Distressed Debt Defined
What is distressed debt?
Distressed debt is a symptom of an underlying financial crisis that could be fatal to an enterprise – or represent a great investment opportunity for the intrepid bond buyer. Characteristics of distressed corporate debt generally include relatively high credit spreads over Treasuries and credit ratings below B. Affected companies and industries will vary from cycle to cycle, but most of these companies share some common elements:
- Poor credit metrics, such as interest coverage and leverage.
- Debt prices meaningfully below par, which are “red flags” for investors.
- Precipitous drops in stockholder value.
- Difficulty in obtaining new financing.
- Creditor demands that are frequently at odds with preserving and enhancing stockholder value.
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How the companies found themselves in these financial straits vary. Traditional retailers may have been disinter-mediated by Amazon or other online retailers. Many oil and gas producers may not be viable at current energy price levels, and may have experienced adverse results and massive write-downs betting on exotic shale plays. For other companies, the cause may simply be generic bad luck or poor management decisions. Ninety-nine percent of these firms are not “too big to fail”, and unlike General Motors or large banks, will not benefit from government bailouts or rescue initiatives.
Instead, most US companies with distressed debt are subject to the often-brutal realities of capitalism and financial markets. And in this competitive framework, these companies will either find a way to succeed (or at least muddle through), or their assets will be marked to market and recycled in some manner. Companies can survive if operations turnaround or if the existing financial constituencies “agree” (perhaps through bankruptcy) to provide additional capital and to restructure obligations and ownership in line with existing operational performance. But if that doesn’t happen, the capital “recycling” can occur through merger market sales of all or a portion of the business – or through a going-out-of-business liquidation.
The Corporate Opportunity
Even in the face of adversity, many management teams can be opportunistic and view their company’s distressed debt prices as a chance to chip away at the company’s mountain of debt at a cheap price. But the merits of this strategy depend in large part on management’s primary goals.
Certainly, having the company buy high coupon debt at a big discount improves certain credit metrics and can indeed be an integral piece of an overall restructuring strategy. However, there are competing considerations, such as the following:
- Are there better corporate uses for the money? Distressed companies are frequently capital-short, and have more pressing and urgent needs than the repurchase of debt.
- Are management and the Board being realistic about the company’s ability to effect a turnaround? If such prospects are pie in the sky, then the repurchase may have been an ill-advised waste of precious resources.
- The benefits of such a distressed debt reduction are first enjoyed by the remaining creditors. The post-repurchase assets support a reduced capital stack, which can translate into increasing bond prices and ultimate creditor recoveries. Is this what the Board had in mind?
- On the other hand, if the Board had stockholder welfare as its first priority, a corporate distressed debt repurchase may not be the wisest choice. The “gift” to the non-selling bondholders may not trickle down to the stockholders. We have written about this topic extensively, and refer the reader to [Abyss 2nd Edition, one of the Appendices]. If the company’s primary constituency is the existing equity, then it’s a good rule of thumb that as little money as possible go out to creditors, unless there is an enforceable deal with such creditors.
As a counter-example, it may be far better for the stockholders themselves to take the distressed debt out at a discount. This is particularly true if the equity ownership (and Board control) is concentrated in the hands of private equity firms that have ample resources to make such commitments. Relative merits of this approach include the following:
- The company does not need to expend finite cash resources on debt repurchase, and can invest in operating initiatives. The Private Equity firm just needs to have liquidity and the belief that it is a good investment.
- Any value enhancement is enjoyed by the purchasing stockholders, as well as the remaining creditors.
- Assuming that the acquired debt’s value and voting power is not diminished in the stockholders’ hands (generally a surmountable issue), then the stockholders’ overall negotiation clout vis-à-vis the creditors may actually be enhanced.
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To be sure, there are a myriad of considerations in choosing the appropriate path, including tax issues, securities law constraints and fiduciary duties. Nevertheless, the company and/or its principal constituencies may significantly benefit from a well thought-through distressed debt repurchase strategy.
The Investor Opportunity
If there is a sexy angle to the distressed debt market, it has to be the image of a swashbuckling investor who identifies a hidden gem, with bonds trading well below restructured value. In this storyline, the investor loads up on the distressed bonds, spearheads a financial restructuring effort giving him a huge chunk of the new equity, and then orchestrates an operational restructuring in which a ton of value is unlocked. Sounds like an easy way to make a killing? It’s not.
But let’s assume that Mr. Swashbuckler does indeed find that hidden gem. He still needs to overcome the following:
- First, he needs to acquire a large position, and that takes a good bit of money. And it is one thing to buy a few bonds. It is quite another to buy a meaningful (and hopefully, controlling) position in the bonds without driving the target securities significantly up in price. Obviously, too high a purchase price wrecks the economics of the trade.
- If the distressed company (the debtor) acts on behalf of its stockholders, Mr. Swashbuckler will have to face the very real problem that the debtor is not likely to roll over for his wishes. Instead, if the debtor is represented by someone like my firm (Gordian Group, which does not represent bondholders and has zero problem in engaging in confrontational negotiations with them), Mr. Swashbuckler will face active opposition to his being able to have unfettered ability to capture the upside. He will likely have to share it with the existing stockholders.
- And both the debtor and the bondholders are likely to have to deal with the secured creditors that are senior to the bonds (most companies with bonds have such secured bank debt). In many cases, secured creditors control the debtor’s pursestrings and can take steps to curtail a restructuring process and force a quick sale of the assets in exchange for allowing the debtor to use cash. Such a quick sale can severely limit Mr. Swashbuckler’s upside.
Anecdotally, this game has been getting harder over the years. Due to a number of factors (including a greater percentage of secured debt senior to bonds), the unsecured bond recoveries have been declining from one distressed cycle to the next.
But if Mr. Swashbuckler does indeed run this financial restructuring gauntlet successfully, then he does have a path to a huge recovery. If he and the new Board can then successfully execute the operational restructuring plan.
Or Is Distressed Debt Fool’s Gold?
What bond price represents great value in a given situation? How do you know that you aren’t simply catching a falling knife – with subsequent trades occurring at prices much lower than what you bought at? What procedures do you have in place to make a decision to cut and run if the situation becomes worse than you thought it would be? What happens to your economics if the public equity markets or the merger market Is in disarray when the restructuring is actually consummated?
Distressed debt is called that for a reason. It is a risky instrument, and an ultimate realization depends upon a host of factors, most of which are out of your control. And at some level, the outcome is determined by a zero-sum game involving banks, bondholders and the stockholders.
These are just some of the questions that the debtor, prospective investors, or both face. And even if you turn out to be right at the end of the day, was the anticipated rate of return adequate to compensate for the very real risks involved?
We would be delighted to field questions and thoughts regarding any or all of these issues.