The field of alternative investments, which comprises any investments besides stocks, bonds, and cash, has grown in both size and accessibility in recent years. There are several types of alternative investments—including private equity, commodities, hedge funds, and collectibles—all of which are relatively illiquid, meaning they can’t be easily converted into cash and are unregulated by the United States Securities and Exchange Commission (SEC).
One type of alternative investment is debt investing, which, as the term implies, is a capital investment in the debt of an organization, government, or entity. There are two types of debt investing: private and distressed.
If you’re new to debt investing, understanding each type is important, as they require different skills, knowledge, and strategies.
Here’s a primer on distressed debt investing, its strategic considerations, and its potential risks and rewards.
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Distressed debt investing—also called distress debt investing, distressed investing, or distress investing—is the process of investing capital in the existing debt of a financially distressed company, government, or public entity.
A financially distressed company is one that has an unstable capital structure. This could mean the company’s debt load is too high or difficult to refinance, or the company can’t meet restrictions on its current debt covenants.
The three things distressed debt investors look for when assessing companies to invest in are:
- Financial distress
- A successful business model
- An in-demand product or service
As Matt Wilson, a portfolio manager at Oaktree Capital Management, says in the online course Alternative Investments, distressed debt investors look for “a good company with a bad balance sheet.”
When an otherwise successful company runs into problems with debt, a distressed debt investor can identify an opportunity and buy a portion of that debt with the goal of gaining a controlling position.
Distressed debt investors focus on gaining control in two situations:
- Restructuring of a distressed company: If a distressed debt investor owns a controlling share of a company’s debt, it can influence its restructuring process and emerge as an equity owner.
- Bankruptcy of a distressed company: In the case that a company can’t be restructured and must liquidate assets and pay stakeholders, debt holders are paid out before equity holders.
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Distressed Debt Investment Strategy
Unlike private equity investments, distressed debt investments are rarely made with a company’s owners or management in mind. If you’re investing in a financially distressed company’s debt, chances are you hope to replace the current management during restructuring or be paid out if the company declares bankruptcy. In either situation, investors likely have a negative—or even hostile—relationship with owners or management.
For that reason, it can be in the best interest of the investor to buy the company’s debt piece by piece over an extended period from other investors to avoid alerting the owners that they’re trying to gain a controlling share of debt. Due to this secrecy, research and due diligence is limited to public information only; for instance, the company’s public financial records. To further complicate the process, investors are typically unaware if other distressed debt investors are trying to gain a controlling share of the company’s debt. As such, distressed debt investing can be a tricky, unpredictable game.
Harvard Business School Professor Victoria Ivashina, one of the professors who teaches Alternative Investments, highlights the strategic nature of this investment type.
“Distress investing is an intricate game of strategy where investors try to anticipate and indirectly influence the company’s financial decisions,” she says in the course.
When investing in a company’s debt, you have choices to make based on the company’s capital structure and your goals. For instance, an example in Alternative Investments presents a company with a capital structure made up of term loans and bonds. As the investor, you can decide where to invest your capital. Term loans are contractually senior to bonds, meaning they’re to be paid out first in the case of bankruptcy. According to United States bankruptcy law, however, two-thirds of bondholders must agree to give loan holders equity. If you’re able to secure two-thirds of the company’s bonds, you can control the restructuring vote and gain equity, but you may not be paid out first.
As noted in the course, distressed debt investing is “a delicate and very sophisticated strategy game that no investor fully controls.” To gain an advantage, familiarize yourself with local bankruptcy laws and practice making decisions based on limited information in various capital structure scenarios.
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Benefits and Risks of Distressed Debt Investing
While distressed debt investments can be risky and difficult to execute, they can provide lucrative returns. Because of this high-risk, high-reward combination, distressed debt is often included as one small piece of a larger investment portfolio. This way, the portfolio is diverse enough to spread out risk.
Potential sources of risk in distressed debt investing include:
- Lack of access to financial information: If you’re aiming for secrecy, due diligence is limited to a company’s public records. This could lead to investment decisions based on an incomplete picture of a company’s finances.
- Potential competition with other investors: Other distressed debt investors may be slowly buying the company’s debt over time and beat you to the majority share or gain seniority. When the restructuring process is triggered, these other investors become what Ivashina calls “accidental partners” in Alternative Investments. In this position, they may have the ability to block your efforts.
- Future financial distress: Just because a company is restructured and you’ve gained an equity position doesn’t mean it’s guaranteed to do well financially in the future. This presents an added risk; even if your efforts pay off, the company could still fall into financial distress again.
Potential benefits of distressed debt investments include:
- Seeing high returns through restructuring: This is the goal of distressed debt investing and the best-case scenario. If you’ve correctly assessed an opportunity, strategically purchased a controlling share of debt, and the restructuring process has been triggered, you can influence the restructuring process and become an equity or debt holder in the revamped company, setting you up for a return on your initial investment down the line.
- Being paid out in the case of bankruptcy: If the company cannot be restructured and must instead liquidate assets and pay out stakeholders, debt holders are the first to be paid. While this isn’t the best-case scenario, you’ll still be paid out for your share, which you theoretically purchased when prices were low. In this case, your return on investment may not be astronomical, but it’s still a win for a distressed debt investor.
Honing Your Strategic Investment Skills
The alternative investments field is made up of a wide range of asset classes that require specific skills, knowledge, risk mitigation, and strategies. Distressed debt investing is no exception.
To gain a deeper understanding of distressed debt investing and other types of alternative investments—including private debt investing, private equity, hedge funds, and real estate—consider taking an online course, such as Alternative Investments.
Understanding the intricacies of each investment type and its potential risks and rewards can enable you to build diverse portfolios and make strategic investment decisions.
Are you interested in expanding your knowledge of alternative investments? Explore our five-week online course Alternative Investments and other finance and accounting courses. Do you want to build your financial fluency? Download our free Financial Terms Cheat Sheet.
