Distressed Securities Investing: When Bad News is Good News

Last time we looked at what distressed securities hedge fund investing was all about, and the types of securities they buy. Now we’ll examine how these investors are able to pick up bonds and other fixed-income securities at bargain prices.

Bankruptcies often happen in waves. In the 1980s, the airline industry was suffering. In the 1990s, theater chains. In the early 2000’s, technology and telecom companies such as Global Crossing, WorldCom and Williams Communications filed for bankruptcy. Recently, of course, it has been major banks and other members of the financial industry.

When a company is in financial distress, the original holders of equity or bonds will often sell their stake, either out of fear of loss or because they are not allowed to hold securities that have fallen below investment grade in their credit rating. Banks often want to sell bad loans that are no longer paying interest in order to get them off their books so they can use the funds to make new loans. Plus, as Dion Friedland, Chairman, Magnum Funds points out, banks are not really in the business of trying to figure out how a reorganization process, which can take years, is going to shake out. Likewise, suppliers and other holders of trade claims just want to recoup a portion of their money and get back to the business of producing goods and services. So both groups are often willing to sell their bonds or trade claims at a steep discount. In recent years, hedge funds have become the biggest buyers of these distressed securities.

Friedland gives the example of when the clothing store Barney’s Inc. filed for Chapter 11 in early 1996. Many clothing designers chose to sell their trade claims and recoup a portion of their money, to cover their production costs. It didn’t matter that Barney’s was a solid company that had simply over-borrowed. Distressed securities investors who knew this and believed the company would emerge successfully out of bankruptcy purchased the claims for as little as 25 cents on the dollar. The price subsequently rose 50 percent in just a few months after a potential buyer for Barney’s stepped forward.

The goal of someone with a hedge fund job as a distressed securities investor therefore is to buy up large amounts of the bonds and bank debt of these distressed companies. The managers may then pressure the company to convert some of these bonds into equity for a major or controlling interest in the company.

A distressed securities hedge fund investor will conduct extensive research and calculations to determine if the purchase price of a security is below its potential value and perhaps even below its liquidation value. The key question is, how much would the claim on this debt be worth if the assets of the company were divided among the creditors? For example, if a company had $75 million in assets and $100 million in debt, its assets would fetch roughly 75 cents on the dollar, less expenses. The restructuring process can take years and is fraught with risk. But if the vulture investor gets it right, he can make a killing.

Hedge fund managers will often try to influence the process by helping the issuer restructures its debt, or implement a plan to turn around its operations. Some managers may even invest new capital in a distressed company to improve its potential for success.

Sometimes companies emerging from a Chapter 11 reorganization will issue new shares. This new equity is commonly referred to as “orphan equity.” Orphan equities are tainted by the financial distress of the issuing company, and thus are not researched and promoted by Wall Street investment banks and brokerages. The only people who are able to understand their intrinsic value are distressed securities hedge fund managers and other investment professionals who can adequately research the liquidation value of the company’s securities, trade claims, or bonds. However, orphan equities can be very profitable for professional investors when the investment community realizes that the company is on the rebound, and regains confidence in its shares once again.

Distressed securities hedge fund managers play an important role in buying up the debt of unhealthy companies. Furthermore, the returns from distressed securities investing often have little correlation with the broader bond and equity markets. Instead, they tend to move according to company or industry-specific events and are highly dependent on the skill of the individual hedge fund manager for returns that outperform the overall market.




Pearlman, Russell. Tough Guys. SmartMoney Magazine, March 1, 2003.


Magnum Funds  www.magnum.com

Greenwich Alternative Investments  www.greenwichai.com

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