To many, distressed investing sounds a lot more complicated than it actually is. Given there are not any great resources online on distressed debt investing, I figured I’d write a basic overview based on my experience investing in distressed debt securities.

Most people break into the buyside via the traditional investment banking path where you are never taught much about how to analyze debt. Even if you join a traditional private equity firm / hedge fund, investment banking does not prepare you at all to be a good investor.

I had absolutely no idea what I was doing when I first broke into the buyside. I am still learning to this day. It takes time to realize what works, what doesn’t and how to consistently make money. Early into your investing career, you need to fail/be wrong over and over again to be able to understand what makes a good investment. Best thing you can do is find a good fund that has a consistent track record that you can learn from.

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What is distressed debt investing?                    

Simply put, distressed investing is an investment style that focuses on investing in companies that seem to be falling apart. This may sound counterintuitive as you may ask why would anyone want to focus on businesses that aren’t doing so well?

On one side of the investing spectrum, you want to focus on the best businesses that are the largest/category winner in the industry and are growing at a rapid clip. These are the businesses that trade at high valuations (the Amazon’s, Facebook’s, Google’s of the world).

Distressed investing is at the complete opposite end of the spectrum. It is all about investing in businesses that people think are garbage businesses. Businesses where revenues and margins are declining. Businesses that are very hairy that nobody wants to touch. Businesses that have too much leverage and are likely going to declare Chapter 11 in the coming months or years.

The strategy behind distressed investing is buying something for 60-70% of what you think it is truly worth while making sure there is very little downside risk.

Example of a basic distressed investment

A good example is a mortgage on a house right after the 2008 financial crisis. Let’s say the borrower has $500K of debt on a house that is now valued at $400K. This is a situation where the borrower is underwater, meaning the value of his house is less than the value of the mortgage. They stop paying their mortgage and now the bank is in a situation where they are forced to foreclose on the house or sell their mortgage claim to another bank / investor. This happened to a lot of people during the financial crisis due to large declines in housing prices.

The buyer in this situation won’t pay 100 cents on the dollar for the mortgage claim. Why would you pay $500K to get claims on a house that is only valued at $400K? A distressed investor would come in and pay ~$300K to get the claim, or 60% of the total debt outstanding. The bank sells the mortgage claim and now the distressed investor can foreclose and sell the house for $400K in the market, a 33% profit.

This is exactly what distressed investing is. Find situations where your downside is protected (AKA the claim to the house, a tangible asset) and the value of the investment is more than what you paid for it.

Different types of debt like securities

• Public Bonds – Bonds issued by public companies. These are usually unsecured (keep reading for the difference between secured and unsecured debt).
• Private Bonds (144a) – Bonds issued usually by private companies.
• Term Loans – Loans are similar to bonds, but are usually secured and issued by sponsor-backed (i.e. private equity) companies. Some public companies issue term loans as well, but not as much as private equity firms.
• Preferred stock – Hybrid between debt and stock, usually pays a large dividend.
• Convertible securities – Similar to bonds, but with an option to convert the debt into equity (through the issuance of new shares) if the stock price exceeds the conversion price.

Capital structure priority

The most important thing in distressed investing is know where your debt sits in the capital structure. Given many distressed companies need to go through bankruptcy, it is EXTREMELY important to know who is first in line to get paid. To determine this, you need to go through a company’s filings and read the legal language in the debt documents (i.e. indentures. credit agreements, security/guarantee agreements).

There is a big difference in risk when it comes to investing in secured debt versus unsecured debt. Secured debt simply means debt that has a lien against collateral. Think about a mortgage on a house. The mortgage is owned by a bank and the bank has the right to take that house away from you if you fail to pay the mortgage. The mortgage is essentially secured by the house, protecting the bank from massive losses if the borrower fails to pay back their loan.

Now there are different layers of secured debt. You could be first in line to get paid (1^st lien) or second in line to get paid (2^nd lien). Unsecured debt gets paid after everyone that has a secured claim gets paid in full.

Guarantor versus non guarantor

To determine who gets paid first and who has claims that are “pari passu” (where your claim is equal to others), you need to map out the capital structure and the subsidiaries of a company. This is an extremely important step in investing in distressed debt because it shows who is in line to get paid first.

Debt that sits at a subsidiary that does not have a guarantee from the parent has no claims to assets outside of that subsidiary. Debt that sits at just the parent and doesn’t have a guarantee from any of its subsidiaries only gets paid after the debt at the subsidiary gets paid first.

