An Introduction to Distressed Debt and Credit Investing

Diversify Risk

Related Opportunities

A Historically Small but Growing Sector

Exponential momentum.

Distressed debt and credit is a rapidly growing sector of the private equity and hedge fund universe, having grown exponentially in the wake of the coronavirus pandemic to a $1 Trillion1 market in the U.S. alone. The sector is focused on investment opportunities that involve any credit instrument that is trading at a significant discount with a greater than average spread for its industry.

A substantial number of these opportunities represent securities that are in outright default and as a result, the investment takes the form of loans or bonds intended to aid companies facing significant challenges2. These distressed securities are, therefore “below investment grade” as the distressed organization is usually in or near bankruptcy3.

Investment Strategies

Distressed debt trading.

At its simplest, Distressed Debt Trading involves purchasing debt obligations which are trading at a distressed level in anticipation of reselling those securities over a relatively short period of time at a higher valuation, generating a trading profit. Funds employing this strategy are generally looking for investment opportunities in which they believe the debt obligations are mispriced and will rebound in value. The holding period on this type of investment is typically short and measured in weeks or even days, which makes this strategy the most liquid in the class.

While each strategy employed within the distressed space is distinct, many funds utilize a hybrid of strategies in some form of combination as the marketplace and opportunities dictate.

Distressed debt active / non-control.

Active/Non-control strategies are substantially different from trading strategies in that the goal for the fund manager is to accumulate significant positions in companies that are likely to go through, or are in, a bankruptcy restructuring process. The goal is to gain a position of influence in the bankruptcy negotiations with the possibility of maximizing returns. This is a generally complex procedure that necessitates a longer holding period as well as a larger, more concentrated position.

Distressed debt control.

In this strategy, a fund manager builds a controlling position in the fulcrum distressed security in a bankruptcy proceeding to effectively buy control of the target company. With this strategy, the distressed debt position is in many respects the start of a much longer process, as after the fund manager wins control of the target he would typically begin the process of maximizing profitability either through restructuring, merging, or liquidation.

Distressed credit restructuring / turnaround.

Distressed credit funds also buy suffering target companies utilizing equity, sometimes purchasing them before an expected bankruptcy and other times during the bankruptcy process. The goal is to gain control of companies that are under par value and then restructure them.

Both Private Equity and Hedge Funds compete within the distressed space. Many funds employ a hybrid approach to more effectively utilize multiple strategies and be more opportunistic in the marketplace4.

Why Distressed Credit?

Distressed investments are counter-cyclical to buyouts: an expanding credit bubble generally enables an expansion of buyout valuations; a recession tends to cause a drop-in borrower cash flow, and this leads to defaults on the mountain of debt. Distressed funds are positioned to buy debt, take the borrowers through a capital restructuring, and benefit from the eventual economic recovery. This should provide diversification throughout the portfolio5.

Acquiring debt or equity below par value creates a potential for greater returns. Investors in distressed debt can become major creditors in a company and could have significant influence during any liquidation process or reorganization that may take place. Investors in distressed credit potentially benefit from an increase in valuation above par after a restructuring and turnaround.

The promise of great reward comes with risk, especially given that the quality and volume of distressed debt opportunities is highly cyclical and that the window for outsized returns can be short. A useful way to understand the risks and return drivers of various investments can be to categorize their exposure to various base market exposures. Defining, measuring or scoring some these risk factors can improve an investor’s ability to properly judge the risk and potential return of different portfolios. Mercer’s model of factor exposures is shown below5:

Why Distressed Debt Now?

With interest rates sitting at historic lows, investors of all types have had to go further out on the risk spectrum in search for yield. This is evidenced by the expansion of the total pool of US high-yield corporate bonds, an asset class which has nearly doubled in size between 2007 and 2018. As high-yield corporate bonds are the types of bonds with the highest likelihood of defaulting, the increased size of this market has naturally also resulted in the increased market size of distressed assets.

Prior to the onset of COVID-19, there were already signs of the beginning of a distressed cycle. There were quantitative signals: The US Non-Financial corporate debt-to-GDP ratio was on a growth trajectory resembling those seen in the previous five recessions. And, due to a significant erosion in credit discipline, 37% of loan deals in 2019 had EBITDA adjustments compared to 8% in 2007. There were qualitative signals too, with rising Idiosyncratic risks that ranged from geopolitical (eg. US elections, EU disbanding, Middle East tensions, China trade war) to industry-specific (eg. technological innovations).

Considerations for Wealth Managers

When considering the role that distressed opportunities may represent for client portfolios, we believe wealth managers should balance the illiquidity premium and portfolio diversification opportunities presented by the asset class. Distressed strategies require an experienced and active hand to navigate effectively, and wealth managers should bear that in mind as they perform due diligence on the asset managers to which they are entrusting their client assets. The following characteristics may be helpful to keep in mind when assessing a distressed debt and credit fund:

  • Track record that demonstrates experience managing distressed debt and leveraged loans and confirms a deep understanding regarding how to navigate an issuer through the process of bankruptcy and associated restructurings;
  • Appreciation for the cyclical opportunities that can arise in the distressed sector and the liquidity to take advantage of those opportunities;
  • Intimate knowledge of the factors contributing to a specific issuer’s distressed condition as well as the issuer’s capital structure across all credit and loan facilities and corresponding opportunities;
  • Robust understanding of the industries, operational norms and competitive landscape of the issuers in the fund’s portfolio.