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Why invest in distressed debt?

Monday June 10, 2019

Distressed debt occurs when a company – usually experiencing financial distress or approaching bankruptcy – sells of its debt at a significantly lower cost, usually because they are over-leveraged and simply have too much debt to continue operations. An investor might purchase bonds of this company at a hefty discount in the hope of making a profit if the company gets back on track (through restructuring, a merger or takeover or through some form of managerial intervention). If the company then becomes a viable firm, this debt will command a higher price.
 
So who invests in distressed debt?
 
Distressed debt can be very lucrative, but it’s not something that usually attracts an individual investor. While some investment companies invest in distressed debt through mutual funds or include it as part of their portfolio, this type of debt often forms part of larger hedge funds or institutional investment. In general, investors can gain access to distressed debt through the bond market, mutual and hedge funds or via the distressed company itself.
 
Why not buy equity instead of debt?
 
In most cases, distressed debt trades at a very low percentage of its par value. So, an investor might be able to buy a $500 bond for $200 as the borrower has a high risk of defaulting. But distressed debt investors would see the value of the debt increase significantly if there’s a turnaround. While shares could have zero value if the company goes bankrupt, debt retains some value. In addition, debt takes precedence over equity if the company goes bankrupt and is dissolved.
 
Would an investor gain ownership or control over a company?
 
Many companies fail simply because they have too much debt. When an investor purchases a company’s distressed debt, they often buy large enough quantities to allow them to negotiate some control of the overleveraged company. Distressed debt investors are often paid before shareholders, and even employees, when the court determines priority order of creditors if the company goes bankrupt or is dissolved. In some cases, creditors take ownership of the company, and can make significant profit if able to revive the company.
 
What are the risks?
 
There is a very high risk of a borrower defaulting on debt such as a government or corporate bond. In order to prevent this, most investors attempt to gauge the creditworthiness of a borrower. That’s why the debt from less creditworthy companies is usually cheaper and offers a higher rate of return. Advanced models and analytics allow more efficient analysis, while spreading out risk through diversification and partnering with other firms mitigate risk if one investment defaults.
 
How does SCORE help value and sell distressed debt?

SCORE was the first in the industry to handle the sales of distressed consumer debt for Canada’s Schedule A banks, and has successfully sold more than $7 billion in distressed debt. We help companies generate immediate income from your non-revenue producing asset to free up core capital. By transferring collections risk to another party, there is the potential to improve overall liquidation rates, provide greater certainty on return and ensure operational savings so our clients can focus on their core activities. After determining the objectives behind a sale and the composition of the sale portfolio, we assist clients in many aspects of completing a sale:

  • Performing portfolio valuations, business casing and assisting with corporate governance
  • Performing due diligence on potential buyers and service providers
  • Vetting accounts and data for sale
  • Creating a sales package and presenting a portfolio that includes bid files, portfolio segmentations, solicitation letters, liquidation curves, Q&A, etc
  • Creating frameworks for various deal structures such as warehouse/bulk, forward flow, back-end, etc
  • Creating purchase agreements and performing negotiations to finalize the sale
If you’d like to benefit from our distressed debt expertise, contact us today on 647.309.1803 to get the conversation started.  
 
Sources:
 
https://www.thebalance.com/distressed-debt-investing-and-how-it-works-4176037
https://www.investopedia.com/articles/bonds/08/distressed-debt-hedge-fund.asp 
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