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Distressed Debt Investing
Resources to Help Investors Better Understand
Their Investment Options in this Asset Class
Manag...
Overview
2
Investing in distressed debt instruments provides certain asset managers
with an opportunity to deliver strong,...
Table of Contents
3
What is distressed debt? 4
How does investing in distressed debt work?
5
Who invests in distressed deb...
1 What is distressed debt?
4
Investing in “distressed debt” is a strategy in which an investor purchases
debt of a financi...
2
5
Distressed debt investing involves the buying of debt instruments issued
by a financially distressed or insolvent comp...
6
An investor typically buys the debt instruments at a discount from a
creditor or on the secondary market.
Creditors can ...
3
7
The majority of investors involved in distressed debt strategies are part of the
alternative investment industry.
Thes...
8
Distressed debt investors purchase claims throughout the capital structure,
including:
Distressed debt investors often b...
9
Distressed debt investors are characterized as either passive or active.
• Passive investors simply buy the debt instrum...
4
10
Distressed debt investors possess unique characteristics that allow them to
pursue this investment strategy, includin...
5 Distressed debt investor involvement
provides a balance of power during the
bankruptcy and restructuring process
11
When...
6 Distressed debt investor involvement is
associated with a more efficient
bankruptcy process
12
Distressed debt investors...
7
Distressed debt investor involvement is
associated with gains in equity value
and post-bankruptcy company
performance
13...
14
Recent bankruptcy cases further exemplify the positive relationship*
The primary reasons include:
• An increased rate o...
Resources
15
1. Jiang, W., Li, K. and Wang, W. “Hedge Funds and Chapter 11” The Journal of
Finance, 67: 513–560 (2012).
2....
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Distressed Debt Investing: Resources to Help Investors Better Understand Their Investment Options in this Asset Class

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"Distressed Debt Investing: Resources to Help Investors Better Understand Their Investment Options in this Asset Class" is aimed at helping investors better understand their investment options in the distressed debt space. The presentation gives an overview of distressed debt investment and the role these investors play in the bankruptcy process by creating liquidity in the credit markets, lowering the cost of lending, and helping companies that may be close to bankruptcy or in bankruptcy with additional capital.

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Transcript of "Distressed Debt Investing: Resources to Help Investors Better Understand Their Investment Options in this Asset Class"

