Introduction to Distressed Debt
Similar to all other aspects of finance and investing, distressed debt investing means higher risk and higher reward. Distressed debt is in itself a very unique asset class that falls under the jurisdiction of alternative asset managers – primarily hedge funds. Although debt markets are very large – far bigger than equity markets, distressed debt is a relatively small subset of the much larger pie.
The more sophisticated the legal frameworks and the deeper the capital markets, the more room there is for distressed debt to trade. In countries without developed capital markets, lending is generally done by banks and they deal with issuers that end up running into trouble and defaulting.
In the US, where ample financing options exist for borrowers, distressed debt is commonplace when overlevered companies that raise money via junk bonds or institutional term loans find that they can no longer service the debt.
When does debt become sufficiently impaired to be classified as “distressed?” There is no hard and fast rule, but when debt service (paying interest or principal) becomes difficult and refinancing options are limited, there is reason to believe that debtholders can expect to take a haircut on their investment. They will not be paid in full.
Distressed Debt Investor Universe
Once debt is mispriced, there is no room for investment bankers to make money (except for the restructuring bankers). As there is no more equity to issue, equity research stops being published and given the high risk nature of the security, this becomes the playground of primarily hedge funds that represent institutions and high net worth clients who are accredited investors and otherwise very knowledgeable players who have experience around bankruptcy.
No financial advisor at the local bank can advise on distressed debt because there are far too many intricacies that they cannot understand or market.
As distressed debt is illiquid and not widely covered, a lot of research must be done and a lot of assumptions must be made to make an informed investment decision. A distressed debt investor must have a very good understanding of the priority of claims, the feasibility of a turnaround and expected recovery scenarios after a restructuring. Binding credit agreements and knowing how to apply the law is important. As such, many distressed debt investors are ex-lawyers, often paired with an MBA from Columbia or Harvard.
Because the expertise is thin in this field and the number of professionals small, the probability that distressed debt is mispriced is high – allowing for incredible returns for investors such as Oaktree or Apollo or Goldman Sachs Special Situations.
Distressed debt can be active (think private equity or an activist hedge fund) or passive investing (think a mutual fund). Some investors have a view on how the business environment will turn and the likelihood of a restructuring. When an event happens and the debt is re-priced, they sell whether they were right or wrong. Some active investors will hire restructuring advisors and push for certain outcomes in court. Sometimes they have a turnaround in mind with themselves or a third party as an operator and will look to convert to equity in a loan-to-own strategy.
Identifying Distressed Securities
Similar to how a very high dividend is not a great purchase but instead the market pricing in a dividend cut because the company cannot sustain the dividend, debt with extremely high yields (above 10%) mean that there are uncertainties about the ability of the debt issuer to service the debt and continuing as a going concern.
Penny stocks (especially after doing reverse share splits several times) and a very low market capitalization compared to the face value of debt is another telltale sign.
Rating agencies will rerate the debt, but they are generally backwards looking – so a B2 stable rated security by Moody’s may already be priced at 60 cents on the dollar if the market perceives there to be difficulties with liquidity coming up.
Looking at Distressed Bond Prices
What is distressed and not distressed? Just because a bond is trading below par or less than 100 cents on the dollar does not mean the value is impaired. This is because prices move relative to the yield offered by comparable securities with similar risk and the risk-free government rate (although the more leveraged the name, the less sensitive it is to interest rate fluctuations whereas investment grade bonds will track underlying treasuries more closely).
A good rule of thumb is bonds trading at 75 cents on the dollar means that distress is certainly priced in.
Recovery Value and Option Value for Distressed Corporates
Usually when it becomes probable that the financial situation of an issuer is deteriorating, investors start to think about what a restructured company would look like. As in what the company would look like with an appropriate capital structure – the current one being inappropriate owing to the excessive debt.
As such there will be views on what an appropriate value for the company is under a normal scenario – for instance the average tractor company in a comparable peer set trades at 5x EV/EBITDA with 3x Debt/EBITDA. Currently, the total debt is at an 8x multiple of EBITDA (although this may not be a “normalized” EBITDA owing to the problems caused by financial distress).
This means that only 3x EBITDA can remain in the form of debt. Depending on whether the company is sold or simply restructured, at least 3 turns of EBITDA in face value of debt and equity will be “lost”.
So in a simplified example, let us consider two options. One is an outright sale of the company.
If the company retains an investment banker and sells at 5x EBITDA, the cash proceeds can pay off an amount equal to 5x EBITDA and the rest of the debt is written off. So the recovery ends up being 5/8 or 62.5 cents on the dollar. If this is the view of a distressed debt investor and the debt is currently priced at 30 cents on the dollar, this is a good purchase.
If there are no buyers and the prospective investor is willing to hold equity instead, the debt could be haircut down to 3x EBITDA and the rest of the debt is converted to equity while the existing equityholders are wiped out.
Equity value will reflect option value versus intrinsic value. When looking at the market capitalization of a distressed company, this reflects the optionality of an unexpected turnaround. So for example, if there is a 15% chance that an airline will turn around or a buyer will surface and pay above the market value, there are investors that may be willing to pay for this equity.
A more likely scenario is a resource company such as a miner. If there is a large spike in the underlying silver price due to a supply shock, cash flow will adequately meet debt service and allow for quick deleveraging. For out of the money securities in a more advanced capital structure such as preferred shares or subordinated debt, if senior debt is already impaired they will likely also trade at option value versus intrinsic value (which is zero).