Distressed Securities

Background:

1. What exactly is distressed securities investing?
2. What are the key risk factors and qualities required for investment success?
3. What investment performances can we anticipate?

Distressed Securities:

A distressed securities fund invests in the senior debt or equity of companies which are experiencing operating difficulties and/or liquidity crises. These securities typically trade at significant discounts to par value. A typical story unfolds as follows:

1. A small, fast-growing company obtains bank loans, secured by receivables and inventory, to finance further expansion.
2. Subsequently the company obtains additional financing to acquire other companies in related fields.
3. Business conditions later contract, interest rates rise, competition increases, and the now highly-leveraged company starts to lose money.
4. As losses mount, the company cannot even pay the loan interest.

At this point, banks are faced with holding non-performing loans and sitting-out bankruptcy proceedings, or selling the now 'distressed' loans at a significant discount. They will decide to take this second option, not wanting additional risks or the headaches of unfamiliar terrain. Now a distressed securities fund will enter the picture. Before investing, fund management will undertake a study to determine the risks and rewards. They will:

1. Analyse the fundamentals of the business.
2. Determine its operational strengths and weaknesses and potential for improvement.
3. Place valuations on the different company securities, debt and collateral and establish a likely time frame for their realisation following financial and operational restructuring.

Should risk/reward parameters meet management’s objectives; the fund will purchase the senior bank debt at a large discount. Some funds then adopt a passive stance, waiting for events to unfold. Others take an active approach, participating in creditor committees and even directing future reorganisation. Finally, following successful restructuring, profits are realised.

A company's fall into restructuring often makes the headlines, with the US government bail out of Chrysler in the 80's unforgettable for many. A more modest example would be the US motor parts company which was in bankruptcy protection due to a combination of excessive debt and unproductive plants. Following detailed analysis, the distressed securities fund developed a recovery plan, purchased the senior debt at sixty cents on the dollar, brought in turnaround artists and hired new skilled management. The debt was converted to new equity, and the eventually productive and financially unburdened company was sold to a larger competitor netting the fund a significant profit.

Risk Factors:

There are three broad risk scenarios:

1. Operating parameters and estimated realisable asset values can deteriorate.
2. Restructuring, both financial and operational, can take longer than anticipated.
3. Economic crises can temporarily reduce the values of distressed securities as investors seek 'safer' investments.

Success Factors:

Clearly distressed securities investing demands a very high level of quality, in-house research and investment experience. Additionally, most management teams utilise outside industry and legal experts to complement their research and restructuring efforts. The best also incorporate strong risk-management controls, with procedures including:

• Acquisition of senior debt of basically sound companies in financial or operational distress.
• Avoidance of leverage.
• Focus on readily-fixable operational problems as opposed to more subjective revenue enhancements.
• Maintenance of cash reserves when conditions turn negative.
• Diversification of investments by company, industry and region.

Future Returns:

Distressed securities investing is classified as ad event-driven" investment strategy, with returns being driven firstly by the identification of opportunity, and then successful completion of often complex restructurings. While economic crises temporarily hurt asset values, returns over full business cycles typically exceed those of equities and are accompanied by both low volatility and low market correlation