Distressed Debt Investing: Using Debt Instruments for Value Investing

There is more than one way to be a value investor.

The classic value investor is someone like Benjamin Graham, often heralded as the father of the craft, who seeks to invest in companies whose shares are trading at a discount to intrinsic value. Intrinsic value is just another way of referring to a company’s “true value”, or what it might be worth if the firm had to be sold off entirely.

Another type of value investor uses debt instruments rather than equity as the means of gaining exposure in the market. This type of investor is a distressed debt value investor and practices a distinct style of its own.

Distressed Debt Investing

Distressed debt investing is a type of value investing where instead of sourcing companies that are selling below intrinsic value, the investor instead searches for debt that is on sale for less than its intrinsic value. Put another way, it refers to debt that trades at a huge discount to par value. The broad rule of thumb when it comes to distressed debt investing is to purchase debt that trades for 80 cents on the dollar, or a 20% discount.

The reason discounts like these exist is because the company issuing the debt is under financial duress, is at risk of going under, and needs to sell to raise funds quickly. Because of this, distressed investors are more sensitive to the overall economic cycle, as distressed companies tend to surface in larger numbers during economic downturns.

There is more than a hint of opportunism to distressed debt investing. Investors who use this approach are often sifting through companies that are undergoing special situations such as bankruptcy, debt restructurings, and reorganizations. It’s these special circumstances that open up opportunities for a savvy value investor, because not too many people can or want to fully understand the complexities of these scenarios.

Distressed debt investing has become quite popular over the last few decades, with up to $50-$70 billion being raised between 2008 and 2012 by funds focusing on this type of investment. Big funds can often become the largest creditor of a business once they snap up large swathes of distressed debt.

Basics of Distressed Debt Investing: What You Need to Know

Before you can dive into the world of distressed debt investing, there are a few things to know.

The Credit Cycle

The way the credit cycle ebbs and flows is a large determinant of when opportunities in distressed debt will arise. When the economy is improving, credit spreads typically tighten and this is one of the best times to be involved in distressed investing.

When the economy is losing steam, credit spreads tend to rise. During this time, corporate debt is growing faster than profits. Once the economy is in a full-out recession, when companies are defaulting and crisis is at a head, investors can use this opportunity to build up exposure in credit markets. It is this behavior which led to distressed investing be referred to as “vulture investing.”

Debt Seniority

There’s an inherent problem with investing in distressed companies; they are going through financial turmoil for a reason. If you are a distressed debt investor looking to pick up undervalued debt, then you need to understand how debt seniority works.

The company you are interested in has a problem. The claims on the enterprise, in the form of creditors, equity holders, etc., are larger than the value of the firm. If this weren’t true, then the company wouldn’t be in financial duress.

If the company is filing for bankruptcy and has to liquidate, then there’s a set order to who gets paid first. The order in which claimants are paid is known as debt seniority. Typically bond holders are paid first, and equity holders are paid last. There’s a range of claims in between, including preferred stock, which is a type of stock that is a hybrid instrument with both the characteristics of stocks and bonds. The entire claim has to be settled as well, so all bond holders are paid entirely, and then the company moves down the ladder.

Bankruptcy

Companies can file for Chapter 11 or Chapter 7 bankruptcy. A lot of public enterprises will file for Chapter 11 because it gives them a semblance of control over the proceedings. Under Chapter 7 the company is required to stop all operations, so it is not as attractive of an option.

A savvy value investor also knows to discount the value of debt if a company is going through restructuring in Chapter 11 or out of court. Typically if restructuring happens out of court, claimants can expect to receive 80 cents on the dollar. If restructuring occurs in court, then they usually earn just 51 cents on the dollar.

Reorganization

Some distressed debt investors specialize in investing in companies going through reorganization although it can be very complicated. Many bigger investment funds will shy away from investing in companies requiring complex restructurings, mainly due to uncertainty around whether they can seize a controlling position, elect the management they want, and control the entire process to give themselves the biggest edge possible.

There’s risk when it comes to investing in distressed debt. It comes primarily from the fact that the investor holds lower-grade securities and there’s a chance that the underlying investments do not recover. The other risk originates from the lack of control a typical investor experiences when companies go through bankruptcy proceedings. These types of events are beyond the supervision of the average investor, and he or she must invest with eyes fully open.