What is distressed debt investing?

Distressed debt investing is the purchase (or sale) of equity or debt securities, bank debt, CDS, trade claims, options etc of companies under financial distress. Unfortunately there is no hard and fast rule to what the definition of financial distress really means. Especially if you ask the company you are interesting in investing in.

I will use bank debt investing as an example. You have par investors. These are investors that buy assets for their CLOs and Floating Rate Mutual Funds. You have stressed investors that buy pieces of paper trading in the 80s that the investor believes will probably not go into bankruptcy (and therefore you get current yield + capital appreciation). Then you have distressed investors which buy things lower than 80, many times significantly lower than 80 in the hope of either the company turning around or the company not turning around and filing (and hence getting the equity - this will be explained later).

I have my Bloomberg open right now. Let us go through some examples. I get a myriad of "runs" everyday (I know...it sounded bad when I typed it as well). These are from every broker or dealer on the Street. A dealer will generally make a market. For example: I just got a run from a major German Investment banking stating:

Washington Mutual Seniors 80-81 3x3 Subs 51-53 3x3

Effectively what this means is that the trader at this investment bank will buy 3 million worth of Washington Mutual Senior bonds at 80 or sell 3 million worth of Washington Mutual Senior bonds at 81. For the Subs, he will buy 3 million at 51 and sell you 3m at 53. Now you know how investment banks make a lot of money. The different between the bid and the ask is denoted as the spread.

The spread in distressed debt investing is PAINFUL to all non investment bank participants. Why? Let me give you another example.

Another investment bank is making a market of 25-40 on a particular distressed cable company right now. That means if you wanted to buy the paper, you'd have to pay 40, but if the desk wanted to buy the paper, he will only pay 25. That is an enormous spread. Now why does this occur? Well, a lot of times its the illiquidty risk. I.E. He needs to be compensated for taking on the ridiculous illiquidity of that paper. The other reason is he wants to make a lot of money.

The next player in the distressed debt investing arena are the brokers. What they do (because they have very little capital to work with) are work orders for distressed debt investors (in my case a distressed debt hedge fund). So let us say I want to sell a bond that I think is going down in the future but the dealers (the investment banks) are making too wide a market...or for that matter maybe they aren't making a market at all. So I goto XYZ Broker and say, "I want to sell 3 million ABC Bond at 85." He then goes out and drums up interest from his clients. If someone bites, then there is generally a dance. My broker will come back and say, "My guy will buy 2 from you at 83, no higher"...so you give in a little bit and say "How about 84?"...the broker goes to his guy who gives in because he really thinks this bond is worth 120. And then you sell your 2 million bonds at 83.75, the broker gets .25 of the action, all all parties are happy.

Ok, now that we got some of the basic trading terminology out of the way for distressed debt investing let's talk about why it is so popular. It really is just another form of Benjamin Graham value investing...(actually all investing is value investing...why would you ever pay more for something that you think is worth less?). I think ABC bond is worth substantially more than for what it is trading at today.

In future posts, I will look at individual case studies. I need to get my disclaimer up first =]

But for now, let us use a hypothetical example. Let's say I am involved in distressed debt investing. A company that I am looking at has 100M of EBITDA. EBITDA is Operating Earnings + Depreciation and Amortization - non recurring one time items. And let's say I think this company is worth 5x EBITDA, therefore I think that if the entire enterprise was sold, someone would pay somewhere around 500M. Now let's say that this company, we will call it Overlevered Co. has 2 billion dollars of debt. Therefore it is 20 times levered (2 billion of debt, 100M of EBITDA). This is WAY too levered. Most companies cannot survive with more than 5 or 6 times leverage (some can be as high as 9-10x levered, like the cell phone tower companies, and the reason this is possible is due to how much cash they generate relative to their EBITDA...again will be explained in a future post).

So Overlevered Co has 2 billion of debt. Let's say, for simplicity, it is all bonds. Let's also say that these bonds are trading at 10 cents on the dollars. Therefore you can buy all the bonds for 200M dollars. You do that because you think the company is worth 500M. The company files for bankruptcy, and now you effectively run the show. This would be a controll type of distressed debt investing. A passive type of distressed debt investing would be where you bought a small chunk of the debt and were along for the ride.

We will continue with our distressed debt investing example in the next post.