Easiest way to think of this is in terms of a liquidation. The subsidiaries get liquidated first, satisfy all the debt claims that sit at that subsidiary, then whatever value is remaining gets pushed upwards to the parent to satisfy any debt at the parent level.

How do you invest in distressed debt to begin with?

The average investor with a Fidelity or Robinhood account does not have the same level of access to investing in debt like institutions do. You may be able to invest in public debt issued by public companies, but most of these are usually not distressed securities.

To invest in distressed debt, you need to have accounts open with the large brokerage firms (GS/MS/BAML/JPM/Citi/etc.) where they connect buyers with sellers of distressed securities. Once you have accounts open with these institutions, you get trading prices sent to you for every piece of security that these firms buy and sell.

Sometimes given how illiquid parts of the debt markets are, it is hard to source “paper” for a lot of debt securities. For example, if there is less than $500MM of a debt issuance outstanding, it is hard to find sellers to get a big position. So even if you do the work and want to invest in a distressed security, buyers may have already scooped up all the supply. Sure, if you want to buy less than $25MM of a security, you should be able to find sellers overtime, but if you work at a larger institution, you will typically only look at larger debt issuances that are liquid.

Benefits of investing in distressed companies

Why would anyone want to focus on investing in companies that are falling apart? Well, here are a few characteristics of distressed companies that may make them very attractive investments:

• Extremely low valuations – Because nobody wants to touch them, they usually trade at very low multiples. The average private equity EBITDA multiple paid for a business these days is in the low teens (~12x EBITDA). Distressed companies usually trade for multiples that are in the single digits.
• Higher likelihood of mispricing – There is a higher probability that a business nobody wants to invest in trades at a price that understates the true value of the company.
• Less crowded – The entire market these days is concentrated in the big technology companies. Focusing on distressed names allows you to generate returns that aren’t correlated to the market (AKA generate more Alpha and less Beta)
• Intellectually more stimulating – Most equity investors don’t dive in that deep when trying to understand a company’s fundamentals. With distress, you need to understand what drives the business and the absolutely downside in case performance turns out worse than expected. Also, there is a legal aspect to distressed investing (i.e. creditor rights, seniority in the capital structure, collateral, bankruptcy process) that you are not exposed to in traditional equity investing.
• Higher on the capital stack, which means you’ll have priority over the equity to get paid back in full.

That said, distressed investing does not come without its risks. You need to know what you are doing or you risk losing tons of money investing in crappy companies.

Risks of investing in distressed companies

• Extremely illiquid – most investment funds (especially hedge funds that are exposed to quarterly redemptions from investors) stay away from stocks and other asset classes that are too illiquid. Most want to be able to trade and get in and out of a position if circumstances change. Debt in general is way less liquid than stocks. If you want to get out of a large position, it will take time (unless you focus solely on debt issued by larger companies)
• Highly volatile – Given the illiquid nature of distressed securities, market pricing can be highly volatile, especially when there is an absence of buyers. There could be one investor who wants to get out of their position quickly and cause the price to move substantially.
• High risk of permanent capital loss – this happens if you don’t know what you are doing. Good distressed investors always focus on what the downside is in the worst case scenario. Thinking this way will cause you to miss a ton of investing opportunities that may actually work out, but because these businesses are typically falling apart, you do not want to risk losing all or most of your money.
• Less information available – This is especially true for private securities where the company does not issue SEC filings. You will have a hard time finding research and being able to talk to management teams of companies if they are not public. Sure, you get access to the dataroom and financials if you are an investor in the debt, but the information is much more limited in most cases.

How is debt investing different than equity investing?

Despite what people may think, investing in debt is very similar to investing in equities. You focus on finding value where others do not see value. Figuring out a differentiated view based on your research that is not yet priced into the value of your debt at market.

How do you value a debt security?

Valuing a piece of debt is the same as valuing a company through the equity. You map out the capitalization of a company and determine the pieces of debt that have priority over others. Then you look at the valuation through that security that you are thinking about investing in.

For example, say you are looking at investing in the unsecured debt of a company that has $1Bn of first lien debt, $500MM of unsecured debt, generates $200MM of EBITDA and spends $50MM per year on Capex. The unsecured debt trades at 50 cents on the dollar.

The valuation through the unsecured at market is 6.3x EBITDA and 8.3X EBITDA-Capex. To determine whether or not this is the right valuation and if the unsecured at 50 cents on the dollar is mis-valued depends on your judgement.

