If the distressing asset is one you’re familiar with, you’ll also know the moat – and have an idea of the strength of the defence. That’s the world of distressed. It’s a complicated place, but it also offers plenty of opportunity to the opportunistic investor.
The textbook distressed-investing strategy entails buying debt at a fraction of its face value and hoping it recovers. Except that it’s more involved than that.
Thorough Due Diligence
With distressed debt, as with all investments, it is important for a potential investor to do thorough due diligence. While one tries to ferret out the company’s financial health, legal compliance, operations, management, and any other salient issue, it is even more important to look at material contracts that may obstruct the debtor from coming out of bankruptcy, including, for instance, licensing rights in technology – sales and distribution agreements; partners that own a large part of the business – in certain jurisdictions such as India and China, a minority shareholder can nevertheless veto business transactions; and then there are term sheets for financing with banks and customers.
In addition to the many items mentioned above, such as assessing the collaterals and contemplatingan exit strategy, and the strategy and investment thesis, one vital aspect of due diligence in the secondary market is valuation. Annual reports must also be scrutinised for the quality of the companies: are they growing? periodically) in order to understand the company and to bring order to whatinvestment. The most straightforward way of valuing distressed debtinstruments are assessed with trading multiples of comparable instruments.
Investors should think about not only a company’s standing at present but also its opportunities for extending its market share and its technical innovativeness, as well as its governance policies and its corporate social responsibility agenda. The findings of the research effort ought to be organised for decision-makers so they have at hand insights about what to do next. The approach should be multidisciplinary, with input from colleagues in finance, law, and operations, among other areas, a set of well-planned and actively monitored objectives, and an explicit framework for evaluation.
Creative Problem-Solving
Distressed equity investments offer the kind of challenging problem that truly excites risk practitioners. But finding them nevertheless requires ingenuity, creativity and perhaps even a little humility. Investors should approach this kind of problem with a curious and open mind, with the goal of collecting as much information and insight as possible regarding the investment opportunity and its context. Once they have done as much of that as possible, they can then try to ‘get out of their own way’ – through a long walk, yoga or meditation – so as to tap into more subconscious aspects of their thinking. Then they can selectively draw upon these resources to bring their best ideas to bear, and hopefully they’ll be able to offer a truly useful solution.
To give you an example, a troubled company might have intellectual property rights which are not reflected fully in their equity valuation, and a liquidation value analysis will help to highlight such attributes over the course of the process, while real estate ownership of public companies might be a second or even third row holding, and thus not that well valued due to market inefficiencies; yet, these assets can be monetised through sale-leaseback or ground floor development.
Assessing these can provide much-needed breathing space for a firm as it navigates stormy situations. This is why flexibility in thinking is critical when evaluating opportunities in distressed equity investments.
Expertise in Asset Valuation
Finally, distressed assets offer better opportunities to investors who are willing to do the work of investing and who’ve honed the ideal strategy. But investors contemplating such global leveraged investments should consider several factors, including proper due diligence and valuation.
Burton: A decent valuer can work with a cost approach and manipulate it, or tap into company data, but he’ll also still use his rolodex of industry contacts. If not enough market evidence, what about the sector trender? A bank can look at what’s happening in a particular business and guide itself to a value.
Further, distressed assets can have complicating factors such as time constraints for recovering assets or making sales – in liquidation, for instance, value depends on making customers happy, and dealing with tension between traders and receivers if they fail to pay back timely. A good valuer understands the nuances of this process and how it can alter value. All of this helps in finding hard-to-detect value in distressed assets.
Market Trends
Investments with underlying companies in distress can offer investors an exceptional chance to generate value if they are willing to accept the risk that goes along with it. However, sourcing these hidden gems takes a lot of time, work and patience.
In the case of real estate, it’s about having a view of the market and the possible trends and directions that may emerge. It also involves an appreciation of the impact of credit cycles on the distressed debt market, as well as cycles of defaults.
You should do a liquidation analysis that tells you what you might make back on your investment once you liquidate, so that you don’t waste money in investing something that has no chance of ever paying off.
Distressed equity investing is often more intellectually challenging – and more fun – than regular equity investing, as it favours taking positions in firms that appear to be imploding, rather than those boasting the biggest hopes or growth prospects (the Amazon’s, Facebook’s and Google’s of this world). You also have to be deep into the arcana of the bankruptcy process and the rights of creditors in order to have a clear understanding of how a business feels financially at this point in time – and to evaluate whether it will eventually be forced into bankruptcy.