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Hedge Fund Monthly

Distressed Securities Strategies
Gary Cressman, Argo Capital Management

December 2003

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 securities

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 being assessed.

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 potential.

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 securities.

  • 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 levels.

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 markets.

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.

Final remarks

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.


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