Turning Company Carrion into Caviar

This story first appeared in the Spring 2017 issue of Middle Market Growth.

Since its advent in the late 1980s and early 90s, distressed debt investing has become a significant part of the alternative investment landscape. Some $15.7 billion was plowed into distressed notes in the United States in 2016. Distressed investors, known as “vultures” for targeting dying companies, often get a bad rap. In reality, they’re not unlike other investors—identifying mispriced market opportunities and placing sound bets.

Distressed investments often involve bankruptcy, making distressed investors easy fodder for the media. Yet, responsibility for the default lies with the officers of the borrowing companies and, to some extent, the original creditors. Generally, credit is extended in ways it shouldn’t be— either at too low a risk-adjusted rate, with too few covenants to protect creditors, or to financially unsound companies. When the market sees greater risk of default, the debt trades at a discount to par value—often at 50 cents on the dollar or below.

Enter the distressed investor. A sophisticated investor can perform fundamental credit analysis to determine any over- or undervaluation, as well as the likelihood the underlying company will perform well in the long run. Though typical, the borrowing company need not be in bankruptcy for a distressed opportunity to occur. But to be sure, distressed investors often enter an investment during or just prior to a bankruptcy proceeding.

The goal, of course, is to identify the fulcrum security, or the most senior note that will not be paid back in full, then negotiate a debt-to-equity conversion that makes sense for both borrower and creditor. Make no mistake, investors want to generate returns, but ideally incentives are aligned in ways that benefit all parties. Through restructurings, companies that are fundamentally sound but have overly
burdensome capital structures can shed some of their debt and focus on investing in their core business, while also servicing creditors.

The most opportune times for distressed investors come at the end of a credit cycle or the beginning of a new one, when loans have been over-extended and companies are overleveraged. Recent fundraising numbers show that investors have been preparing for such a downturn; $16.8 billion was raised in distressed debt vehicles in 2016, up nearly 40% from 2015.

When I first decided to create PitchBook in 2007, I had no idea we were about to fall into the worst recession since the Great Depression. I suspect the newest downturn in the credit cycle will arrive in a similar fashion—when we least expect it. In the meantime, distressed investment will continue to make up a small but integral part of the private equity marketplace.

There are always certain sectors, companies, or regions in distress. Creditors and borrowers get greedy, bankruptcies are filed, and distressed investors then pick out the most salvageable pieces, while hopefully helping a few companies return to solvency while they’re at it.