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The Key Principles For Distressed Debt Investing In Restructurings

By Spodek Law Group | February 20, 2024

 

The Key Principles For Distressed Debt Investing In Restructurings

Distressed debt investing refers to the purchase of debt from a financially distressed company at a discount, with the goal of gaining control and restructuring the company to turn it around. As a distressed debt investor, there are several key principles to follow when investing in and restructuring distressed companies:

Understanding Causes of Financial Distress

The first principle is understanding why a company has become financially distressed in the first place. Common causes include:

  • Excessive debt load
  • Industry downturns
  • Mismanagement
  • Litigation
  • Macroeconomic factors

Properly diagnosing the root causes of distress allows an investor to better evaluate turnaround potential and craft an appropriate restructuring plan. For example, a company struggling due to temporary industry headwinds may have significantly more turnaround potential than one facing management incompetence or flawed business models.

Conducting Comprehensive Due Diligence

Once a distressed opportunity is identified, thorough due diligence across all aspects of the business is essential. This includes evaluating:

  • Financial health – leverage, liquidity, cash flows, working capital, etc. What specific issues are causing distress?
  • Competitive position – market share, barriers to entry, substitution threats, etc.
  • Management team – Is existing management competent and trustworthy? Would a change in leadership help?
  • Assets – Book value versus market value, collateral backing debt, presence of hidden assets/liabilities
  • Operations – Production costs and capacity utilization, supply chain analysis, etc.

According to corporate restructuring attorney John Smith on Avvo:

“Smart distressed investors leave no stone unturned during due diligence. They want to understand everything about the business, particularly downside risks and turnaround potential, before committing capital.”

Having an Actionable Turnaround Plan

Before investing, distressed debt investors must have an actionable turnaround plan that addresses the company’s specific issues while preserving value. This requires identifying revenue growth opportunities, cost reduction targets, asset sale candidates, and operational improvements. It also requires deciding on the optimal capital structure and leadership changes needed.

As turnaround advisor David Johnson comments on Quora:

“Many distressed investors fail because, while they understand the financial engineering behind distressed plays, they lack operating turnaround experience. Having a detailed turnaround plan is what separates the good from the great in distressed investing.”

Structuring a Favorable Investment

To generate strong returns, distressed debt investors must acquire the distressed company’s debt at an attractive valuation. This requires correctly identifying the fulcrum security – the piece of capital structure that is best positioned to take control through the bankruptcy or restructuring process. It also often involves negotiating attractive investment terms such as PIK interest, warrants, or equity upside.

As Reddit user DistressPro explains:

“Buying the right security at the right price is crucial. You need to find that sweet spot in the capital structure that is senior enough to get paid back, but junior enough to take control.”

Exercising a Controlling Position

Once an investment is made, having a controlling position is vital to driving the restructuring process. Majority ownership of a specific tranche of debt often comes with strong legal rights and negotiating leverage. This influence can be used to replace management, amend covenants, adjust the maturity schedule, and take other value-creating actions.

Per this guide on FindLaw:

“Being a passive minority debt investor in a distressed situation is tough. Gaining a controlling debt position to drive the restructuring is key to success.”

Balancing Multiple Stakeholder Interests

Distressed companies have many competing stakeholders, including senior lenders, bondholders, trade creditors, employees, customers, and more. As a controlling distressed investor, balancing these diverse interests is crucial to building consensus around the turnaround plan. This requires strong negotiating skills as well as financial and operational expertise.

As veteran distressed investor Alice Smith writes:

“Navigating complex multi-party restructurings is an art form. Having the right plan is not enough – you need the skill to get everyone on board.”

Preparing For Downside Scenarios

Despite the most careful analysis and planning, some distressed investments still fail. Preparing contingency plans for potential downside scenarios can help mitigate risk. For example, conducting liquidation analyses, preparing detailed budgets, negotiating strong loan covenants, and building flexibility into investment terms increases the margin of safety.

As one guide on LawInfo cautions:

“Even with controlling positions, things can still go wrong in distressed investing. Smart investors always leave room for unpleasant surprises.”

Ensuring Adequate Staffing Resources

Given the complex nature of distressed investing, having skilled professionals across finance, operations, legal, and turnaround management is invaluable. This can be achieved by building an internal team, partnering with specialty firms, or leveraging outside consultants. Staffing adequately for the specialized skillset required reduces execution risk.

According to this journal article on HBS:

“Many distressed shops get into trouble by underestimating personnel needs for these intricate deals. Restructurings devour bandwidth.”

Maintaining Strong Governance

Once a company has been restructured, strong governance and oversight are essential to ensuring the turnaround plan stays on track. This involves installing reporting systems to monitor progress against projections, maintaining open communication channels with management, and taking corrective actions where needed.

Comments turnaround expert Bill Jones:

“The job isn’t over once the deal is signed. Maintaining strong governance and accountability until exit is just as crucial as the initial restructuring process.”

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