What makes a good distressed debt investment?

If you know a little bit about value investing already, then you should know the basic difference between a good investment and a bad investment (read all the best investing books if you haven’t already). You want buy investments worth $1 for 65 cents.

Here are a few characteristics of potentially good distressed investments:

• Cyclical company operating at trough profit margins
• Over-levered but profitable businesses – companies take on too much debt at times and get way over their skis (most likely due to a lot of M&A)
• Good Co / Bad Co dynamic – bad part of the business is masking the performance / value in the good part of a business
• Turnaround – these can be tricky investments as you really have to believe that new management can turnaround a business

Why do companies file for bankruptcy?

The main reasons companies file for bankruptcy are as follows:

• Cyclicality (i.e. gaming/casinos, airliners, cruise ships, commodity-exposed): companies whose profit margins rise and fall depending on the macro cycle
• Too much leverage: companies that are inherently profitable before interest (EBITDA – Capex is positive) but have taken on too much debt so the interest burden is too high
• Unprofitable businesses: companies that can no longer generate any profit before interest
• Inability to refinance existing debt: debt that is maturing needs to be refinanced with new debt if a company doesn’t have cash on hand to pay off the debt

What happens in bankruptcy?

The purpose of bankruptcy is to come up with a go forward plan to put a company in the best position it can be in going forward. This involves a number of different steps including

1. Determining who the creditors of the company are
2. Separating the creditors into different classes (who is first and last in line to get paid)
3. Valuing the enterprise (what is the total value of the company)
4. Proposal of plans for reorganization (who gets what in terms of the economics in the company going forward)
5. Securing the votes and agreeing to a plan

Determining the value of the company in court is one of the most important parts of a bankruptcy process. It determines who gets paid in full, who gets their debt reinstated, who gets their debt converted to an equity claim and who gets bageled (i.e. the value of their claim becomes worthless). Equity and unsecured debt investors are most at risk of getting no value going forward.  

Most common misconception of bankruptcy

Bankruptcy has such a negative connotation associated with it. People believe that when a company goes bankrupt then that is the end for the company and its employees. In reality, most companies file bankruptcy simply because they have too much debt. They are still profitable before interest and just need to file in order to right size their capital structure to a level that the company can handle.

Employees are usually unaffected. Sure, there may be some layoffs and cost cuts that need to be made, but most employees are unaffected by a company that files for bankruptcy.

There are two types of bankruptcies: Chapter 11 and Chapter 7. Most bankruptcies are Chapter 11, which are just reorganizations where the company continues to exist going forward. If a company files Chapter 7, then that means the company and its assets get liquidated.

How are distressed funds structured differently than typical hedge funds?

The last thing you want to do is join a fund that invests in very illiquid debt securities, but has a fund structure that allows quarterly redemptions. Investing in distressed instruments can be very risky and usually requires you to have a long-term investment horizon. You do not want your fund to close down because they had to sell everything at fire sale prices if investors want to redeem their capital at the worst time possible (i.e. during a market downturn).

Ideally you want to join a longer duration fund that is structured more like a private equity fund. This allows you to invest over the long run and not worry about investing in illiquid instruments.

Best distressed debt firms

1. Baupost Group
2. Apollo
3. Oaktree Capital
4. Silver Point Capital
5. Aurelius Capital
6. Davidson Kepner
7. Fortress
8. Anchorage Capital
9. Beachpoint
10. GoldenTree Asset Management
11. Avenue Capital
12. Sculptor Capital (AKA Och-Ziff)
13. Appaloosa
14. Canyon Capital
15. Mudrick Capital
16. Bayside Capital
17. King Street Capital

If you are focusing on breaking into distressed investing, don’t worry if you can’t get a job at one of the firms above. There are many smaller successful distressed firms that manage $500MM to $2Bn. What matters is that you join a team that has a track record where you can learn how to invest successfully over time.

How to get a job at a distressed debt fund?

Getting a job in distressed is the same as getting a job anywhere else. Have a good background and show that you are interested in working in distressed. The best way to break into the field is to start your career in investment banking.

Read about how to get that job you love for more info.

Distressed investing salaries and bonuses

Pay is very similar to pay at private equity and hedge funds. If the fund is structured like a hedge fund, then pay is highly variable depending on the performance of the fund in a given year. If it is structured more like a private equity fund, then expect your bonus to be less variable year after year. More detail here:

• Hedge Fund Salaries and Bonuses
• Private Equity Salaries and Bonuses