Although certain types of distressed securities investing may be considered for risk-diver-sification potential, some of its typical risks are not well captured by such measures as correlation and standard deviation, which are usually the guideposts in portfolio optimization. Investors look to distressed securities investing primarily for the possibility of high returns from security selection (exploiting mispricing), activism, and other factors.
Investment Characteristics
The market opportunity that distressed securities investing offers to some investors arises from the problems that corporate distress poses to other investors. Many investors are barred either by regulations or by their investment policy statements from any substantial holdings in below-investment-grade debt. These investors must sell debt that has crossed the threshold from investment grade to high yield (so-called fallen angels). Banks and trade creditors may prefer to convert their claims to cash rather than participate as creditors in a possibly long reorganization process. Failed leveraged buyouts have also been a source of distressed securities opportunities.139 The impetus of some investors to off-load distressed debt creates opportunities for bargain hunters.
Old equity claims may be wiped out in a reorganization, replaced by new shares issued to creditors, and sold to the public as the company emerges from reorganization. These shares may be shunned by investors and analysts, and thus be mispriced. Distressed securities may offer a fertile ground for experts in credit analysis, turnarounds, business valuation, and bankruptcy proceedings to earn returns based on their skill and experience.
A common theme in distressed securities investing is that it often demands access to specialist skills and deep experience in credit analysis and business valuation. Distressed companies are potentially near the end of their life as going concerns. The investor needs to assess not only potential outcomes for the company as a going concern but also the bare-bones liquidation value of the company. The investor needs to understand the sources of the company's problems, its core business, and its financing structure. A distressed securities fund's abilities in this regard are one element in due diligence.
For a private or institutional investor investing indirectly via a hedge fund or other vehicle, this type of investment inherits the liquidity characteristics specified in the structure of the vehicle. Discussion of the types of risk involved in distressed securities investing follows an overview of strategies in the next section.
Roles in the Portfolio
According to the 2005 Commonfund Benchmarks Study of U.S. educational endowments, overall allocation to distressed debt among the institutions surveyed was 5 percent for the year ended June 30, 2005.Investors, private and institutional, are making substantial allocations to this alternative investment and need to understand the ranges of distressed securities strategies available and their risk characteristics.
From the perspective of the direct investor in
distressed securities, there are a number of different strategies that may be adopted. As we discuss them, the reader should be aware that the hedge fund and private equity businesses and benchmark vendors use a variety of classifications and some differences in definition. The aim here is to convey the gist of what the various approaches involve.
Long-Only Value Investing The simplest approach involves investing in perceived undervalued distressed securities in the expectation that they will rise in value as other investors see the distressed company's prospects improve. When the distressed securities are public debt, this approach is high-yield investing. When the securities are orphan equities, this approach is orphan equities investing.
Distressed debt arbitrage (or distressed arbitrage)
involves purchasing the traded bonds of bankrupt companies and selling the common equity short. The hedge fund manager attempts to buy the debt at steep discounts. If the company's prospects worsen, the value of the company's debt and equity should decline, but the hedge fund manager hopes that the equity, in which the fund has a short position, will decline to a greater degree. Indeed, as a residual claim, the value of equity may be wiped out. If the company's prospects improve, the portfolio manager hopes that debt will appreciate at a higher rate than the equity because the initial benefits to a credit improvement accrue to bonds as the senior claim. Typically, the company will have already suspended any dividends, but debtholders will receive accrued interest. This approach has been popular with hedge funds.
