There is much more to distressed debt investing than bond ratings. While all distressed debt is rated as speculative, it has greater risk and potential reward than high-yield bonds.
Martin Fridson defined distressed debt as debt that has a yield over 1000 basis points above U.S. Treasuries with the same time to maturity. Distressed debt offers more potential for gain than typical high-yield bonds, but it also requires a different approach.
The Difficulties of Distressed Debt Investing
Distressed debt carries a higher risk of loss, and there are several significant barriers for ordinary investors. Obtaining and using accurate information is both more important and more difficult. It is crucial to exercise legal due diligence by verifying ownership and inspecting Uniform Commercial Code (UCC) filings.
The illiquidity of distressed debt is one of the reasons why it has a higher yield, but the lack of liquidity creates additional issues. Investors must do substantial research before entering positions to avoid costly early exits. Finally, distressed debt is usually sold in blocks of one million dollars or more. That puts it out of reach for most investors and makes diversification difficult even for many high-net-worth individuals.
The Role of Strategy
The market is small, so distressed debt market participants must develop strategies that account for the goals of other players. It is necessary to perform a capital structure analysis before any restructuring takes place and consider what the capital structure might look like after a restructuring.
Even when bankruptcy does not occur, market participants must include it in their strategies because the possibility influences the outcome of restructuring negotiations. In general, bankruptcy is an inherent part of distressed debt investing and requires contingency plans.
It will become increasingly difficult for the firm to maintain liquidity and continue operating after it has declared bankruptcy. Distressed assets will perform differently during bankruptcy, so it is vital to make the correct investments. Fixed assets, real estate, and short-term assets all require unique strategies.
Game Theory Analysis
Bankruptcy is only one of the possibilities that we must consider in a game theory analysis. There are frequently a few large creditors who determine the shape of a restructuring. At Ashton Global, we analyze the strategies of other market participants to make sure that our investors are part of winning coalitions on the top issues.
We focus on locating the fulcrum security that will be converted into equity during restructuring. That is critical because parties with equity after restructuring are often able to reorganize the company to their advantage.
The Role of Information
Access to information and using all available information are the keys to successful distressed debt investing. Crucially, this is not an open and perfectly competitive market with perfect information.
Banks and other large creditors often gain access to information that is not available to the public after signing confidentiality agreements. This situation creates an asymmetric information advantage with significant strategic implications.
We scour credit memorandums, the prospectus, and credit agreements to determine which securities offer the best claims to the firm’s assets. We also go through the footnotes of all offering documents and securities.
Distressed debt offers the highest potential return of any type of debt security. Using all the available information can turn the danger of bankruptcy into an opportunity to gain control of the company.
The relatively small size of the companies involved, the illiquidity of the assets, and the limited number of players make distressed debt like private equity. These inefficiencies in the distressed debt market create niche opportunities where Ashton Global can generate alpha.