  1. 1. Distressed Debt Investing Resources to Help Investors Better Understand Their Investment Options in this Asset Class Managed Funds Association | May 2014
  2. 2. Overview 2 Investing in distressed debt instruments provides certain asset managers with an opportunity to deliver strong, and often less-correlated returns for investors and play a constructive role in the corporate restructuring process. This presentation gives an overview of distressed debt investment and the important role these investors play in the bankruptcy process by creating liquidity in the credit markets, lowering the cost of lending, and helping companies that may be close to bankruptcy or in bankruptcy with additional capital.
  3. 3. Table of Contents 3 What is distressed debt? 4 How does investing in distressed debt work? 5 Who invests in distressed debt? 7 What differentiates distressed debt investors? 10 Distressed debt investor involvement provides a balance of power 11 during bankruptcy and restructuring Distressed debt investor involvement is associated with a more 12 efficient bankruptcy process Distressed debt investor involvement is associated with gains in 13 equity and post-bankruptcy company performance Resources 15 Slide:
  4. 4. 1 What is distressed debt? 4 Investing in “distressed debt” is a strategy in which an investor purchases debt of a financially distressed or insolvent company with the hopes of realizing a financial return. Distressed investments include public and private market debt, loans and bonds, vendor and trade claims. The term “distressed” refers to a material drop in price of the debt instruments due to an event such as a missed interest payment, the beginning of a company restructuring or the filing of bankruptcy petition, all of which suggest a lower probability of the company repaying its debts .
  5. 5. 2 5 Distressed debt investing involves the buying of debt instruments issued by a financially distressed or insolvent company from its early creditors and debt holders, or on the secondary market. Debt instruments purchased by an investor may include bonds, notes, claims, and loans. Once a financially distressed company enters bankruptcy, the actual bankruptcy claims may be traded as well, with the nature of each claim (such as seniority of the claim and the claim holder’s role within the bankruptcy process) determined by the type of underlying debt instrument creating the claim. How does investing in distressed debt work?
  6. 6. 6 An investor typically buys the debt instruments at a discount from a creditor or on the secondary market. Creditors can include: • Banks • Insurance companies • Mutual funds • Other bond holders The earlier creditors may have an incentive to sell their debt holdings because they may be either prohibited from investing in the securities of bankrupt companies, they do not have the capacity to deal with the often long and expensive process of bankruptcy, or they may wish to redeploy capital to more traditional opportunities. An example of a creditor’s motivation for selling debt holdings: An insurance company has bonds in 100 companies and one company has become distressed. The investment manager for the insurer may not want to commit the time, money, or resources on the bankruptcy proceedings for an investment that represents 1% of the portfolio and sells the debt instrument to a distressed debt investor at a discount. How does investing in distressed debt work? (continued)
  7. 7. 3 7 The majority of investors involved in distressed debt strategies are part of the alternative investment industry. These investors often work alongside the financially distressed company to execute a successful restructuring or bankruptcy proceeding. Recent empirical studies* have shown that when a hedge fund is involved as an investor in a bankruptcy proceeding or restructuring, there is a greater probability of a successful financial recovery with benefits to creditors, shareholders, and the company itself. *A sample of 474 bankruptcy cases from 1996 to 2007 shows hedge fund involvement in 90% of cases, with hedge funds representing half of all trading volume in distressed debt markets, one third of trading volume in leveraged loans and one quarter of trading volume in high-yield bonds between 2005 and 2006. Out of the 474 bankruptcy cases studied, hedge funds have been found to become post- bankruptcy shareholders in 28% of cases involving no bankruptcy financing and 34% of cases that include bankruptcy financing. Jiang, W., K. Li and W. Wang “Hedge Funds and Chapter 11” The Journal of Finance 67: 513–560 (2012): 513-514. Who invests in distressed debt?
  8. 8. 8 Distressed debt investors purchase claims throughout the capital structure, including: Distressed debt investors often become post-bankruptcy shareholders in the company as their debt is converted into equity in the company. • Senior bonds • Subordinated bonds • Secured/unsecured debt • Loans/vendor claims • Common stock • Preferred stock Who invests in distressed debt? (continued)
  9. 9. 9 Distressed debt investors are characterized as either passive or active. • Passive investors simply buy the debt instruments in the hope of realizing a return through price appreciation determined by the actions of others. • Active investors buy the debt instruments with the intent of participating in the restructuring or bankruptcy process, working directly with company management or other creditors to ensure a successful outcome. • Active investors may include those who do not seek control of the financially distressed company, and instead engage the financially distressed company as a member of the creditor’s committee or another role in the bankruptcy process. Often, such investors will provide debt financing to operate during the bankruptcy or inject equity capital in the company after it exits bankruptcy. • Active investors may also include those that seek control in the financially distressed company in order to have a greater impact on the restructuring or post-bankruptcy operations of the company. Active investors seeking control may retain a seat on the board of directors, replace management with investor personnel or even purchase the company outright after bankruptcy. Who invests in distressed debt? (continued)
  10. 10. 4 10 Distressed debt investors possess unique characteristics that allow them to pursue this investment strategy, including: • Capacity to purchase large positions in distressed debt and equity. • Ability to inject fresh capital. Because of flexible mandates these investors can convert debt to equity and inject fresh capital to recapitalize a distressed company. • Capacity to withstand length of time and the cost of restructuring or bankruptcy proceedings. • As a major class of investor, distressed debt funds provide a much needed source of liquidity for earlier creditors who do not have the capacity or expertise to engage in the bankruptcy process. • Many times, these investors become shareholders in the post-bankruptcy company and provide much needed financing to companies during the bankruptcy process. What differentiates distressed debt investors?
  11. 11. 5 Distressed debt investor involvement provides a balance of power during the bankruptcy and restructuring process 11 When distressed debt investors participate in the bankruptcy process, they typically have a high incentive to ensure the company has a successful emergence from bankruptcy because they will often own the post-bankruptcy equity of the company. Due to these investors’ combination of financial resources, capacity and expertise, they are able to balance the power between two sets of competing interests: 1. Creditors who may have a “liquidation bias” of having the distressed company sold so asset sales can be used to satisfy debt claims. 2. Executives of the distressed company, which often have an incentive to maintain the status quo and exit the bankruptcy process with minimal restructuring, oversight and replacement of executives.
  12. 12. 6 Distressed debt investor involvement is associated with a more efficient bankruptcy process 12 Distressed debt investors’ involvement during the bankruptcy process has been associated with both a higher degree of debt recovery (both secured and unsecured) as well as a positive impact on overall company value. There are several possible explanations for the positive effects of these investors during the bankruptcy process*: Overcome Liquidation Bias – they fight the desire to liquidate a distressed company, leading to a higher probability of emergence from bankruptcy and corresponding preservation of jobs, tax revenue and stakeholder interests. Provide Financing – since distressed debt investors often become shareholders in the post-bankruptcy company, they have a long-term incentive to ensure the financial stability of the company, and often provide much needed “debtor-in-possession” (DIP) financing and “exit” financing to the company during the bankruptcy process. *For empirical evidence on the positive impact of each of the trends above, see Jiang et al., “Hedge Funds and Chapter 11” The Journal of Finance 67: 513–560 (2012).
  13. 13. 7 Distressed debt investor involvement is associated with gains in equity value and post-bankruptcy company performance 13 In a 2012 study, a rise in the price of a distressed company’s stocks and bonds was documented as a result of the announcement of hedge funds’ involvement in a bankruptcy: “Hedge fund presence increases the likelihood of a successful reorganization … higher total debt (including secured and unsecured) recovery and a more positive stock market response at the time of a bankruptcy filing, suggesting a positive effect of hedge fund creditors on the firm’s total value.” * * Jiang, et al., “Hedge Funds and Chapter 11” The Journal of Finance, 67: 513–560 (2012).
  14. 14. 14 Recent bankruptcy cases further exemplify the positive relationship* The primary reasons include: • An increased rate of debt recovery for unsecured and junior claim holders (because distressed debt investors usually fall into this class of claim holders) • Relief of financial constraints (since these investors often offer DIP financing) • Higher probability of companies emerging from bankruptcy (because these investors are often post-bankruptcy shareholders, have an incentive for the long-term existence of the company) * Jiang et al., “Hedge Funds and Chapter 11” The Journal of Finance 67: 513–560 (2012). Distressed debt investors help with gains in equity value and post- bankruptcy company performance (continued)
  15. 15. Resources 15 1. Jiang, W., Li, K. and Wang, W. “Hedge Funds and Chapter 11” The Journal of Finance, 67: 513–560 (2012). 2. Harner, Michelle H. “The Corporate Governance and Public Policy Implications of Activist Distressed Debt Investing” Fordham Law Review 77.2 (2008).
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