Distressed securities are bonds, shares and other financial
claims on companies that are in, or about to enter or exit,
bankruptcy or other financial distress. Distressed securities
sell at discount prices and may offer substantial profit-making
potential to investors who have the ability to understand
and analyse them, with all the risks and values involved.
Such securities can be bank debt, publicly-held debt or equity,
or privately-held debt, including trade claims.
Distressed securities investment has become a "booming"
market in the last decade with more participants getting involved
as the market has increased in size and diversity. This market
is not new; distressed investors have long been around and
have been trading in instruments ranging from US railway bonds
and shares, to REITs or specific company situations. As company
defaults have soared in the last few years, the number of
opportunities in distressed investments has increased significantly.
The fundamental approach to assessing the value of distressed
Generally, distressed investments rely on fundamentals that
go beyond the asset-valuation approach of a company, extending
to the legal and structural issues in the environment where
a company operates.
Prices of its securities fall prior to a company experiencing
financial distress. A company running into difficulties will
have its securities traded at a large discount. In most cases,
private and institutional investors will sell the company's
securities at discount prices either because they are not
prepared to bear the risks involved in a future reorganisation/restructuring
or because the owners of these securities are constrained
to hold low investment credits in their portfolios. Often,
these securities become oversold. Distressed opportunities
arise from these situations. This is when distressed securities
investors capitalise on the knowledge, flexibility and patience
that creditors of a company do not have. In addition, banks
very often will prefer to sell non-performing loans or other
debt at a substantial discount to free up some cash to make
other investments. Distressed securities investors make an
investment return by holding positions through a restructuring
process believing that the security prices will approach fair
value once the restructuring is complete or, alternatively,
by taking a fundamental view that these securities are undervalued
compared with the actual or intrinsic value of the company
These securities are purchased by investors, subject to a
thorough assessment of the upside and the downside potential
of the situation. Generally speaking, investors will select
these distressed opportunities with an initial screening,
limiting the potential for an investment loss and assessing
the fair value of these securities to determine the upside
It is important to highlight the difference in passive or
active investment approaches that an investor can take when
buying distressed securities.
A passive investor will buy distressed securities and will
hold onto them until they appreciate, having - in most situations
- done a great deal of analytical work. This investment can
take a long-term approach by buying positions in undervalued
securities and waiting for the return to materialise. Alternatively,
an investor may have a shorter-term investment horizon in
situations where a restructuring process is moving along fairly
and rapidly, but where (presupposing a successful outcome
to the restructuring process) the securities do not yet reflect
the true value of the asset.
An active investor in distressed securities will get involved
and will try to influence the restructuring and the refinancing
process through active participation in a creditor committee.
Such an investor may take a "hands-on" approach
to ensure that the workout process is handled on a fair basis,
representing the interests of the creditors. In some cases,
an active investor can take the leading role in reorganising
the company, leading the creditors' committee and, very often,
getting involved in legal aspects of the situation. This approach
is more time-demanding and also requires a lot of analytical
work and legal expertise.
Even though one can have different approaches to value and
to getting involved in distressed investments, a systematic
view of the strategy can be summarised by four key factors:
- Knowledge of the fundamental earnings power of the underlying
assets of the distressed firm, and to be able to understand
whether a company is viable, with particular consideration
of the events that led to the fall in the price of the company's
- Understanding of the quality of management and its motivation,
as well as that of the company's owners during a restructuring/reorganisation,
so as to assess the willingness to implement a restructuring
and to repay the debt.
- Deployment of specialised legal and economic resources.
- Having the patience to wait out a long reorganisation/workout
process, which may in some cases take a few years.
The number of corporate defaults has increased in the last
few years, generating tremendous growth in distressed investments.
This is not only a valid statement about the US market after
2000, but is also a fair comment about other developed markets
in Europe and Asia, as well as emerging markets.
Distressed securities investments are part of event-driven
strategies, which concentrate on companies that are (or may
be) subject to restructurings, liquidations, bankruptcies
or other special situations. It is very important to specialists
in distressed assets to keep a good investment diversification
between companies, types of securities and sectors. Typically,
distressed funds will have low leverage and low volatility.
The benefits of diversification into distressed investments
are corroborated by the low correlation that distressed securities
have with other debt or equity investments. More often, company
specifics drive the prices of distressed securities. A successful
company restructuring leading to an increase in securities
prices from distressed levels has little or no relationship
to the macro scenario that drives equity and debt markets.
One should look at distressed investments on a micro level;
a "bottom-up" approach.
Investment in distressed securities in emerging markets
The significant growth of distressed investment in emerging
markets coincides with the post-crisis periods in Asia, Russia
and, more recently, Latin America. The Asian financial crisis
of 1997-1998, with currency devaluations impacting several
countries in the region, was the catalyst for an increase
in distressed securities investments in emerging markets.
The Russian crisis in 1998 reinforced the dynamics of distressed
investments. The investment cycle regarding distressed investments
in emerging markets has also been extended with the collapse
of Argentina in 2001, when the country defaulted on its external
debt and Latin American corporate defaults soared to record
Investors in distressed securities in emerging markets take
the same approach as that described above. However, a number
of other aspects should be considered when assessing opportunities
in different countries: the health of the banking system,
the bankruptcy laws, the supply and availability of domestic
credit, the situation regarding debt workouts and the macro
scenario for liability management, plus political factors
that may impact different sectors (including tariff-related
businesses) and liquidity factors in both domestic and international
One of the major drawbacks to investing in distressed securities
in emerging markets is the uncertain and sometimes fragile
legal framework in the countries involved. However, the rewards
can be substantial for investors with the right set of skills
and with experience in dealing in emerging markets.
The outlook should be bright for investment in distressed
securities as more participants get involved in this strategy
and demand a greater diversification from traditional asset
classes, and where the supply of distressed securities continues
to rise as more companies get into financial trouble. As long
as companies get into trouble and creditors continue to sell
securities at discounted prices (in many situations this is
forced by regulatory constraints that do not allow them to
hold low-credit-rated securities) distressed investors will
continue to make money and thrive as the opportunities arise.