunities, workout, junk bonds…

It’s an asset class that goes by many different names, but isn’t a common component of many people’s portfolios.

But if you take a look into any major hedge fund, chances are they’ll have a dedicated distressed (or other name from above) fund within them.

What Is Distressed Investing?

At a high level, investing in distressed involves purchasing a company’s debt at a discount to par in the hopes that the company turns itself around. Essentially you’re paying £5 for something that was once worth £10 with the belief that one day it will be worth £8, £9 or even £10 again.

Investors look for companies that are in financial distress, but have a solid business case and have the potential to turn themselves around. As Matt Wilson, a portfolio manager at Oaktree Capital Management says, you’re looking for “a good company with a bad balance sheet.”

Distressed Investing Strategies

When investing in distressed debt an investor is typically looking for one of 3 outcomes:

A) The ‘pull to par’ trade
B) Investing ahead of a restructuring
C) Investing ahead of a bankruptcy

Let’s explore these 3 scenarios in more detail.

Pull To Par

The ‘pull to par’ trade is when an investor buys into a bond/loan below its par value (less than 100) with the belief that it’s undervalued by the market. This can happen for a variety of reasons, for example, airline bonds were trading at steep discounts in March 2020 with COVID fresh on the scene, even UK government bonds traded in the 40s (out of 100) earlier this year after Liz Truss and Kwasi Kwarteng’s mini budget.

Investors buy into these ‘discounted’ securities believing that they’re undervalued by the market and will eventually recover and ‘pull to par’. In fact, using the above example, if you’d bought UK government bonds (otherwise know as Gilts) at the low price of 42 on October 12th you’d be up approximately 49 percent in around 6 weeks! (measured to Nov 25th).

That would be an example of a short term ‘event driven’ strategy. Investors can also take a longer term approach and invest in a distressed company with the view that it will recover over the coming years and its debt will be repaid at face value. ‘Pull to par’ is generally considered a more passive investment strategy. Strategies B and C, however, take a more active approach.

Investing Ahead Of A Restructuring

First of all, what is a restructuring? A restructuring is when a company makes changes to its operational or capital structure, typically whilst under financial stress. In the most simple of cases, companies could extend the maturity of their bonds/loans to give themselves some breathing room.

For example, company X might have £500m of bonds due to mature in June 2023, but company X’s cashflow right now isn’t amazing. They may opt to push the maturity of these bonds to 2026 when they forecast their financial situation to be much stronger. Doing this, however, would require investor consent; so companies usually offer bondholders incentives to agree to the new terms, such as an increase in the coupon rate.

No two restructurings are created equal, and companies have a range of options available to them (and often pay hefty fees to investment banks/ legal firms to advise them). Companies could raise new debt to repay the old instruments, usually at a higher interest rate. In more complicated scenarios, companies can exchange their debt for different securities altogether such as equity or convertible debt, or perform multiple restructurings in quick succession (not recommended…)

Unfortunately if all else fails, we’re left with our third option…

Investing Ahead Of A Bankruptcy

Perhaps the most aggressive (and maybe frowned upon) distressed investment strategy is when an investor buys a company’s debt, knowing it can’t repay, with the intention of taking it through bankruptcy proceedings.

Otherwise known as ‘asset stripping’ or ‘vulture investing’, in this scenario an investor buys into a company’s debt at a discount with the belief they can make their money back through the company’s liquidation.

For example, an investor sees that Company X has £100m of bonds maturing in June 2023, but no means of repaying them. Let’s say these bonds are currently trading at a price of 60, and there’s no other debt senior to it in the capital structure (this is an important point, as senior debt gets paid out ahead of junior debt in the event of a liquidation).

So the investor can buy this £100m of debt for £60m market value. But they believe that the company’s assets (property, equipment, factories, vehicles, etc.) are worth £80m. They buy the debt for £60m, take the company through bankruptcy proceedings where all of its assets are sold, and end up with £80m net proceeds, turning a profit of £20m or 33%.

That’s a very simplified example, and in reality the process is much more complex. Assets are usually sold at steep discounts in the event of a bankruptcy and there are other factors to consider such as pension liabilities, creditors/suppliers who haven’t been paid etc.

It’s also important to note that the company as whole ceases to exist, potentially leading to hundreds if not thousands of job losses… So it’s not the most ethical of investment strategies.

How Can Individuals Invest In Distressed?

Right now, accessing distressed opportunities is borderline impossible for most individual investors. Minimum buy-ins for bond investments range from £100k–200k and for loans it’s £2 million…

Even if you have the capital required, understanding these types of investments can be difficult.

At Darksquare we aim to solve both these problems, listing carefully curated alternative investment offerings, without the high minimum investment requirements.

We’ll be pulling together a more detailed guide on distressed investing, as well as covering other areas such as forestry and renewables. Join our waitlist for early access.