Distressed investors play a significant role in corporate restructurings; they acquire control of the distressed firm’s assets by investing in its debt prior to the restructuring event. The authors highlight the importance of distressed investors providing liquidity and explain the complexities of their process.
Distressed investors gain control of a distressed firm’s assets by investing in a debt tranche in the firm, which will usually be transformed into equity in the event of default. The process involves valuing the firm’s assets, arriving at the post-restructuring sustainable capital structure in view of the current position, and finally, executing the plan through implementation of the new capital structure. The authors highlight the complexities of the process, including potential valuation issues, negotiations with creditors and prior investors, and reorganization of the business, if required.
How Is This Research Useful to Practitioners?
This research is highly relevant for private equity investors and practitioners involved in vulture investing as well as mergers and acquisitions. The authors discuss the important role distressed investors play in providing liquidity for firms on the verge of bankruptcy or for corporate restructuring. The high-return potential on such deals is justified by the substantial risk carried by the distressed investor, who has to manage a large number of stakeholders with varied interests.
The key to success for distressed investors is proper valuation and implementation of an appropriate post-restructuring capital structure that will ensure the firm’s viability. It is in the interest of initial investors and creditors/lenders of the distressed firm to negotiate the best price on their securities, especially if they expect a turnaround after the restructuring deal. Distressed investors’ interests lie in securing the highest discount possible, which will increase the chances of turnaround as well as investors’ profit potential. Thus, the situation calls for exhaustive negotiations from both ends. Distressed investors’ negotiating leverage arises from the likelihood that the outstanding securities will become worthless if the deal does not occur.
For many reasons, there are a limited number of distressed investors in any market. Properly assessing and valuing distressed firms requires specialized skill and knowledge. The high level of uncertainty regarding the future of the distressed firm requires a very high risk tolerance level and the ability to sustain a long holding period. Many potential investors may also be prohibited from investing in such securities by their mandates.
How Did the Authors Conduct This Research?
The authors’ goal is to explain the process by which distressed investors take control of a firm prior to bankruptcy or reorganization. Using a hypothetical case study that the authors constructed, the finding help explain how distressed investing works and how the various players might fare in this fictitious case, depending on the company’s fortunes. They cite different case studies as well as research and other articles on bankruptcy law. They conclude that in many cases, distressed firms enter the bankruptcy process under Chapter 11 but that bankruptcy does not materialize because alternatives are provided by distressed investors through the negotiation process. Therefore, there is a greater likelihood that initial stakeholders will obtain a better deal compared with what they would obtain from the winding-up process.
The incidence of bankruptcy has increased in recent times because of the 2007–09 financial crisis. A key point of the article is that this area requires specialized knowledge. Therefore, a high-net-worth individual who wants to participate must do so by investing in a limited partnership that buys distressed debt. For high-net-worth investors, there is opportunity in the revival of distressed firms, provided that they have the necessary vision, risk tolerance, and specialized skills to identify and execute the deal.