Guide: 8 reasons why the girl next door is speaking to distressed debt managers
There are a number of factors that distinguish distressed debt from other assets classes. These are also reasons why distressed debt can offer better risk adjusted returns compared to traditional asset classes. This however should not be read as distressed debt being a low risk strategy, to contrary, it’s very high risk and yielding very high returns in hands of the right manager. Below, we list 8 reasons why distressed debt is able to offer these attractive return opportunities:
- Demand and supply: at the time when a company admits to having financial difficulties, the “par investors”, those expecting to get repaid in full at maturity, will look to cut their losses and sell in the market. Unless it is a slow and gradual processes, this results in an excess supply of debt for sale, compared with the number of potential buyers who understand a) the company b) the new information in enough detail in order to be value the debt and put a price to it. It may take anything from a day to weeks, before the market stabilises around the “fair value” given available information. For a distressed investor, who has done his work in advance or has been able to work fast, it offers an attractive entry point into a distressed situation.
- Liquidity premium: distressed debt, whether bonds, bank loans or trade claims, is highly illiquid, both in terms being able to acquire it as well as selling. Establishing large positions in particular situations can be extremely lengthy, equally it can be close to impossible to exit certain positions by simply selling in the market. This warrants a liquidity premium for the investor such instruments.
- Access to information: access to information is key to distressed investors, however not everyone has the experience and knowledge where to find such information. Here we refer to both information about the company itself, as well as the legal process the company faces following a filing for bankruptcy in a particular jurisdiction. This is an area where there is a significant difference between investing in Europe or the US. The US has a much more established and transparent bankruptcy process, whereas in Europe, each country has it owns rules and procedures, more importantly however a lot often depends on a particular administrator or judge ruling over a case (e.g. in France or Germany).
- No control premiums: unlike in equity markets, a distressed investor can take control of a company (by owning more that 50% of the equity following a restructuring) without paying a takeover premium and without disclosing its holdings prior to the restructuring discussions. Currently, in debt capital markets, there are no limitation or disclosure requirements as to how much debt any one investor can hold. This enables active control distressed investors to take over companies by buying majority positions in a company’s various debt instruments.
- Leverage: companies in distress are in most cases over leveraged and need to have their debt levels reduced. Following a restructuring, however you still end up with a company that is leveraged, just like an LBO would be. In a recession, getting leverage on a new investment would be either impossible or extremely costly, in distressed debt its already there.
- Binary outcomes: in illiquid markets, with misinformed players, binary outcome situations are not necessarily correctly priced according to their odds. As in points, 1. and 3. the opportunity lies in the fact that skilled distressed investors transacts, through banks and brokers, with “non-distressed experienced” counter parties. In this case distressed investors are better at assessing the odds of the various outcomes, which may only look binary to the inexperienced investor.
- Emotional attachment and regulation: this point covers a number of economically irrational decisions that are made by sellers of distressed debt. These include situations, where
- funds cannot hold defaulted debt in their portfolios due to rating restrictions
- banks do not want to sell their debt in order to delay taking a write-down
- a bank does not take equity in a restructured company, because that would result in having to consolidate the company or would simply result in the economics of the investment moving from one department (loans) to another (equity investments)
- Equity investors inject new capital into a company disregarding debt trading levels
- Negotiations: very difficult to quantify, yet this clearly has value, the option to negotiate your take in a restructuring. If a distressed debt investor is able to take advantage of a hold out position or negotiate better terms by taking consideration in form of equity as opposed to new debt, he may be able to achieve better returns for his investors.
Another feature of distressed debt worth mentioning is its relatively low correlation among its investments. The primary driver of returns is the actual process relating to company in question and less so the market. For example, the price of debt of company facing insolvency is more likely to be driven by whether a new facility is made available rather than a move in the credit or equity markets. This is backed up to some extent by research done by Eisdorfer at University of Connecticut in his paper “Are Financially Distressed Firms Priced Differently?” (http://ssrn.com/abstract=743684 ), showing that companies facing financial difficulties are more influenced by cashflow news rather than expected return news (and I would argue market movements relate to expect return news more than cashflow news!).
From historical data, it also appears that distressed debt as an asset class has relatively low correlation to more traditional asset classes. This however unfortunately works least when credit markets turn south and credit spreads widen. As seen in 2008 and 2009, the premium of distressed debt over high yield spreads lead to distressed debt being one of the worst performing hedge fund strategies in 2008.
Now you may ask, is it really that attractive? Well here is a chart companies various hedge fund strategies since 2001. Return vs volatility. Keep in mind these indices based on indices – so a lot diverisification which plays to the benefit of distressed!