In this distressed debt for private equity firms blog series post we explore whether debt trading prices of a portfolio company matters.
Do Distressed Debt Trading Prices Matter?
Should Private Equity firms view distressed debt trading prices of a portfolio company’s debt as being a reason for concern or just an external event that can be ignored for the moment?
Reasons to Ignore Prices
Hypothetically, the strongest argument for ignoring the current bond prices goes along the following lines:
- The Private Equity firm has the investment largely under control, and the bond price drop can be attributed to a misunderstood acquisition or other such event;
- In a relatively short time frame, the world will once again come to understand the financial strength of the investment;
- Any gain on bond retirements at a discount would be subject to taxes; and
- The likely cost of capital associated with the funds used to retire the debt would further mitigate any gains.
But in reality, would the foregoing points be well-researched or just part of a misplaced article of faith on the part of the Private Equity firm? In our experience, the latter is far more common than the former.
Reasons Not to Ignore Prices
While we are certainly not rabid advocates of the efficient market theories, we do note that informed investors are betting real money that the portfolio company is now a risky situation.
Similarly, rating agencies are more than fallible, but they generally are eventually more right than wrong with respect to corporate debt.
Faced with negative views from these corners, we believe that the Private Equity firm should take another look, even though it may not want to immediately abandon its a priori view that the portfolio company is in reasonably good shape.
What’s the Chance Your Portfolio Company Will Go Bankrupt?
According to research by Edward Altman, a distinguished finance professor at NYU, when a company is rated CCC or worse, it has a 60% probability of eventually going into bankruptcy or other serious form of default. Companies rated single-B have a 37% probability of eventual default.
Even if the Private Equity firm believes in its own investments, with statistics like Altman puts forth, it pays the Private Equity firm to re-examine its due diligence and assumptions.
If indeed there are reasons to be worried, it is far better for the Private Equity firm to take action sooner rather than later. Over the years, we have developed effective techniques to address the gamut of challenges and opportunities presented by outstanding distressed debt. In upcoming posts, we will illustrate how the Private Equity firm can use these techniques in a few specific hypothetical situations. Subscribe for updates and contact us if you’d like to have a conversation.