Hedge Fund Strategies: Distressed Securities

A company facing bankruptcy may not sound like an attractive investment opportunity, but it can be for those who understand the dynamics of distressed securities.

Distressed securities are the capital structures of a particular company or government that is either in default, under bankruptcy protection, or heading in that direction.

Because of the risk of the organization going under, and being unable to fulfill all its financial obligations, distressed securities often trade at steep discounts and are attractive to investors looking for a bargain and willing to take the risk.

If a company doesn’t have enough assets to repay creditors, it may declare bankruptcy. In that case, the equity holders typically are left with nothing. So distressed securities hedge fund investors usually focus on buying the bank debt, trade claims and the bonds of a distressed company. In a bankruptcy, fixed income creditors and bondholders divvy-up the assets of the business, according to the seniority of their debt.

The success of a distressed securities hedge fund manager therefore lies in research and experience. A manager must uncover a situation that is not as dire as it appears to the marketplace. Or he may believe the company will survive or come out stronger after a Chapter 11 reorganization, or that the company’s value upon liquidation will cover his investment.

Some distressed debt hedge funds are known as “vulture funds.” These funds swoop down and snap up the debt of dying companies. Vulture funds are somewhat controversial and often disparaged by government officials. Yet they play an important role in buying up the debt of unhealthy companies, sometimes taking control and pressuring the company’s management to make necessary but difficult financial and restructuring decisions.

The challenge for someone holding a hedge fund job as a distressed securities fund manager is to buy assets for a price well below their intrinsic or market value. Managers must carefully analyze distressed companies to uncover accounting problems or hidden value. It requires in-depth information about a company and the market in which it operates, along with sophisticated legal and financial skills.

Next time we’ll look at how distressed securities hedge fund managers are able to pick up bonds and other securities at pennies on the dollar.

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